Lahore School of Economics BBA III Summer Term II-2010 History & Balance Sheet Analysis

Chap # 1 Overview of Financial Statement Analysis

Chapter Preview Users of Financial Statements Business Activities Types of Financial Statements Information Accompanying financial Statements Financial Statement Analysis Preview Capital Market Efficiency & its implications on Financial Statement Analysis

Users of Financial Statements Internal Users External Users

Users of Financial Statements Internal Users Management of the Company External Users Creditors Equity Investors Merger & Acquisition Analyst Regulatory Agencies Suppliers

Business Activities in a Market Economy Planning Activities Financing Activities Investing Activities Operating Activities

Business Activities – Planning Activities A company’s goals & objectives are captured in a business plan or strategy that describes a company’s purpose, strategy & tactics for activities Shareholder’s letter MD&A

Business Activities – Financing Activities Financing activities are the means company use to pay for various ventures undertaken to carry out its business plan. Equity Financing Earnings Distribution Earnings re-investment Credit Financing Implicit Financing Explicit Financing Risks for investors

Business Activities – Investing Activities Investing activities are the acquisition & maintenance of investments by companies to sell products or provide services. Value of Investments always equals the value of Financing obtained. Excess Financing? Size of Investment Vs Company Success

Business Activities – Operating Activities Operating Activities represent the “carrying out” of the business plan given necessary investing & Financing. Basic Components (RPPML)

Financial Statements & Business Activities Financing Operating Financing Investing

Types of Financial Statements Balance Sheet Income Statement Statement of Shareholder’s Equity Statement of Cash flows

Types of Financial Statements – Balance Sheet Asset = Liabilities + Shareholder’s Equity Balance Sheet summarizes financial position of a company at a given point in time. Working Capital Investing Activities = Financing Activities Investments = Creditor Financing + Shareholder Financing

Types of Financial Statements – Income Statement An income statement measures company’s financial performance between balance sheet dates & Hence, reflects a period of time. Net Income shows net worth of a company, before considering distributions to & contributions from shareholders. Accrual Basis of Accounting

Types of Financial Statements – Statement of Shareholder’s Equity The statement of shareholder's Equity reports changes in component accounts comprising equity. This statement is useful in identifying reasons for changes in shareholder’s claims on the assets of a company. Individual Equity Account Balances change due to selling stock, Repurchase of stock, issuing stock & re-investing of Net Income.

Types of Financial Statements – Statement of Cash flows Under Accrual Accounting, net income does not typically equal net cash flows except over the life of the firm. The statement of cash flows details cash inflows & outflows related to a company’s operating, investing & Financing activities over a period of time.

Information accompanying Financial Statements Management’s Discussion & Analysis (MD&A) Management Report Auditor Report Explanatory Notes Supplementary Information Social Responsibility Reports Proxy Statements

Information accompanying Financial Statements – MD&A The MD&A section reviews a company’s financial condition & results of operations They must also disclose prospective information involving material events & uncertainties regarding future operations. Qualitative information Forward looking information Required by Law

Information accompanying Financial Statements – Management Report A management Report sets out the responsibilities of management in preparing a company’s Financial Statements. Purpose: 1) To reinforce senior management’s responsibilities for the company’s Financial & Internal controls. 2) To reinforce the shared role of management, directors & auditors in preparing Financial statements.

Information accompanying Financial Statements – Auditor Report An external auditor is an independent certified public Accountant hired by management to assess weather the company’s Financial Statements are prepared in conformity with generally accepted Accounting Principles. Types of Auditor Opinions: 1) Unqualified opinion 2) Qualified Opinion 3) Adverse Opinion 4) Disclaimer of opinion

Information accompanying Financial Statements – Explanatory Notes Explanatory Notes are a means of communicating additional information regarding items included & excluded from the body of the statements. Explanatory notes include information on: 1) Accounting Principles & Methods 2) Detailed disclosure regarding each account 3) Commitments & contingencies 4) Transactions with related parties 5) Legal proceedings

Information accompanying Financial Statements – Supplementary Information Certain supplemental schedules required by accounting regulatory agencies appear in exhibits to Annual Reports filed with SEC. Supplemental Schedules include information on: 1) Business Segment Data 2) Export Sales 3) Marketable Securities 4) Valuation Accounts 5) Quarterly Financial Data

Information accompanying Financial Statements – Proxy Statements A proxy is a mean whereby a shareholder authorizes another person to act for him/her at a meeting of shareholder. A proxy statement contains information necessary for shareholders in voting on matters for which the proxy is solicited.

