Financial Statement Financial Statement AnalysisAnalysis

ByBy

A.S.P.G. ManawadugeA.S.P.G. Manawaduge

B.Y.G. RathnasekaraB.Y.G. Rathnasekara

Chapter 01- Introduction

Financial Statement AnalysisFinancial Statement Analysis

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

It is part of business analysis.It is part of business analysis.

Business AnalysisBusiness Analysis

Evaluation of the company’s prospects and Evaluation of the company’s prospects and risks for the purpose of making business risks for the purpose of making business decision.decision.

These decisions extend to equity and debt These decisions extend to equity and debt valuation, credit risk assessment, earnings valuation, credit risk assessment, earnings predictions, audit testing, compensation predictions, audit testing, compensation negotiations ect.negotiations ect.

Initial step in BA is to evaluate company’s Initial step in BA is to evaluate company’s

business environment and strategies to determinebusiness environment and strategies to determine Future business prospectsFuture business prospects Expected growthExpected growth Competitive strength & weaknessCompetitive strength & weakness Earning potential Earning potential Earning performanceEarning performance Sustainability Sustainability Financial condition Financial condition

Type of Business AnalysisType of Business Analysis

1. Credit analysis1. Credit analysis-- Trade creditorsTrade creditors-- Nontrade creditorsNontrade creditors

Evaluation of the creditworthiness Evaluation of the creditworthiness i.e ability to honor its credit obligationi.e ability to honor its credit obligationThis include analysis of liquidity and solvencyThis include analysis of liquidity and solvencyShort term credit-Short term credit- Financial conditions cash flows Financial conditions cash flows and liquidity of current assetsand liquidity of current assetsLong term creditLong term credit – Projection of cash flows, – Projection of cash flows, evaluation of extended profitability evaluation of extended profitability

2. Equity analysis2. Equity analysis

Technical analysisTechnical analysisSearches for pattern in the price or volume Searches for pattern in the price or volume history of a stock to predict future price history of a stock to predict future price movementsmovements

Fundamental analysisFundamental analysisAnalyzing and interpreting key factors for Analyzing and interpreting key factors for economy the industry and the company. The economy the industry and the company. The main part of fundamental analysis is evaluation main part of fundamental analysis is evaluation of a company’s financial position and of a company’s financial position and performance. performance.

Use of Business AnalysisUse of Business Analysis

CreditorsCreditors Equity holdersEquity holders ManagersManagers Mergers, acquisitions and divestitures Mergers, acquisitions and divestitures Directors Directors Regulators Regulators Labor unionsLabor unions Customers Customers

Components of Business AnalysisComponents of Business Analysis

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

Cont.Cont.

To accurately forecast future payoff it is necessary To accurately forecast future payoff it is necessary to evaluate company’s business prospects and its to evaluate company’s business prospects and its financial statementfinancial statement

Evaluation of business prospects is a goal of Evaluation of business prospects is a goal of business environment and strategy analysis.business environment and strategy analysis.

Company’s financial status is assessed from its Company’s financial status is assessed from its financial statements using financial analysis. financial statements using financial analysis.

Quality of financial analysis depends on the Quality of financial analysis depends on the reliability and economic content of the FS. This reliability and economic content of the FS. This require accounting analysis.require accounting analysis.

Component Processes of Business AnalysisComponent Processes of Business Analysis

Business environment and Strategy Analysis

Industry Analysis Strategy Analysis

Accounting Analysis

Financial Analysis

ProfitabilityCash Flows risk

Prospective Analysis

Cost of Capital Estimate

Intrinsic Value

Financial Statement Analysis

Analysis of company’s future prospect is to Analysis of company’s future prospect is to identify and assess a company’s economic and identify and assess a company’s economic and industry circumstances.industry circumstances.

This include analysis of its product labor and This include analysis of its product labor and capital market.capital market.

analysis of business strategy seeks to identify analysis of business strategy seeks to identify and assess company’s competitive strengths and and assess company’s competitive strengths and weaknesses along with its opportunities and weaknesses along with its opportunities and threats. threats.

1. 1. Business Environment and Strategy Business Environment and Strategy AnalysisAnalysis

Business Environment AnalysisBusiness Environment Analysis

It consists of two partsIt consists of two parts

Industry analysisIndustry analysis

Strategy analysis Strategy analysis

Industry AnalysisIndustry Analysis

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

Strategy analysisStrategy analysis

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

2. Accounting Analysis2. Accounting Analysis

Process of evaluating the extend to which a Process of evaluating the extend to which a company’s accounting reflects economic company’s accounting reflects economic reality.reality.

