CHAPTER ONE
INTRODUCTION TO FINANCIAL
STATEMENT ANALYSIS
▪ Explain business analysis and its relation to
financial statement analysis
▪ Describe component analyses that constitute
financial statement analysis
▪ Describe the purpose of each financial
statement
▪ Apply two basic financial statement analysis
techniques
What is financial statement
analysis?
Business Analysis
Business analysis is the evaluation of a
company’s prospects and risks for the
purpose of making business decisions.
Component Processes of
Business Analysis
Business
Environment &
Strategy Analysis
Accounting Financial Prospective
Analysis Analysis Analysis
Intrinsic Value
Financial Statement Analysis
Financial Prospective
Accounting
Analysis Analysis
Analysis
• Accounting analysis is a process of evaluating the
extent to which a company’s accounting reflects
economic reality.
• Financial analysis is the use of financial statements to
analyze a company’s financial position and
performance, and to assess future financial
performance.
• Prospective is the forecasting future payoffs
Business Activities
Planning
Investing Activities Financial
Activities Activities
Operating Activities
Revenues and expenses from providing
goods and services
Planning activities:
• Business plan
• Information on company objectives and
tactics, market demands, competitive
analysis, sales strategies (pricing,
promotion and distribution),
management performance and financial
projection.
• Differentiate business analysis from
financial statements analysis
Financing activities refer to
methods that companies use to
raise the money to pay for the
company’s needs.
Investing Activities
Investing activities refer to a
company’s acquisition and
maintenance of investment for
purposes of selling products and
providing services, and for the purpose
of investing excess cash.
• Operating assets vs. financial assets
Operating Activities
• Operating activities represent the carrying out
of the business plan given its financing and
investing activities.
• Operating activities involve at least five
possible components: research and
development, procurement, production,
marketing and administration.
Financial Statements Reflect
Business Activities
Balance Sheet
Income Statement
Statement of Shareholders’
Equity
Statement of Cash Flows
1-12
1-13
1-14
RE account in IS (in period year) different amount RE in balance sheet (accumulate years)
Links between financial statements
Adjust A
• Revenues and expenses
affect earnings and
Balance Sheet adjusted earnings are
reported in retained
earnings account on the
balance sheet.
• Cash transactions in the
Income Statement statement of cash flows
are summarized in the
cash balance on the
balance sheet.
• All revenue and expense
Statement of Cash Flows accounts affect one or
more balance sheet
accounts.
Additional Information
(Beyond Financial Statements)
▪ Annual Report
A comprehensive report on a company’s activities throughout the preceding year.
Annual reports are intended to give shareholders and other interested people
information about the company's activities and financial performance.
▪ Management Report
The purposes of this report are to reinforce:
- Senior management’s responsibilities for the company’s financial and internal control
system
- The shared roles of management, directors, and the auditor in preparing financial
statements.
▪ Auditor Report 4 types: unqualified, qualified, disclaimed
- An opinion on whether or not the company’s financial statements are prepared in
conformity with generally accepted accounting principles.
- A review of the auditor’s report to ascertain whether the company received an
unqualified opinion
Additional Information
(Beyond Financial Statements)
▪ Explanatory Notes
- Notes are a means of communicating additional information regarding items
included or excluded from the body of the statements.
- Explanatory notes include information on: Accounting Principles and methods
employed; detailed disclosures regarding individual financial statement items;
commitments and contingencies; business combinations, transactions with related
parties, legal proceedings, significant customers; stock options..
▪ Proxy Statements
A proxy statement contains information necessary for shareholders in voting on matters
for which the proxy is solicited. Proxy statements contain a wealth of information
regarding a company including
- The identity of shareholders owning 5% or more of outstanding shares
- The biographical information on the board of directors
- Compensation arrangements, employee benefit plans
▪ Prospectus
A prospectus is a disclosure document that describes a financial security for potential
buyers.
Analysis Tools
• Comparative financial statement analysis
• Common-size financial statement analysis
Comparative analysis
• Year-to-Year Change Analysis
• Index-Number Trend Analysis
Year-to-Year Change Analysis
Comparing financial
statements over relatively
short time periods – two to
three years – is usually
performed with analysis of
year-to-year changes in
individual accounts. It has
the advantage of presenting
changes in absolute dollar
amounts as well as in
percentages.
NI nearly unchanged, but sales increase 7.38%, the
cost (other expense) control, but they so small =>
should be ignored
Why do analysts usually
compute both changes in absolute
dollar amounts and percentages?
-
Index-Number Trend Analysis
The company’s cash balance at December
31, Year 1, is $12,000. Its cash balances at
December 31, Year 2 and Year 3, are
$18,000 and $9.000 respectively. Compute
index numbers for three years and make
comparison between them.
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒃𝒂𝒍𝒂𝒏𝒄𝒆
𝑰𝒏𝒅𝒆𝒙 𝒏𝒖𝒎𝒃𝒆𝒓 = 𝒙 𝟏𝟎𝟎
𝑩𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒃𝒂𝒍𝒂𝒏𝒄𝒆
. 100,150,75
Compare Y1, Y2: 1 - 75/100 = 50%
Operating expense increasing greater than Revenues => gap between rev and ex large => control the cost
COGS, sell and
administration cost
Comparative financial statement
analysis
▪ Review consecutive balance sheets,
income statements or statements of
cash flows from period to period.
▪ Direction, speed, & extent of a
trend
▪ Comparing trends in related items
▪ Horizontal analysis
Common-Size Analysis
goodwill quite bigger => MA, Receivable quite big => credit policies
NCL quite big => credit risk high
Treasury stock is high = outstanding: common stock - treasury => if we don't have data => we consider N0 of
treasury = N0 common stock
Common-Size Analysis
1. Sources of financing – including the
distribution of financing across current
liabilities, noncurrent liabilities, and
equity
2. Composition of assets – including
amounts for individual current and
noncurrent assets
*Common-size analysis of a balance sheet
is often extended to examine the accounts
that make up specific subgroups
Common-Size Analysis
increase (cost control)
decrease
Common-Size Analysis
• Understanding internal makeup of financial
statements
• Intercompany comparisons
• Failure to reflect the relative sizes of the
f
companies under analysis
• Time comparisons of a company’s common-
size statements