Preview of Financial Statement Analysis Building Blocks of Analysis Comparative Financial Statement Analysis (Horizontal Analysis) Common Size Financial Statements (Vertical Analysis) Ratio analysis of Financial Statements

Preview of Financial Statement Analysis – Building Blocks Short Term Liquidity Funds Flow Capital Structure & Long Term solvency Return on Investment Asset utilization Operating Performance

Preview of Financial Statement Analysis – Comparative Financial Statement Analysis Financial Statement users conduct comparative Financial Statement Analysis (Horizontal Analysis)by setting consecutive balance sheets, income statement & cash flow statement side by side & reviewing changes. Two techniques: 1) Year to year change analysis 2) Index number trend series analysis

Comparative Financial Statement Analysis – Year to year change Analysis - Example XYZ Company’s Income statement Year 1Year 2 Revenues Cost of Revenues Gross Profit Operating Expense 300 Interest Expense EBT Taxes Net Income 98260

Comparative Financial Statement Analysis – Year to year change Analysis - Example XYZ Company’s Income statement Year 1Year 2Change ($)Change (%) Revenues % Cost of Revenues % Gross Profit % Operating Expense % Interest Expense % EBT % Taxes % Net Income %

Comparative Financial Statement Analysis – Year to year change Analysis - Example XYZ Company’s Balance Sheet Year 1Year 2 Cash Marketable Sec A/R Property3500 Total Assets A/P Short Term Loan Common Stock4000 Retained Earnings TL & Equity

Comparative Financial Statement Analysis – Year to year change Analysis - Example XYZ Company’s Balance Sheet Year 1Year 2Change ($)Change (%) Cash % MKT Sec % A/R % Property3500 Zero Total Assets % A/P % S. Term Loan % C.S4000 Zero RE % TL & Equity %

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example Year 1Year 2Year 3 Revenues Cost of Revenues Gross Profit Operating Expense Interest Expense EBT Taxes Net Income

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example Year 1Year 2Year 3 Revenues Cost of Revenues Gross Profit Operating Expense Interest Expense EBT Taxes Net Income

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example Year 1Year 2Year 3 Cash Marketable Sec A/R Property Total Assets A/P Short Term Loan Common Stock Retained Earnings TL & Equity

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example Year 1Year 2Year 3 Cash Marketable Sec A/R Property 100Zero Total Assets A/P Short Term Loan Common Stock 100Zero112.5 Retained Earnings TL & Equity

Common Size Financial Statement Analysis Common Size Financial Statement Analysis (Vertical Analysis) is an inquiry into the internal structure of Financial statements. Comparison of company’s common size statements with competitors or over the years, alerts our attention to differences in account structures or distributions.

Common Size Financial Statement Analysis - Example Year 1Year 2 Revenues Cost of Revenues Gross Profit Operating Expense 300 Interest Expense EBT Taxes Net Income 98260

Common Size Financial Statement Analysis - Example Year 1Year 2 Revenues 100 Cost of Revenues 45%43.3% Gross Profit 55%56.67% Operating Expense 30%20% Interest Expense 10% EBT 15%26.67% Taxes 5.2%9.3% Net Income 9.8%17.3%

Common Size Financial Statement Analysis - Example Year 1Year 2 Cash 34.72%35.93# Marketable Sec %11.97% A/R 6.25%10.17% Property 48.61%41.92% Total Assets 100% A/P 2.78%4.2% Short Term Loan 33.33%32.93% Common Stock 55.55%47.90% Retained Earnings 8.3%14.97% TL & Equity 100%

Ratio Analysis of Financial Statements Financial Ratios are tools providing us with clues & symptoms of underlying conditions. Ratios, properly interpreted identify areas requiring further investigation. Factors affecting Ratios Ratio Interpretation

Financial Statement Analysis in an efficient Capital Market Pricing Efficiency refers to a market where prices at all times fully reflect all available information that is relevant to the valuation of securities. Forms 1. Weak form Efficient 2. Semi Strong form Efficient 3. Strong Form Efficient

Financial Statement Analysis in an efficient Capital Market Weak Form Efficient Weak Efficiency means that the price of a security reflects past price & trading history of a security. Semi Strong Form Efficient Semi Strong Efficiency means that the price of the security fully reflects all public information. Strong Form Efficient Strong Efficiency exists in a market where prices of security reflects all information, weather or not it is publicly available.

Overview of Financial Statement Analysis Chapter Preview Users of Financial Statements Business Activities Types of Financial Statements Information Accompanying financial Statements Financial Statement Analysis Preview Capital Market Efficiency & its implications on Financial Statement Analysis