Financial statements are the sources of Financial statements are the sources of information for accounting analysis.information for accounting analysis.

Accounting analysis is important for Accounting analysis is important for comparative analysis. comparative analysis.

Limitations in Accounting AnalysisLimitations in Accounting Analysis Impossible to adopt uniform rules.Impossible to adopt uniform rules. Problem of setting standards.Problem of setting standards. Failure of standard to meet needs.Failure of standard to meet needs. Error in accounting estimate Error in accounting estimate

These limitations lead to, These limitations lead to,

-- Comparability problemsComparability problems

-- Accounting distortions Accounting distortions

Accounting distortionsAccounting distortions are deviations of are deviations of accounting information from the underline accounting information from the underline economics.economics.Forms of distortionsForms of distortions -- Managerial estimate subject to error or Managerial estimate subject to error or

omissions.omissions. -- Managers use their discretion in Managers use their discretion in accounting to manipulate or window accounting to manipulate or window dress dress - - Accounting standards fail to capture Accounting standards fail to capture

economic reality.economic reality.

Accounting RiskAccounting Risk

Uncertainty in financial statement analysis Uncertainty in financial statement analysis due to accounting distortions.due to accounting distortions.

A major goal of accounting analysis is to A major goal of accounting analysis is to evaluate and reduce accounting risk and to evaluate and reduce accounting risk and to improve the economic content of FS improve the economic content of FS including the comparability. including the comparability.

This requires restatement andThis requires restatement and

reclassification of FSreclassification of FS

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

3.3. Financial AnalysisFinancial Analysis

Use of FS to analysis a company’s financial Use of FS to analysis a company’s financial

position and performance and to assess position and performance and to assess

future financial performance.future financial performance.

Financial AnalysisFinancial Analysis

It consist of three areasIt consist of three areas

Profitability analysisProfitability analysis

Risk analysisRisk analysis

Analysis of sources and uses of fundsAnalysis of sources and uses of funds

Profitability AnalysisProfitability Analysis

Evaluation of company’s ROIEvaluation of company’s ROI- Company’s sources and levels of profitsCompany’s sources and levels of profits- Identifying and measuring the impact of Identifying and measuring the impact of

various profitability driversvarious profitability drivers- evaluation of two major source of evaluation of two major source of

profitability –margins and turnover profitability –margins and turnover - Reasons for changes in profitability and Reasons for changes in profitability and

the sustainability of earnings. the sustainability of earnings.

Risk AnalysisRisk Analysis

Evaluation of a company’s ability to meet its Evaluation of a company’s ability to meet its

commitments. commitments.

Assessing the solvency and liquidity along Assessing the solvency and liquidity along

with its earning variability with its earning variability

Analysis of sources and uses of fundsAnalysis of sources and uses of funds

Evaluation of how company obtaining Evaluation of how company obtaining and developing its fundsand developing its funds

4. Prospective analysis4. Prospective analysis

Forecasting of future profits – cash flows or Forecasting of future profits – cash flows or both both

5. Valuation5. Valuation

This is the main objective of many type of This is the main objective of many type of business analysisbusiness analysis

If refers to the process of converting forecast If refers to the process of converting forecast of future profit into an estimate of company of future profit into an estimate of company valuevalue

This need a valuation model and estimation This need a valuation model and estimation of company costs of capital. of company costs of capital.

Financial StatementsFinancial Statements

Basis of AnalysisBasis of Analysis

Business ActivitiesBusiness Activities

Planning Activities Planning Activities

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

Planning activity cont.Planning activity cont.

Planning help to identify expected opportunities Planning help to identify expected opportunities and obstacles. and obstacles.

Following information are important for planning Following information are important for planning Objectives and tacticsObjectives and tactics Market demandMarket demand Competitive analysisCompetitive analysis Sales strategies (Pricing, promotion, distribution) Sales strategies (Pricing, promotion, distribution) Management performanceManagement performance Financial projections Financial projections

Financing ActivitiesFinancing Activities

Methods that company use to raise the Methods that company use to raise the money to pay for the need.money to pay for the need.

