overview of financial statement analysis chapter 1 robinson, munter, grant

Overview of Financial Statement Analysis

Chapter 1

Robinson, Munter, Grant

Grant, Munter & Robinson

Chapter 1 2

Learning Objectives

• Nature and purpose of Financial Analysis

• Accounting standards and processes underlying financial reports

• Role of professional financial analysts

Grant, Munter & Robinson

Chapter 1 3

Analysis for Decision Making

Financial statement analysis is a tool for making complex investment and credit decisions. Specifically, it is used to:– Evaluate historical performance– Predict future cash flows– Establish the value of an enterprise– Evaluate management

Grant, Munter & Robinson

Chapter 1 4

Pricing Investments

• The price an investor is willing to pay depends on predicted future cash flows

• Future cash flows from extending credit– Interest income

– Return of principal

• Future cash flows from equity investments– Dividends

– Proceeds – attributable to value growth – from stock sale

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Chapter 1 5

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

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Chapter 1 6

Cash Flows and Prices

Investors would like to pay an amount for an investment such that its annual future cash flows will provide a rate of return (r) greater than or equal to the return other potential uses of the money would provide.

Grant, Munter & Robinson

Chapter 1 7

Cash Flows and Prices

In cases of identical payouts, return equals

pricepurchase

flowscashfutureannualr

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Chapter 1 8

Cash Flows and Prices

Given a desired rate of return and an estimate of future cash flows, purchase price can be estimated as:

return of Rate

flowscash Future Price

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Chapter 1 9

Evaluating Management

• Financial statement analysis may be the basis for a manger’s performance appraisal

• Managers’ compensation may be a function of the this appraisal

• It’s important to understand which elements of performance are within or beyond managers’ control

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Chapter 1 10

Analysis Techniques

• Use publicly available data from financial statements including– Income Statement– Statement of Owners’ Equity– Balance Sheet– Statement of Cash Flows– Notes to Financial Statements

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Chapter 1 11

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

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Chapter 1 12

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• Comparison of large, diverse, multinational firms

is complex (and covered in detail in chapters 9 and 18)

Grant, Munter & Robinson

Chapter 1 13

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

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Chapter 1 14

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

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Chapter 1 15

Accounting and Reporting Standards

Analysts must become familiar enough with the accounting options available to the firm being studied in order to understand and evaluate the information presented in the financial statements

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Chapter 1 16

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.– The accounting profession worked to develop and refine

accounting principles and auditing procedures.

• 1970s– Financial Accounting Standards Board is created as the

authority on financial reporting for publicly traded US firms.

Grant, Munter & Robinson

Chapter 1 17

Development of International Accounting Standards

• International Accounting Standards (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

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Chapter 1 18

Regulatory Requirements

• SEC filing requirements– Form 10-K audited annual report– Form 10-Q quarterly report– Form 8-K periodic informational reports

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Chapter 1 19

Transactions and the Accounting Process

• Remember, Assets = Claims

• Original owners put $1,000 in corporate checking account

Assets = ClaimsCash Common Stock

$1,000 = $1,000

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Chapter 1 20

Transactions and the Accounting Process

• Maintain the Assets = Claims equality

• Build on previous transaction

• Corporation spends $50 on inventory= Claims

Cash Inventory Common Stock$1,000 = $1,000($50) $50$950 $50 = $1,000

Assets

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Chapter 1 21

Transactions and the Accounting Process

• Change the previous transaction:• Corporation purchases $50 of inventory on credit

=Cash Inventory Accts. Payable Common Stock

$1,000 = $1,000 $50 $50

$1,000 $50 = $50 $1,000

ClaimsAssets

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Chapter 1 22

Transactions and the Accounting ProcessExpanded Transaction Model

• Original owners put $1,000 in corporate checking account

• Corporation purchases $50 of inventory on credit

• Purchase a $5,000 building for $500 cash and $4,500 mortgage

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Chapter 1 23

Expanded Transaction Model

Assets = Claims

Cash Inventory Building Accounts Payable

Mortgage

Payable

Common Stock

$1,000 $1,000

$50 $50

($500) $5,000 $4,500

$500 $50 $5,000 = $50 $4,500 $1,000

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Chapter 1 24

Transactions and the Accounting ProcessExpanded 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

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Chapter 1 25

Expanded Transaction Model

Assets = Claims

Cash A/R Inventory Accounts Payable

Common

Stock

Retained

Earnings

($2,000) ($2,000)

$30,000 $30,000

($15,000) ($15,000)

($2,000) $30,000 ($15,000) = $13,000

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Chapter 1 26

Basic Financial StatementsUsing 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

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Chapter 1 27

The Professional AnalystBuy-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

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Chapter 1 28

The Professional AnalystProfessional Designation

• Association for Investment Management and Research (AIMR)– Established professional standards and ethics for

financial analysts

– Sets disciplinary procedures in the event that unethical behavior is suspected or detected

– Manages the Chartered Financial Analyst (CFA®) exam

• A series of three examinations covering economics, finance, statistics and financial statement analysis

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Chapter 1 29

The Professional AnalystRole of the Analyst

• Incorporate incrementally informative data into recommendations

• Analysis is an ongoing process utilizing many types of resources

• Financial statement analysis is the starting point of this process

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Chapter 1 30

Summary

• Objectives of financial analysis– Forecasting future cash flows– Evaluating past performance

• Role of accounting information

• Importance of accounting standards

• Primary financial statements

• Market efficiency (role of analysts)