Financial Statement Analysis Chapter 01- Introduction By A.S.P.G. Manawaduge B.Y.G. Rathnasekara

Financial Statement Analysis FSA is the application of analytical tools and techniques to general purpose financial statement and related data to derive estimates and inference useful in business analysis. It is part of business analysis.

Business Analysis Evaluation of the company’s prospects and risks for the purpose of making business decision. These decisions extend to equity and debt valuation, credit risk assessment, earnings predictions, audit testing, compensation negotiations ect.

Initial step in BA is to evaluate company’s business environment and strategies to determine Future business prospects Expected growth Competitive strength & weakness Earning potential Earning performance Sustainability Financial condition

Type of Business Analysis 1. Credit analysis - Trade creditors - Nontrade creditors Evaluation of the creditworthiness i.e ability to honor its credit obligation This include analysis of liquidity and solvency Short term credit- Financial conditions cash flows and liquidity of current assets Long term credit – Projection of cash flows, evaluation of extended profitability

2. Equity analysis Technical analysis Searches for pattern in the price or volume history of a stock to predict future price movements Fundamental analysis Analyzing and interpreting key factors for economy the industry and the company. The main part of fundamental analysis is evaluation of a company’s financial position and performance.

Use of Business Analysis Creditors Equity holders Managers Mergers, acquisitions and divestitures Directors Regulators Labor unions Customers

Components of Business Analysis BA encompasses interrelated processes These processes are to estimate company value Company value is estimated using a valuation model. Input to the valuation model include estimate of future payoffs and the cost of capital. The process of forecasting future payoff is called prospective analysis.

Cont. To accurately forecast future payoff it is necessary to evaluate company’s business prospects and its financial statement Evaluation of business prospects is a goal of business environment and strategy analysis. Company’s financial status is assessed from its financial statements using financial analysis. Quality of financial analysis depends on the reliability and economic content of the FS. This require accounting analysis.

Component Processes of Business Analysis Business environment and Strategy Analysis Industry Analysis Strategy Analysis Financial Statement Analysis Financial Analysis Accounting Analysis Prospective Analysis Cash Flows Profitability risk Cost of Capital Estimate Intrinsic Value

1. Business Environment and Strategy Analysis Analysis of company’s future prospect is to identify and assess a company’s economic and industry circumstances. This include analysis of its product labor and capital market. analysis of business strategy seeks to identify and assess company’s competitive strengths and weaknesses along with its opportunities and threats.

Business Environment Analysis It consists of two parts Industry analysis Strategy analysis

Industry Analysis Industry is viewed as a collection of competitors that jockey for bargaining power with consumers and suppliers and that actively compete among themselves and face threats from new entrants and substitute product Industry Analysis must assess both industry prospect and actual and potential competition

Strategy analysis It includes, Evaluation of both company’s business decisions and its success at establishing a competitive advantage. It includes, Expected strategic responses to its business environment Impact of these responses on its future success and growth

2. Accounting Analysis Process of evaluating the extend to which a company’s accounting reflects economic reality. Financial statements are the sources of information for accounting analysis. Accounting analysis is important for comparative analysis.

Limitations in Accounting Analysis Impossible to adopt uniform rules. Problem of setting standards. Failure of standard to meet needs. Error in accounting estimate These limitations lead to, - Comparability problems - Accounting distortions

Accounting distortions are deviations of accounting information from the underline economics. Forms of distortions - Managerial estimate subject to error or omissions. - Managers use their discretion in accounting to manipulate or window dress - Accounting standards fail to capture economic reality.

Accounting Risk Uncertainty in financial statement analysis due to accounting distortions. A major goal of accounting analysis is to evaluate and reduce accounting risk and to improve the economic content of FS including the comparability. This requires restatement and reclassification of FS

Accounting analysis includes evaluation of a company’s earning quality /accounting quality. Evaluation of earning quality requires analysis of factors such as - company business - its accounting policies - the quantity and quality of information disclosed - performance and reputation of management - Opportunity and incentives for earning management - evaluation of sustainable earning power

3. Financial Analysis Use of FS to analysis a company’s financial position and performance and to assess future financial performance.