There are two main sources of financingThere are two main sources of financing-Equity investors Equity investors -CreditorsCreditors

These activities depend on conditions in financial These activities depend on conditions in financial market. i.e. Sources of financingmarket. i.e. Sources of financing

In looking to financing market In looking to financing market company should considercompany should consider

amount of financing necessaryamount of financing necessary sources of financingsources of financing timing of repaymenttiming of repayment structure of financing agreementsstructure of financing agreements

Financing activities are also involve Financing activities are also involve

Return: Equity investor’s share of earningReturn: Equity investor’s share of earning

Earning distribution: Dividend payoutEarning distribution: Dividend payout

Earning reinvestment: Retention RatioEarning reinvestment: Retention Ratio Public placement or private placementPublic placement or private placement Financing from creditorsFinancing from creditors

Debt creditorsDebt creditors

Operating creditorsOperating creditors

Investing ActivitiesInvesting Activities

Acquisition and maintenance of investment Acquisition and maintenance of investment Investing funds in different assets.Investing funds in different assets.

-- Operating assets and Financial assetsOperating assets and Financial assetsor or

- - Current assets and non current assetsCurrent assets and non current assets

Investing decisions involveInvesting decisions involve- - types of investments necessary types of investments necessary -- amount require for each typeamount require for each type-- acquisition timingacquisition timing-- assets location assets location

Operating activitiesOperating activities

Carrying out of the business plan given its Carrying out of the business plan given its financing and investing activitiesfinancing and investing activities

R & DR & D Procument Procument ProductionProduction MarketingMarketing AdministrationAdministration

Financial Statement Reflect Financial Statement Reflect Business activities Business activities

Balance sheet :reflect Financing activities,&Balance sheet :reflect Financing activities,&Investing activities Investing activities

Income statement: reflect Operating Income statement: reflect Operating activities.activities.

Cash flow statement: reflect financing, Cash flow statement: reflect financing, investing and operating activitiesinvesting and operating activities

Statement of changes in equity: reflect Statement of changes in equity: reflect Financing activitiesFinancing activities

Additional informationAdditional information

In addition to the major components of FS In addition to the major components of FS following information is presented with FSfollowing information is presented with FS

Management’s discussion and analysisManagement’s discussion and analysis Management reportManagement report Auditor reportAuditor report Explanatory notesExplanatory notes Supplementary informationSupplementary information

Analysis ToolsAnalysis Tools

Comparative analysisComparative analysis Common-size analysisCommon-size analysis Ratio analysisRatio analysis Cash flow analysisCash flow analysis Valuation Valuation

Comparative AnalysisComparative Analysis

This is done by requiring consecutive This is done by requiring consecutive balance sheets, income statement from balance sheets, income statement from period to period.period to period.The most important information often The most important information often revealed from comparative FS analysis is revealed from comparative FS analysis is trend.trend.Two techniques of comparative analysis.Two techniques of comparative analysis.1.1.Year to year change analysisYear to year change analysis2.2. Index number trend analysisIndex number trend analysis

Year-to year change analysisYear-to year change analysis

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

Index Number Trend AnalysisIndex Number Trend Analysis

Useful tool for long term trend comparison. Useful tool for long term trend comparison.

A base period should be selected with a preselected A base period should be selected with a preselected index number usually set to 100.index number usually set to 100.

Base year should be a normal year with regard to Base year should be a normal year with regard to business condition.business condition.

Only the significant items are analyzed.Only the significant items are analyzed.

Current year balanceCurrent year balance

Current year index No = --------------------------Current year index No = -------------------------- x 100 x 100

Base year balanceBase year balance

Common Size FS AnalysisCommon Size FS Analysis

FS analysis can benefit form knowing what FS analysis can benefit form knowing what proportion of a group or subgroup is made proportion of a group or subgroup is made up of a particular account. Values of the up of a particular account. Values of the items are brought to a common size.items are brought to a common size.

e.g. Balance sheet items are expressed as a e.g. Balance sheet items are expressed as a % of total assets.% of total assets.

This analysis is specially useful for inter This analysis is specially useful for inter company comparison. company comparison.

Ratio Analysis Ratio Analysis

A ratio expresses a mathematical relation between A ratio expresses a mathematical relation between two quantities.two quantities.If the two quantities are 1000 and 500 ratios can If the two quantities are 1000 and 500 ratios can be presented as follow.be presented as follow.

i.i. 50%50%ii.ii. 2:12:1iii.iii. ½ ½ iv.iv. 22

To be a meaningful, a ratio must refer to an To be a meaningful, a ratio must refer to an economically important relation.economically important relation.

