1. Financial Statement Risk analysis
Chapter 9

2. Introduction to Financial statements
Used to make business decisions
Provide information about a company’s financial activities
Four Key Financial Statements:
1. Balance Sheet
2. Income Statement
3. Statement of Changes in Shareholders’ Equity
4. Statement of Cash Flows

3. Balance sheet
Summarizes a company’s assets, liabilities, and shareholders’ equity at a specific point in time (“snapshot”)
Based on GAAP
Accounting equation
Assets – Liabilities = Equity

4. Balance sheet Assets Liabilities Shareholders’ Equity Current Assets
Cash
Marketable Securities
Accounts/Notes Receivables
Prepaid Expenses
Inventories
Fixed Assets
Land
Buildings
Equipment
Intangibles such as goodwill, patents, copyrights, and trademarks
Liabilities
Current Liabilities
Accounts/Wages/Taxes Payable
Short-term Debt
Noncurrent Liabilities
Long-term Debt
Shareholders’ Equity
Total Shareholders’ Equity (Owners’ Equity)
*p 9.7 for a sample balance sheet

5. Income statement
Measures a company’s performance of profitability over a specific period of time
Based on GAAP
Reports a company’s profit gain or loss with its revenue

6. Components of the income statement
Revenue: income that a company receives from normal business activities such as from the sale of goods and services to customers
Expenses: outflow of money to pay for a good or service
Cost of goods sold
Gross Profit: sales minus cost of goods sold
Operating Income: amount of profit from a business’s operations after taking out operating expenses (EBIT)
Net Income: a company’s earnings after subtracting all expenses
“bottom line”

7. Statement of changes in shareholders’ equity
Shows increases or decreases in the equity of the business from the beginning to the end of the period
4 major components of shareholders’ equity:
1. Paid-Capital
2. Retained Earnings
3. Accumulated Other Comprehensive Income
4. Treasury Stock

8. components of shareholders’ equity
Paid-In Capital
Capital contributed to a business by owners through the purchase of stock from the business
Retained Earnings
Portion of profits kept by the company to be reinvested in the business for future needs
Accumulated Other Comprehensive Income
Measures gains and losses of the company that have not been realized yet
Includes changes in pension costs, foreign currency investments, and appreciation/depreciation of investments
Treasury Stock
The buying back of a company’s own stock
*p 9.15 for a sample statement of changes in stockholders’ equity

9. Statement of cash flows
Purpose is to provide information about a business’s cash receipts and cash payments during a period of time
Operating Activities reflect the transactions of operating cash inflows and outflows
Investing Activities show the cash inflows and outflows in the purchase or sale of assets, the receiving or selling of marketable securities, and payment of loans
Financing Activities include paying of dividends, issue or repurchase of the company’s stock, bonds, and other debt
*p 9.16 for a sample statement of cash flows

10. Supplemental sources of financial information
Notes to financial statements
SEC filings
Annual reports

11. Notes to financial statements
Contain details to better explain the data within the financial statements
Summary of loss contingencies is closely related to risk management and issues of insurance
Examples:
Litigations
Product warranty and defect obligations
Possibility of damage or loss of property due to hazards

12. SEC filings
Financial statements and documents submitted to the Securities and Exchange Commission
Most frequently accessed reports include the Form 10-K, Form 10-Q, and Form 8-K

13. Sec filings
Form 10-K : annually filed report that is similar to the company’s own annual report, only much more in detail
Form 10-Q : shortened version of the 10-K; quarterly filed report that provides a view of the company’s condition financially for the prior three months
Form 8-K : a current report that is filed to announce a major event to the shareholders

14. Company annual reports
The formal documents reporting the company’s performance for the year
Required sections of the annual report includes the following:
Financial statements and notes
Auditor’s report
Report of management
Management’s discussion and analysis of operations and financial position
Other beneficial financial data
Companies may provide additional information that is not required as well

15. Reports
The Report of Management is an internal control report acknowledging management’s responsibility to the quality of accounting principles, employee communications, and other internal auditing procedures.
Management’s Discussion and Analysis of Results (MD&A) gives a narrative explanation through management’s perception of how the company is performing, its current position, and its future outlook.

16. Sarbanes-Oxley act of 2002
Federal law put in place to protect investors, enhance internal controls, and increase penalties for fraudulent financial activity against corporate directors
Increases financial reporting transparency

17. Income statement trend analysis
Used to see how a business has performed over two or more periods of time
Usually applied to the income statement
Calculate the percentage of change from one year to the next
Annual Percentage Change
Trend analysis can be helpful in predicting the future prospects of a business

18. Liquidity risk Ratio Analysis
Liquidity: how quickly an asset can be converted to cash with no loss of value
Can be measured using:
Working Capital = Current Assets – Current Liabilities
Current Ratio = Current Assets / Current Liabilities
Acid-Test Ratio = (Current Assets – Inventory) / Current Liabilities
Also known as the Quick Ratio

19. Capital structure
The way a corporation finances its assets through a mixture of long- term debt and equity
Equity
Common stockholders versus Preferred stockholders
Debt
Short-term liabilities: due within one year or less
Long-term liabilities: due in more than one year

20. Financial leverage
The usage of debt to increase returns to shareholders
Financial leverage analysis compares the possible earnings per share (EPS) under different levels of debt and equity
Return on Equity (ROE) = Net Income / Equity

21. Limitations of financial leverage
Additional cost of increased debt
Cash flow availability and flexibility economized
Increased risk of default and possibility of bankruptcy

22. Operating leverage Components of a company’s cost structure:
Fixed Costs : costs that basically remains unchanged regardless of changes in production level or cost of goods and services
Examples include rent and interest
Variable Costs : costs that vary according to production output
Examples include wages, utilities, and raw materials used
Changing these percentages influences operating leverage
Advantages and disadvantages for both fixed and variable costs
Vs. Financial leverage which is the use of Debt