McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Statement Analysis K R Subramanyam John J Wild

1-2 1 CHAPTER Overview of Financial Statement Analysis

1-3 Business Analysis Evaluate Prospects Evaluate Risks Business Decision MakersEquity investorsCreditorsManagersMerger and Acquisition AnalystsExternal AuditorsDirectorsRegulatorsEmployees & UnionsLawyers

1-4 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

1-5

1-6 Credit Analysis Trade Creditors 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

1-7 Credit Analysis 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 Credit worthiness: Ability to honor credit obligations (downside risk)

1-8 Equity Analysis 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 Assessment of downside risk and upside potential

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1-10 Accounting Analysis Accounting Risk Accounting Risk Process to evaluate and adjust financial statements to better reflect economic reality

1-11 Financial Analysis Profitability analysis — Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Analysis of — Evaluate source & cash flows deployment of funds Profitability analysis — Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Analysis of — Evaluate source & cash flows deployment of funds Common tools Ratio analysis Ratio analysis Cash flow analysis Cash flow analysis Process to evaluate financial position and performance using financial statements

1-12 Prospective Analysis Intrinsic Value Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Process to forecast future payoffs

1-13 Dynamics of Business Activities Business ActivitiesTime

1-14 Business Activities

1-15 Business Activities Financing activities Owner (equity) Nonowner (liabilities)

1-16 Investing activities Buying resources Selling resources Investing = Financing Business Activities

1-17 Operating Activities Revenues and expenses from providing goods and services Business Activities

1-18 Financial Statements Reflect Business Activities

1-19 Financial Statements Balance SheetIncome Statement Statement of Shareholders’ Equity Statement of Cash Flows

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1-21 Balance Sheet Total Investing = Total Financing = Creditor Financing + Owner Financing Total Investing = Total Financing = Creditor Financing + Owner Financing

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1-23 Income Statement Revenues – Cost of goods sold = Gross Profit Gross profit – Operating expenses = Operating Profit Revenues – Cost of goods sold = Gross Profit Gross profit – Operating expenses = Operating Profit Colgate’s Profitability (in $billions) $ $5.536 = $6.701 Gross Profit $ $ = $2.160 Operating profit

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1-25 Statement of Cash Flows Net Cash Flows from Operating Activities Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities

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1-27 Additional Information (Beyond Financial Statements) Management’s Discussion & Analysis (MD&A) Management Report Auditor Report Explanatory Notes to Financial Statements Supplementary Information Proxy Statement

1-28 Analysis Preview Purpose:Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types:  Year-to-year Change Analysis  Index-Number Trend 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 Comparative Analysis

Analysis Preview 1-29

1-30 Analysis Preview Purpose :  Evaluation of internal makeup of financial statements  Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues, & expenses Purpose :  Evaluation of internal makeup of financial statements  Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues, & expenses Common-Size Analysis

1-31 Analysis Preview

1-32 Analysis Preview

1-33 Analysis Preview 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 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 Ratio Analysis

1-34 Analysis Preview Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money) Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money) Valuation Valuation - an important goal of many types of business analysis Valuation - an important goal of many types of business analysis

1-35 Analysis Preview Debt (Bond) Valuation B t is the value of the bond at time t I t +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 ) B t is the value of the bond at time t I t +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 )

1-36 Analysis Preview Equity Valuation V t is the value of an equity security at time t D t +n is the dividend in period t+n k is the cost of capital E refers to expected dividends V t is the value of an equity security at time t D t +n is the dividend in period t+n k is the cost of capital E refers to expected dividends

1-37 Analysis Preview Equity Valuation - Free Cash Flow to Equity Model Equity Valuation - Free Cash Flow to Equity Model FCF t+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 FCF t+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

1-38 Analysis Preview Equity Valuation - Residual Income Model BV t is the book value at the end of period t Ri t+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RI t = NI t - (k x BV t-1 )] k is the cost of capital E refers to an expectation BV t is the book value at the end of period t Ri t+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RI t = NI t - (k x BV t-1 )] k is the cost of capital E refers to an expectation

1-39 Analysis in an Efficient Market Three assumed forms of market efficiency Weak Form - prices reflect information in past prices Semi-strong - prices reflect all public Form information Strong Form - prices reflect all public and private information Weak Form - prices reflect information in past prices Semi-strong - prices reflect all public Form information Strong Form - prices reflect all public and private information

1-40 Book Organization