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

2. 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.

3. 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.

4. 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

5. 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

6. 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.

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

8. 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.

9. 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.

10. 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

11. 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.

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

13. 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

14. 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

15. 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.

16. 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

17. 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.

18. 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

19. 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

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

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

22. 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.

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

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

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

26. 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.

27. Financial Statements
Basis of Analysis
Business Activities

28. 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.

29. 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

30. 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

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

32. 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

33. 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

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

35. 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

36. 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

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

38. 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

39. 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.

40. 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

41. 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.

42. 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.

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

44. 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

45. 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

46. 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)

47. 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 )

48. 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

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

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

51. 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

52. 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.

53. 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

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

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

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

57. Solution Remaining period 4 years. 12
Annual interest is 100,000 x = 12000
100
Value = 12,000 / (1.1) / (1.1) / (1.1)3
/ (1.1) / (1.1) 4

58. 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

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

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

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

62. 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 + k) (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)

63. 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

64. 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+k) (1 + k)n

65. 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

66. 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