Financial Statement Analysis

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Financial Statement Analysis

• Professor William F. OBrien, MBA, CPA

Winter 2001
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The 3 Ps

• Preparation
• Processing
• Presentation

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Reasons for Analysis

• Investment decisions
• Credit decisions
• Performance
• Valuation (investment)
• Legal liability amount (credit perf.)
• Going concern decisions (credit perf.)
• Unreasonable returns (performance)

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FSA Steps

• Identify the economic characteristics
• Identify the corporate strategies
• Understand the financial statements
• Assess the profitability and risk
• Value the particular firm

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Tools for Economic Analysis

• Value Chain Analysis
• Porters Five Forces
• Economic Attributes Framework

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Porters Five Forces

• Buyer Power
• Supplier Power
• Rivalry among Firms
• Threat of New Entrants
• Threat of Substitutes

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Economic Attributes Framework

• Demand
• price sensitivity
• demand growth
• cyclical demand
• seasonal demand
• Supply
• number of suppliers
• barriers to entry
• Manufacturing
• capital intensity
• process complexity
• Marketing
• marketing channel--corporate or consumer
• demand pull or demand creation
• Financing
• Nature of assets
• Asset risk
• Source of cash flow--internal or external

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Strategic Analysis Framework

• Nature of product or service
• Degree of Integration
• Degree of Geographical Diversification
• Degree of Industry Diversification

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Financial Statements

• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Footnotes
• Auditors Report
• Management Discussion and Analysis

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Income Statement Classification

• Operating income
• Other income and expense
• Income from continuing operations
• Income, gains losses from discontinued
  operations
• Extraordinary gains and losses
• Changes in accounting principles

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Comprehensive Income

• Net income plus or minus the changes in
  shareholders equity from other than net income
  or transactions with owners.

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Other F/S Considerations

• Quality of Earnings
• Statement of Cash Flows
• Auditors Report

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Tools of Profit and Risk Analysis

• Common Size Financial Statements
• Percentage Change Statements
• Comparative Analysis
• Critical Financial Ratios

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Risks of Comparative Analysis

• Timing
• GAAP Application
• Degree of Conservatism
• Management Attitude
• Size
• Geographic Diversification

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Critical Financial Ratios

• Profitability Ratios
• EPS
• ROCE
• Risk Ratios
• Current ratio
• CFO/Avg. Current Liabilities
• Debt/Equity

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Valuation

• Price-Earnings Ratio
• Market value to Book value Ratio

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Role of FSA in Capital Markets

• One View FSA has no impact
• The Other View
• FSA is a catalyst
• FSA identifies individual opportunities
• Equity markets are not perfectly eff.
• FSA cleanses F/S biases
• FSA has unique purpose itself

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Sources of Information

• Annual Report
• Form 10-K
• Form 10-Q
• Form 8-K
• Prospectus
• Form 20-F (foreign entity 10-K)

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Statement of Cash Flows

• FASB 95--1987
• Components
• Operating cash Operations and working capital
• Investing cash Non-current assets and
  investments
• Financing cash L/T debt, equity and dividends

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Businesses are like Fruit Trees
Fruit Operating Activities
Trunk Branches Investing Activities
Roots Financing Activities
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Net Income vs. Cash FlowIndirect Method

• Net Income
• /- Non-cash Items
• /- Changes in Operating Working Capital
• Cash Flow from Operations

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Indirect vs. Direct Method

• FASB prefers the direct method
• FASB requires net income to cash from operations
  reconciliation
• Components
• Cash from customers
• Cash from dividends
• Cash from interest income
• Other operating cash receipts
• Cash paid to suppliers
• Cash paid to employees
• Cash paid for taxes
• Cash paid for interest
• Other operating cash payments