Financial Statement Analysis K R Subramanyam John J Wild

Overview of Financial Statement Analysis 1 CHAPTER

Business Decision Makers Business Analysis Evaluate Prospects Evaluate Risks Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Directors Regulators Employees & Unions Lawyers 3

Information Sources for Business Analysis Trade reports Regulatory filings Economic Indicators Industry Statistics Financial Statements Quantitative Web sites Vision/Mission Statement Financial press Press Releases Chairperson’s Letter Management discussion & Analysis Qualitative 4

Types of Business Analysis Credit Analysis Equity Analysis Management & Control Mergers, Acquisitions & Divestitures Director Oversight Regulation External Auditing Labor Negotiations Financial Management 5

Credit Analysis Creditors Non-trade Creditors Provide major financing Provide goods or services Most short-term Usually implicit interest Bear risk of default Non-trade Creditors Provide major financing Most long-term Usually explicit interest Bear risk of default 6

Credit worthiness: Ability to honor credit obligations Credit Analysis Credit worthiness: Ability to honor credit obligations (downside risk) Liquidity Ability to meet short-term obligations Focus: Current cash flows Make up of current assets and liabilities Liquidity of assets Solvency Ability to meet long-term obligations Focus: Long-term profitability Capital structure 7

Equity Analysis Assessment of downside risk and upside potential Technical analysis / Charting Patterns in price or volume history of a stock Predict future price movements Fundamental Analysis Determine Intrinsic value without reference to price Analyze and interpret key factors Economy Industry Company 8

Technical analysis / Charting

Technical analysis / Charting

Equity Analysis Assessment of downside risk and upside potential Technical analysis / Charting Patterns in price or volume history of a stock Predict future price movements Fundamental Analysis Determine Intrinsic value without reference to price Analyze and interpret key factors Economy Industry Company 11

Cost of Capital Estimate Prospective Analysis Accounting Business Environment & Strategy Analysis Industry Strategy Financial of cash flows Profitability Risk Cost of Capital Estimate Intrinsic Value Component Processes of Business Analysis 12

Business Environment and Strategy Analysis 56-1 แบบแสดงรายการข้อมูลประจำปี 56-2 รายงานประจำปี ฯลฯ

Business Environment and Strategy Analysis 56-1 และ 56-2 ข้อมูลทั่วไป ปัจจัยความเสี่ยง ลักษณะการประกอบธุรกิจ โครงสร้างเงินทุนและการจัดการ รายการระหว่างกัน การวิเคราะห์ฐานะการเงินและผลการดำเนินงาน

Business Environment and Strategy Analysis 56-1 การประกอบธุรกิจของแต่ละสายผลิตภัณฑ์ ทรัพย์สินที่ใช้ในการประกอบธุรกิจ ข้อพิพาททางกฎหมาย การควบคุมภายใน

Accounting Analysis Process to evaluate and adjust financial statements to better reflect economic reality Comparability problems — across firms and across time Manager estimation error Distortion problems Earnings management Accounting Standards Accounting Risk 16

Financial Analysis Process to evaluate financial position and performance using financial statements Profitability analysis — Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Analysis of — Evaluate source & cash flows deployment of funds Common tools Ratio analysis Cash flow analysis 17

Process to forecast future payoffs Prospective Analysis Process to forecast future payoffs Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Intrinsic Value 18

Dynamics of Business Activities Time Investing Operating Financing Planning End of period Beginning of period 19

Managerial performance Business Activities Planning Activities: Goals & Objectives Competition Pricing Market demands Tactics Promotion Managerial performance Opportunities Projections Distribution Obstacles 20

Business Activities Financing Financing activities Owner (equity) Nonowner (liabilities) Creditor Debt creditor Operating creditor 21

Business Activities Investing Financing Investing = Financing Investing activities Buying resources Selling resources Investing activities Operating asset/Financial asset Current/Non-current asset Investing = Financing 22

Revenues and expenses from providing Business Activities Planning Activities Investing Financial Operating Activities Revenues and expenses from providing goods and services 23

Financial Statements Reflect Business Activities Planning Investing Current: Cash Accounts Receivable Inventories Marketable Securities Noncurrent: Land, Buildings, & Equipment Patents Investments Assets Balance Sheet Financing Notes Payable Accounts Payable Salaries Payable Income Tax Payable Bonds Payable Common Stock Retained Earnings Liabilities & Equity Statement of Shareholders’ Equity Operating Sales Cost of Goods Sold Selling Expense Administrative Expense Interest Expense Income Tax Expense Net Income Income statement Cash Flow Statement of Cash Flows 24

Statement of Shareholders’ Equity Statement of Cash Flows Financial Statements Balance Sheet Income Statement Statement of Shareholders’ Equity Statement of Cash Flows 25

1-26 26

Balance Sheet Colgate Financing (in $billions) Total Investing = Total Financing = Creditor Financing + Owner Financing Colgate Financing (in $billions) $9.138 = $7.727 + $1.410 27

1-28 28

Income Statement Colgate’s Profitability (in $billions) Revenues – Cost of goods sold = Gross Profit Gross profit – Operating expenses = Operating Profit Colgate’s Profitability (in $billions) $12.238 - $5.536 = $6.701 Gross Profit $6.701 - $4.5411 = $2.160 Operating profit 29

1-30 30

Statement of Cash Flows Net Cash Flows from Operating Activities Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities 31

1-32 32

Additional Information (Beyond Financial Statements) Management’s Discussion & Analysis (MD&A) Management Report Auditor Report Explanatory Notes to Financial Statements Supplementary Information Proxy Statement 33

Analysis Preview Comparative Analysis Yr2 Yr1 Yr3 Comparative Analysis Purpose: Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types:  Year-to-year Change Analysis  Index-Number Trend Analysis 34

1-35 Analysis Preview 35

Analysis Preview Common-Size Analysis Purpose :  Evaluation of internal makeup of financial statements  Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues, & expenses 36

Analysis Preview 37

Analysis Preview 38

Analysis Preview Ratio Analysis Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis) Output: Mathematical expression of relation between two or more items Cautions:  Prior Accounting analysis is important  Interpretation is key - long vs short term & benchmarking 39

Valuation - an important goal of many types Analysis Preview Valuation Valuation - an important goal of many types of business analysis Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money) 40

Analysis Preview Debt (Bond) Valuation Bt is the value of the bond at time t It +n is the interest payment in period t+n F is the principal payment (usually the debt’s face value) r is the investor’s required interest rate (yield to maturity) 41

Analysis Preview Equity Valuation Vt is the value of an equity security at time t Dt +n is the dividend in period t+n k is the cost of capital E refers to expected dividends 42

Equity Valuation - Free Cash Flow to Equity Analysis Preview Equity Valuation - Free Cash Flow to Equity Model FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures] k is the cost of capital E refers to an expectation 43

Equity Valuation - Residual Income Model Analysis Preview Equity Valuation - Residual Income Model BVt is the book value at the end of period t Rit+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)] k is the cost of capital E refers to an expectation 44

Financial Statement Analysis Introduction and Overview Book Organization Financial Statement Analysis Part I Introduction and Overview Part III Financial Analysis Part II Accounting Analysis Chapter 1: Overview of Financial Statement Analysis Chapter 2: Financial Reporting and Chapter 3: Analyzing Financial Activities Chapter 4: Analyzing Investing Activities Chapter 5: Analyzing Investing Activities: Special topic Chapter 6: Analyzing Operating Activities Chapter 7: Cash Flow Chapter 8: Return on Invested Capital Chapter 9: Profitability Chapter 10: Prospective Chapter 11: Credit Chapter 12: Equity Analysis and Valuation 45