Financial Analysis It consist of three areas Profitability analysis Risk analysis Analysis of sources and uses of funds

Profitability Analysis Evaluation of company’s ROI Company’s sources and levels of profits Identifying and measuring the impact of various profitability drivers evaluation of two major source of profitability –margins and turnover Reasons for changes in profitability and the sustainability of earnings.

Risk Analysis Evaluation of a company’s ability to meet its commitments. Assessing the solvency and liquidity along with its earning variability

Analysis of sources and uses of funds Evaluation of how company obtaining and developing its funds

4. Prospective analysis Forecasting of future profits – cash flows or both

5. Valuation This is the main objective of many type of business analysis If refers to the process of converting forecast of future profit into an estimate of company value This need a valuation model and estimation of company costs of capital.

Financial Statements Basis of Analysis Business Activities

Planning Activities A company exists to implement specific goals and objectives. Company’s goals and objectives are captured in a business plan, that describes the company’s purpose strategy and tactics for its objectives.

Planning activity cont. Planning help to identify expected opportunities and obstacles. Following information are important for planning Objectives and tactics Market demand Competitive analysis Sales strategies (Pricing, promotion, distribution) Management performance Financial projections

Financing Activities Methods that company use to raise the money to pay for the need. There are two main sources of financing Equity investors Creditors These activities depend on conditions in financial market. i.e. Sources of financing

In looking to financing market company should consider amount of financing necessary sources of financing timing of repayment structure of financing agreements

Financing activities are also involve Return: Equity investor’s share of earning Earning distribution: Dividend payout Earning reinvestment: Retention Ratio Public placement or private placement Financing from creditors Debt creditors Operating creditors

Investing Activities Acquisition and maintenance of investment Investing funds in different assets. - Operating assets and Financial assets or - Current assets and non current assets Investing decisions involve - types of investments necessary - amount require for each type - acquisition timing - assets location

Operating activities Carrying out of the business plan given its financing and investing activities R & D Procument Production Marketing Administration

Financial Statement Reflect Business activities Balance sheet :reflect Financing activities,& Investing activities Income statement: reflect Operating activities. Cash flow statement: reflect financing, investing and operating activities Statement of changes in equity: reflect Financing activities

Additional information In addition to the major components of FS following information is presented with FS Management’s discussion and analysis Management report Auditor report Explanatory notes Supplementary information

Analysis Tools Comparative analysis Common-size analysis Ratio analysis Cash flow analysis Valuation

Comparative Analysis This is done by requiring consecutive balance sheets, income statement from period to period. The most important information often revealed from comparative FS analysis is trend. Two techniques of comparative analysis. Year to year change analysis Index number trend analysis

Year-to year change analysis Comparing financial statements over relatively short time periods two to three years is performed with analysis of year to year changes in individual accounts. Changes in absolute dollar amounts as well as percentages can be presented.

Index Number Trend Analysis Useful tool for long term trend comparison. A base period should be selected with a preselected index number usually set to 100. Base year should be a normal year with regard to business condition. Only the significant items are analyzed. Current year balance Current year index No = -------------------------- x 100 Base year balance

Common Size FS Analysis FS analysis can benefit form knowing what proportion of a group or subgroup is made up of a particular account. Values of the items are brought to a common size. e.g. Balance sheet items are expressed as a % of total assets. This analysis is specially useful for inter company comparison.

Ratio Analysis A ratio expresses a mathematical relation between two quantities. If the two quantities are 1000 and 500 ratios can be presented as follow. i. 50% ii. 2:1 iii. ½ iv. 2 To be a meaningful, a ratio must refer to an economically important relation.

Factors Affecting Ratios Effect of economic events Industry factors Management policies Accounting methods

Ratio interpretation Simply computation is not useful. Ratios should be interpreted with care. They are interpreted in comparison with Prior ratios Predetermined standard Ratios of competitors

Major areas for which RA can be applied. 1. Credit analysis i. Liquidity – Ability to meet short term obligation ii. Capital structure and solvency - ability to meet long term obligation

2. Profitability i. ROI – to asses the rewards to the suppliers of funds ii. Operating performance. To evaluate profit margin from operating activities. iii. Asset utilization – To evaluate effectiveness and intensity of assets in generating sales. 3. Valuation To estimate the intrinsic value of a company (stock)

