Financial Statement Analysis Angeline M. Lavin, Ph.D., CFA

Major Financial Statements Corporate shareholder annual and quarterly reports must include –Balance sheet –Income statement –Statement of cash flows Reports filed with Securities and Exchange Commission (SEC)

Financial Statements Corporate shareholder annual and quarterly reports must include –Balance sheet (Exhibit 10.1) –Income statement (Exhibit 10.2) –Statement of cash flows (Exhibit 10.3) Reports filed with Securities and Exchange Commission (SEC) –10-K and 10-Q All reports must be prepared using GAAP

Analysis of Financial Ratios Ratios are more informative than raw numbers Ratios provide meaningful relationships between individual values in the financial statements Ratios help investors evaluate management performance in terms of profitability, efficiency and risk.

Relative Financial Ratios Enable comparison of a firm’s performance to –The aggregate economy –Its industry or industries –Its major competitors within the industry –Its past performance (time-series analysis)

Five Categories of Financial Ratios 1. Internal liquidity (solvency) 2. Operating efficiency and profitability 3. Business and financial risk analysis 4. Growth analysis 5. External liquidity (marketability)

Common Size Statements Normalize balance sheets and income statement items to allow easier comparison of different size firms Common size balance sheet: all accounts are expressed as a percentage of total assets Common size income statement: all accounts are expressed as a percentage of sales

Financial Statement Quality High-quality balance sheets typically have –Conservative use of debt –Assets with market value greater than book –No liabilities off the balance sheet

Financial Statement Quality High-quality income statements reflect repeatable earnings Gains from nonrecurring items should be ignored when examining earnings High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs

The Value of Financial Statement Analysis Financial statements, by their nature, are backward-looking An efficient market will have already incorporated these past results into security prices, so why analyze the statements? Analysis provides knowledge of a firm’s operating and financial structure This aids in estimating future returns

Specific Uses of Financial Ratios 1. Stock valuation 2. Identification of corporate variables affecting a stock’s systematic risk (beta) 3. Assigning credit quality ratings on bonds 4. Predicting insolvency (bankruptcy) of firms

Stock Valuation Models Valuation models attempt to derive a value based upon one of several cash flow or relative valuation models All valuation models are influenced by: Expected growth rate of earnings, cash flows, or dividends Required rate of return on the stock Financial ratios can help in estimating these critical inputs