Factors Affecting RatiosFactors Affecting Ratios

Effect of economic events Effect of economic events Industry factorsIndustry factors Management policiesManagement policies Accounting methodsAccounting methods

Ratio interpretation Ratio interpretation

Simply computation is not useful. Ratios Simply computation is not useful. Ratios should be interpreted with care.should be interpreted with care.

They are interpreted in comparison withThey are interpreted in comparison with Prior ratiosPrior ratios Predetermined standardPredetermined standard Ratios of competitors Ratios of competitors

Major areas for which RA can be Major areas for which RA can be applied.applied.

1. Credit analysis1. Credit analysis

i. i. Liquidity – Ability to meet short term Liquidity – Ability to meet short term obligationobligation

ii.ii. Capital structure and solvencyCapital structure and solvency

- ability to meet long term - ability to meet long term obligationobligation

2. Profitability 2. Profitability i. i. ROI – to asses the rewards to the ROI – to asses the rewards to the suppliers of fundssuppliers of fundsii. ii. Operating performance. To evaluate Operating performance. To evaluate

profit margin from operating activities.profit margin from operating activities. iii.iii. Asset utilization – To evaluate Asset utilization – To evaluate

effectiveness and intensity of assets effectiveness and intensity of assets in in generating sales.generating sales.

3.3. Valuation Valuation To estimate the intrinsic value of aTo estimate the intrinsic value of a

company (stock)company (stock)

Types of ratiosTypes of ratios

11. Liquidity. Liquidity Current ratioCurrent ratio Acid-test ratioAcid-test ratio Collection periodCollection period Days to sell inventoryDays to sell inventory

2. Capital structure & solvency2. Capital structure & solvency Total debt to equityTotal debt to equity Long term debt to equityLong term debt to equity Interest coverage (Times interest earned )Interest coverage (Times interest earned )

3.3. ROI ROI Return on assetsReturn on assets Return on equity Return on equity

4.4. Operating performance Operating performance Gross profit margin Gross profit margin Operating profit marginOperating profit margin Pretax marginPretax margin Net profit marginNet profit margin

5. Asset utilization5. Asset utilization Cash turnoverCash turnover Accounts receivable turnoverAccounts receivable turnover Inventory turnoverInventory turnover Working Capital turnoverWorking Capital turnover PPE turnoverPPE turnover Total assets turnoverTotal assets turnover

6.6. Market Measures Market Measures Price earning ratioPrice earning ratio Earning yieldEarning yield Dividend yieldDividend yield Dividend pay outDividend pay out Price to book valuePrice to book value

Cash flowCash flow analysisanalysis

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

ValuationValuation

It refers to estimating the intrinsic value of a It refers to estimating the intrinsic value of a company or its stock. The basis of company or its stock. The basis of valuation is “valuation is “present value theorypresent value theory.”.”

The theory states,The theory states,

the value of debt or equity security is equal the value of debt or equity security is equal to the sum of all expected future payoffs to the sum of all expected future payoffs from the security that are discounted to the from the security that are discounted to the present at an appropriate discount rate. present at an appropriate discount rate.

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

Debt ValuationDebt Valuation

The value of The value of Present value of its Present value of its

a debt security =a debt security = future payoffs future payoffs

discounted at andiscounted at an

appropriate rate appropriate rate

Value of the bond at time ‘t’ or Bt is Value of the bond at time ‘t’ or Bt is calculated as follow:calculated as follow:

1t+1 1t + 2 1t + n F 1t+1 1t + 2 1t + n F

Bt = ------- + --------- + …..---------- + -------Bt = ------- + --------- + …..---------- + -------

(1 + r)(1 + r)1 1 (1 + r)(1 + r)2 2 (1 + r)(1 + r)n n (1 + r)(1 + r)n n

Example:Example:

A company issued 1000 ten year A company issued 1000 ten year debenture Rs. 100 each with year end debenture Rs. 100 each with year end interest rate of 12% percent per anum interest rate of 12% percent per anum on 01.01.2000on 01.01.2000

You are asked to calculate value of the You are asked to calculate value of the debenture as at 01.01.2006. When the debenture as at 01.01.2006. When the yield to maturity is 10%.yield to maturity is 10%.

SolutionSolution

Remaining period 4 years.Remaining period 4 years.