Types of ratios 2. Capital structure & solvency 1. Liquidity Current ratio Acid-test ratio Collection period Days to sell inventory 2. Capital structure & solvency Total debt to equity Long term debt to equity Interest coverage (Times interest earned )

4. Operating performance 3. ROI Return on assets Return on equity 4. Operating performance Gross profit margin Operating profit margin Pretax margin Net profit margin

5. Asset utilization Cash turnover Accounts receivable turnover Inventory turnover Working Capital turnover PPE turnover Total assets turnover

Market Measures Price earning ratio Earning yield Dividend yield Dividend pay out Price to book value

Cash flow analysis A tool to evaluate the sources and uses of funds .It provide insight into how a company is obtaining its financing and deploying its resources

Valuation It refers to estimating the intrinsic value of a company or its stock. The basis of valuation is “present value theory.” The theory states, the value of debt or equity security is equal to the sum of all expected future payoffs from the security that are discounted to the present at an appropriate discount rate.

To value a security an investor need Expected future payoffs over the life of the security Discount rate Future payoffs from bonds are principal and interest Future payoffs from stocks are dividends and capital appreciation. Discount rate in case of bond is the prevailing interest rate i.e. yield to maturity In the case of stock it is the risk adjusted cost of capital i.e. expected rate of return

Debt Valuation The value of Present value of its a debt security = future payoffs discounted at an appropriate rate

Value of the bond at time ‘t’ or Bt is calculated as follow: 1t+1 1t + 2 1t + n F Bt = ------- + --------- + …..---------- + ------- (1 + r)1 (1 + r)2 (1 + r)n (1 + r)n

Example: A company issued 1000 ten year debenture Rs. 100 each with year end interest rate of 12% percent per anum on 01.01.2000 You are asked to calculate value of the debenture as at 01.01.2006. When the yield to maturity is 10%.

Solution Remaining period 4 years. 12 Annual interest is 100,000 x ----- = 12000 100 Value = 12,000 / (1.1) + 1200 / (1.1)2 + 12000 / (1.1)3 + 1200 / (1.1)4 + 100000 / (1.1) 4

Equity valuation Value of the equity security is the present value of future payoffs discounted at an appropriate rate. Equity investor looks for two main (uncertain) payoffs. 1. Dividends 2. Capital appreciation

Value of E (D t +1) E (D t +2) E (Dt + 3) Equity = ------------- + -------------- + --------------- …… security (1+ k)1 (1+ k)2 (1+ k)3 At time t This model is called the ‘dividend discount model.

Alternatively value of the equity security is the present value of future cash flows.

Practical Consideration The dividend discount model face practical problems. Infinite horizon Payments are discretionary Different dividend policy

Free cash flow model E(FCFt +1) E(FCF 1 + 2) (FCF1 + n ) Equity value of a time t is computed replacing expected dividends with expected free cash flows to equity. E(FCFt +1) E(FCF 1 + 2) (FCF1 + n ) Vt = ----------------- + -----------------+ ….. ------------------ (1 + k)1 (1 + k)2 (1 + k)n FEF 1+n is free cash flow to equity in period t +n, and k is cost of capital. Free cash flows to equity are defined as (cash flows from operation ) - (capital expenditure + increase in debt)

Value of the entire firm FCF to the firm equal to operating cash flows (adjusted for interest expense and revenue) less investment in opening assets. Value of the entire firm equal the discounted expected future free cash flows using the weighted average cost of capital. Value of = Value of - value of the debt The equity the firm

Residual Income Model Equity value at time t is the sum of current book value and the present value of all future expected residual income. E(RIt+1) E(RIt +2) ERIt+n Vt = Bvt + ------------ + ------------- + …. ---------- (1 + k)1 (1+k)2 (1 + k)n

Bvt = Book value at the end of the period t RIt+n is residual income in period t + n k is cost of capital. Residual income at a time t is defined as Comprehensive - a charge on beginning Net income book value

Analysis in an efficient market The EMH deals with the reaction of market prices to financial and other information There are three forms of EMH Weak form: Price reflect fully the information contained in historical price movement Semi strong form: Price reflect fully all publicly available information (historical price movement +A/R) Strong form: Price reflect all information including inside information