Overview of Financial Statement Analysis Chapter 1

LiChap 12 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 p

LiChap 13 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.

LiChap 14 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

LiChap 15 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

LiChap 16 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

LiChap 17 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

LiChap 18 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

LiChap 19 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.

LiChap 110 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

LiChap 111 Regulatory Requirements SEC filing requirements –Form 10-K audited annual report –Form 10-Q quarterly report –Form 8-K special informational reports

LiChap 112 Financial Reporting Environment Regulators FASB AICPA Industry Practices GAAP Enforcement and Monitoring Mechanisms SEC Corporate Governance Managers Auditors Statutory Financial Reports (Financial Statements) Alternative Information Sources Economy and Industry Information Voluntary Disclosure Users Analysts Investors and Creditors Other Users Litigation

LiChap 113 Form 10-K (Annual Report) 10-Q (Quarterly Report) Other SEC Filings 14-A (Proxy Statement/ Prospectus) Statutory Financial Reports 8-K (Current Report) 20-F (Registration Statement/ Annual Report [Foreign])

LiChap 114 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

LiChap 115 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

LiChap 116 Transactions and the Accounting Process Remember, Assets = Claims Original owners put $1,000 in corporate checking account

LiChap 117 Transactions and the Accounting Process Change the previous transaction: Corporation purchases $50 of inventory on credit

LiChap 118 Transactions and the Accounting Process Expanded Transaction Model Purchase a $5,000 building for $500 cash and $4,500 mortgage

LiChap 119 Expanded Transaction Model Assets=Claims CashInventoryBuildingAccounts Payable Mortgage Payable Common Stock $1,000 $50 ($500)$5,000$4,500 $500$50$5,000=$50$4,500$1,000

LiChap 120 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

LiChap 121 Expanded Transaction Model Assets=Claims CashA/RInventoryAccounts Payable Common Stock Retained Earnings ($2,000) $30,000 ($15,000) ($2,000)$30,000($15,000)=$13,000

LiChap 122 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

LiChap 123 The Professional Analyst Buy-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

LiChap 124 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