overview of financial statement analysis chapter 1
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Overview of Financial Statement Analysis
Chapter 1
Li Chap 1 2
Learning Objectives
• Nature and purpose of Financial Analysis
• Accounting standards and processes underlying financial reports
• Role of professional financial analysts
• No need to read appendix 1A, 1B, and p12-17.
Li Chap 1 3
Goal
Financial statement analysis is a tool for making complex investment and credit decisions. Specifically, its basic goal is to value a firm by estimating its future cash flows and determining its financial health.
Li Chap 1 4
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
Li Chap 1 5
Analysis Techniques
• Starting point is to use publicly available data from financial statements including– Income Statement– Statement of Owners’ Equity– Balance Sheet– Statement of Cash Flows– Notes to Financial Statements
Li Chap 1 6
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
Li Chap 1 7
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
Li Chap 1 8
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
Li Chap 1 9
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.
• 1970s– Financial Accounting Standards Board is created as the
authority on financial reporting for publicly traded US firms.
Li Chap 1 10
Environmental Factors
Financial Accounting Standards Board
Generally Accepted Accounting Principles
Provide input to
Help set
Securities and
Exchange Commission
Unions
Investors
Accountants
Politicians
Lenders
Others
AICPA
Li Chap 1 11
Regulatory Requirements
• SEC filing requirements– Form 10-K audited annual report– Form 10-Q quarterly report– Form 8-K special informational reports
Li Chap 1 12
Financial Reporting Environment
Regulators
FASB
AICPA
Industry Practices
GAAP
Enforcement and Monitoring Mechanisms
SECCorporate
Governance
Managers
Auditors
Statutory Financial Reports(Financial Statements)
Alternative Information Sources
Economy and Industry Information
Voluntary Disclosure
Users
Analysts
Investors and
CreditorsOther Users
Litigation
Li Chap 1 13
Form 10-K (Annual Report)
10-Q(Quarterly Report)
OtherSEC Filings
14-A(Proxy Statement/
Prospectus)
Statutory Financial Reports
8-K(Current Report)
20-F (Registration Statement/Annual Report [Foreign])
Li Chap 1 14
Development of International Accounting Standards
• International Accounting Standards Board(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
Li Chap 1 15
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
Li Chap 1 16
Transactions and the Accounting Process
• Remember, Assets = Claims
• Original owners put $1,000 in corporate checking account
Assets = ClaimsCash Common Stock
$1,000 = $1,000
Li Chap 1 17
Transactions and the Accounting Process
• Change the previous transaction:• Corporation purchases $50 of inventory on credit
=Cash Inventory Accts. Payable Common Stock
$1,000 = $1,000 $50 $50
$1,000 $50 = $50 $1,000
ClaimsAssets
Li Chap 1 18
Transactions and the Accounting ProcessExpanded Transaction Model
• Purchase a $5,000 building for $500 cash and $4,500 mortgage
Li Chap 1 19
Expanded Transaction Model
Assets = Claims
Cash Inventory Building Accounts Payable
Mortgage
Payable
Common Stock
$1,000 $1,000
$50 $50
($500) $5,000 $4,500
$500 $50 $5,000 = $50 $4,500 $1,000
Li Chap 1 20
Transactions and the Accounting ProcessExpanded 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
Li Chap 1 21
Expanded Transaction Model
Assets = Claims
Cash A/R Inventory Accounts Payable
Common
Stock
Retained
Earnings
($2,000) ($2,000)
$30,000 $30,000
($15,000) ($15,000)
($2,000) $30,000 ($15,000) = $13,000
Li Chap 1 22
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
Li Chap 1 23
The Professional AnalystBuy-Side and Sell-Side Analysts
• Buy-side– 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
Li Chap 1 24
Role of the Analysts• Financial analysts do not believe in semi-
strong form of market efficiency.
• However, their job makes the market price more efficient.
• If interested in becoming a CFA, visit http://cfainstitute.org/cfaprogram/