1212

Annual interest is 100,000 x ----- = 12000Annual interest is 100,000 x ----- = 12000

100100

Value = 12,000 / (1.1) + 1200 / (1.1)Value = 12,000 / (1.1) + 1200 / (1.1)22 + 12000 / (1.1) + 12000 / (1.1)33

+ 1200 / (1.1)+ 1200 / (1.1)44 + 100000 / (1.1) + 100000 / (1.1) 4 4

Equity valuationEquity valuation

Value of the equity security is the present Value of the equity security is the present value of future payoffs discounted at an value of future payoffs discounted at an appropriate rate.appropriate rate.

Equity investor looks for two main Equity investor looks for two main (uncertain) payoffs.(uncertain) payoffs.

1. Dividends1. Dividends

2. Capital appreciation 2. Capital appreciation

Value of E (D t +1) E (D t +2) E (Dt + 3) Value of E (D t +1) E (D t +2) E (Dt + 3)

Equity = ------------- + -------------- + --------------- ……Equity = ------------- + -------------- + --------------- ……

security (1+ k)security (1+ k)1 1 (1+ k)(1+ k)2 2 (1+ k)(1+ k)33

At time tAt time t

This model is called the ‘dividend discount model.This model is called the ‘dividend discount model.

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

Practical ConsiderationPractical Consideration

The dividend discount model face practical The dividend discount model face practical problems.problems. Infinite horizon Infinite horizon Payments are discretionaryPayments are discretionary Different dividend policyDifferent dividend policy

Free cash flow modelFree cash flow model

Equity value of a time t is computed replacing expected Equity value of a time t is computed replacing expected

dividends with expected free cash flows to equitydividends with expected free cash flows to equity..E(FCFt +1) E(FCF 1 + 2) (FCF1 + n ) E(FCFt +1) E(FCF 1 + 2) (FCF1 + n )

Vt = ----------------- + -----------------+ ….. ------------------Vt = ----------------- + -----------------+ ….. ------------------ (1 + k)(1 + k)1 1 (1 + k)(1 + k)2 2 (1 + k)(1 + k)nn

FEF 1+n is free cash flow to equity in period t +n, and k is cost FEF 1+n is free cash flow to equity in period t +n, and k is cost of capital.of capital.Free cash flows to equity are defined asFree cash flows to equity are defined as(cash flows from operation ) - (capital expenditure + increase in debt)(cash flows from operation ) - (capital expenditure + increase in debt)

Value of the entire firmValue of the entire firm

FCF to the firm equal to operating cash FCF to the firm equal to operating cash flows (adjusted for interest expense and flows (adjusted for interest expense and revenue) less investment in opening assets.revenue) less investment in opening assets.

Value of the entire firm equal the discounted Value of the entire firm equal the discounted expected future free cash flows using the expected future free cash flows using the weighted average cost of capital.weighted average cost of capital.

Value of = Value of - value of the debtValue of = Value of - value of the debt

The equity the firmThe equity the firm

Residual Income Model Residual Income Model

Equity value at time t is the sum of Equity value at time t is the sum of current book value and the present current book value and the present value of all future expected residual value of all future expected residual income.income.

E(RIt+1) E(RIt +2) ERIt+nE(RIt+1) E(RIt +2) ERIt+n

Vt = Bvt + ------------ + ------------- + …. ----------Vt = Bvt + ------------ + ------------- + …. ----------

(1 + k)(1 + k)11 (1+k) (1+k)22 (1 + k) (1 + k)nn

Bvt = Book value at the end of the period tBvt = Book value at the end of the period t

RIt+n is residual income in period t + n k is RIt+n is residual income in period t + n k is cost of capital.cost of capital.

Residual income at a time t is defined asResidual income at a time t is defined as

Comprehensive - a charge on beginningComprehensive - a charge on beginning

Net income book value Net income book value

Analysis in an efficient marketAnalysis in an efficient market

The EMH deals with the reaction of market prices The EMH deals with the reaction of market prices to financial and other informationto financial and other information

There are three forms of EMHThere are three forms of EMHWeak form: Price reflect fully the information Weak form: Price reflect fully the information

contained in historical price contained in historical price movement movement

Semi strong form: Price reflect fully all Semi strong form: Price reflect fully all publicly available information publicly available information

(historical price movement +A/R) (historical price movement +A/R)Strong form: Price reflect all information including Strong form: Price reflect all information including

inside information inside information