Overview of Financial Statement Analysis Chapter 1 Robinson, Munter, Grant

Learning Objectives Nature and purpose of Financial Analysis Accounting standards and processes underlying financial reports Role of professional financial analysts Grant, Munter & Robinson Chapter 1

Analysis for Decision Making Financial statement analysis is a tool for making complex investment and credit decisions. Specifically, it is used to: Evaluate historical performance Predict future cash flows Establish the value of an enterprise Evaluate management Grant, Munter & Robinson Chapter 1

Pricing Investments The price an investor is willing to pay depends on predicted future cash flows Future cash flows from extending credit Interest income Return of principal Future cash flows from equity investments Dividends Proceeds – attributable to value growth – from stock sale Grant, Munter & Robinson Chapter 1

Estimating cash flows requires Current and relevant information An evaluation of the firm’s profit and growth potential An assessment of the firm’s survival likelihood Grant, Munter & Robinson Chapter 1

Cash Flows and Prices Investors would like to pay an amount for an investment such that its annual future cash flows will provide a rate of return (r) greater than or equal to the return other potential uses of the money would provide. Grant, Munter & Robinson Chapter 1

Cash Flows and Prices In cases of identical payouts, return equals Grant, Munter & Robinson Chapter 1

Cash Flows and Prices Given a desired rate of return and an estimate of future cash flows, purchase price can be estimated as: Grant, Munter & Robinson Chapter 1

Evaluating Management Financial statement analysis may be the basis for a manger’s performance appraisal Managers’ compensation may be a function of the this appraisal It’s important to understand which elements of performance are within or beyond managers’ control Grant, Munter & Robinson Chapter 1

Analysis Techniques Use publicly available data from financial statements including Income Statement Statement of Owners’ Equity Balance Sheet Statement of Cash Flows Notes to Financial Statements Grant, Munter & Robinson Chapter 1

Analysis Techniques Time series analysis Compare a firm to itself over time Firms provide at least two periods of comparable data in each set of financial statements Grant, Munter & Robinson Chapter 1

Analysis Techniques Cross-sectional Analysis Compare several firms over the same time period Designed to hold economic effects constant Enables analyst to determine how a firm is doing given the prevailing macroeconomic conditions Comparison of large, diverse, multinational firms is complex (and covered in detail in chapters 9 and 18) Grant, Munter & Robinson Chapter 1

Financial Statements and Performance Financial statements are prepared in a consistent manner (enabling cross-sectional and time series comparisons) Accounting rules are designed to reflect firm performance Grant, Munter & Robinson Chapter 1

Basic Financial Statements Income Statement provides results of business activities Balance Sheet states assets and claims against them (liabilities and owner’s equity) Statement of Cash Flows provides prior cash flow information helps analyst assess the firm’s ability to pay interested parties Grant, Munter & Robinson Chapter 1

Accounting and Reporting Standards Analysts must become familiar enough with the accounting options available to the firm being studied in order to understand and evaluate the information presented in the financial statements Grant, Munter & Robinson Chapter 1

Development of US Accounting Standards 1900 No mandated reporting requirements even though the professions of accounting and auditing existed. 1933/34 Securities Acts give the SEC authority to regulate financial reporting. The accounting profession worked to develop and refine accounting principles and auditing procedures. 1970s Financial Accounting Standards Board is created as the authority on financial reporting for publicly traded US firms. Grant, Munter & Robinson Chapter 1

Development of International Accounting Standards International Accounting Standards (IASB) 14 member committee of auditors, accountants, academics and financial statement users Developed International Accounting Standards (IAS) to help investors cope with financial analysis in global capital markets Rules are not used worldwide, but a number of countries do use the framework Grant, Munter & Robinson Chapter 1

Regulatory Requirements SEC filing requirements Form 10-K audited annual report Form 10-Q quarterly report Form 8-K periodic informational reports Grant, Munter & Robinson Chapter 1

Transactions and the Accounting Process Remember, Assets = Claims Original owners put $1,000 in corporate checking account Grant, Munter & Robinson Chapter 1

Transactions and the Accounting Process Maintain the Assets = Claims equality Build on previous transaction Corporation spends $50 on inventory Grant, Munter & Robinson Chapter 1

Transactions and the Accounting Process Change the previous transaction: Corporation purchases $50 of inventory on credit Grant, Munter & Robinson Chapter 1

Transactions and the Accounting Process Expanded Transaction Model Original owners put $1,000 in corporate checking account Corporation purchases $50 of inventory on credit Purchase a $5,000 building for $500 cash and $4,500 mortgage Grant, Munter & Robinson Chapter 1

Expanded Transaction Model Assets = Claims Cash Inventory Building Accounts Payable Mortgage Payable Common Stock $1,000 $50 ($500) $5,000 $4,500 $500 Grant, Munter & Robinson Chapter 1

Transactions and the Accounting Process Expanded Transaction Model The company pays rent of $2,000 for the current month The company sells inventory to a customer on account (receivable) at a retail price of $30,000 The portion of the inventory which was sold cost $15,000 to purchase Grant, Munter & Robinson Chapter 1

Expanded Transaction Model Assets = Claims Cash A/R Inventory Accounts Payable Common Stock Retained Earnings ($2,000) $30,000 ($15,000) $13,000 Grant, Munter & Robinson Chapter 1

Basic Financial Statements Using recorded information the… Balance Sheet Reports totals of assets and claims on the date ending the reporting period Statement of Cash Flows Reports all cash inflows and outflows (more in chapter 4) The cash column of the transaction model Statement of Shareholders’ Equity Reports changes in the owners’ claim accounts during the period Grant, Munter & Robinson Chapter 1

The Professional Analyst Buy-Side and Sell-Side Analysts Provide information within the investment firm Information is rarely available to outsiders Sell-side Provide information to brokers who work with external clients Reports are created with external clients in mind Grant, Munter & Robinson Chapter 1

The Professional Analyst Professional Designation Association for Investment Management and Research (AIMR) Established professional standards and ethics for financial analysts Sets disciplinary procedures in the event that unethical behavior is suspected or detected Manages the Chartered Financial Analyst (CFA®) exam A series of three examinations covering economics, finance, statistics and financial statement analysis Grant, Munter & Robinson Chapter 1

The Professional Analyst Role of the Analyst Incorporate incrementally informative data into recommendations Analysis is an ongoing process utilizing many types of resources Financial statement analysis is the starting point of this process Grant, Munter & Robinson Chapter 1

Summary Objectives of financial analysis Forecasting future cash flows Evaluating past performance Role of accounting information Importance of accounting standards Primary financial statements Market efficiency (role of analysts) Grant, Munter & Robinson Chapter 1