McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Statement
Analysis
K R SubramanyamJohn J Wild
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1CHAPTER
Overview of Financial Statement Analysis
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Business Analysis
Evaluate ProspectsEvaluate Prospects Evaluate RisksEvaluate Risks
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Information Sources for Business Analysis
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Credit Analysis
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Credit Analysis
Liquidity
Ability to meet short-term obligations Focus: • Current cash flows• Make up of current assets and liabilities• Liquidity of assets
Liquidity
Ability to meet short-term obligations Focus: • Current cash flows• Make up of current assets and liabilities• Liquidity of assets
Solvency
Ability to meet long-term obligations Focus:• Long-term profitability• Capital structure
Solvency
Ability to meet long-term obligations Focus:• Long-term profitability• Capital structure
Credit worthiness: Ability to honor credit obligations(downside risk)
Credit worthiness: Ability to honor credit obligations(downside risk)
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Equity Analysis
Technical analysis / Charting
• Patterns in price or volume history of a stock
• Predict future price movements
Technical analysis / Charting
• Patterns in price or volume history of a stock
• Predict future price movements
Fundamental Analysis
Determine Intrinsic value without reference to price
• Analyze and interpret key factors
– Economy
– Industry
– Company
Fundamental Analysis
Determine Intrinsic value without reference to price
• Analyze and interpret key factors
– Economy
– Industry
– Company
Assessment of downside risk and upside potentialAssessment of downside risk and upside potential
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Accounting Analysis
AccountingRiskAccountingRisk
Process to evaluate and adjust financial statements to better reflect economic reality
Process to evaluate and adjust financial statements to better reflect economic reality
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Financial Analysis
Profitability analysis — Evaluate return on investments
Risk analysis ——— Evaluate riskiness & creditworthiness
Analysis of — Evaluate source & cash flows deployment of funds
Profitability analysis — Evaluate return on investments
Risk analysis ——— Evaluate riskiness & creditworthiness
Analysis of — Evaluate source & cash flows deployment of funds
Common toolsCommon tools
Ratioanalysis
Ratioanalysis
Cash flow
analysis
Cash flow
analysis
Process to evaluate financial position and performance using financial statements
Process to evaluate financial position and performance using financial statements
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Prospective Analysis
Intrinsic ValueIntrinsic Value
Business Environment& Strategy Analysis
Business Environment& Strategy Analysis
Accounting AnalysisAccounting Analysis
Financial AnalysisFinancial Analysis
Process to forecast future payoffsProcess to forecast future payoffs
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Dynamics of Business Activities
Business ActivitiesBusiness Activities TimeTime
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Business Activities
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Business Activities
Financing
Financing activities
• Owner (equity)
• Nonowner (liabilities)
Financing activities
• Owner (equity)
• Nonowner (liabilities)
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Investing activities
• Buying resources
• Selling resources
Investing activities
• Buying resources
• Selling resources
Investing = Financing Investing = Financing
Business Activities
FinancingInvesting
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Operating ActivitiesRevenues and expenses from providing
goods and services
Operating ActivitiesRevenues and expenses from providing
goods and services
Business Activities
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Financial Statements Reflect Business Activities
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Financial Statements
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Balance Sheet
Total Investing = Total Financing
= Creditor Financing + Owner Financing
Total Investing = Total Financing
= Creditor Financing + Owner Financing
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Income Statement
Revenues – Cost of goods sold = Gross Profit
Gross profit – Operating expenses = Operating Profit
Revenues – Cost of goods sold = Gross Profit
Gross profit – Operating expenses = Operating Profit
Colgate’s Profitability(in $billions)
$12.238 - $5.536 = $6.701 Gross Profit
$6.701 - $4.5411 = $2.160 Operating profit
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Statement of Cash Flows
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Additional Information(Beyond Financial Statements)
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Analysis Preview
Purpose: Evaluation of consecutive financial statements
Output: Direction, speed, & extent of any trend(s)
Types: Year-to-year Change Analysis
Index-Number Trend Analysis
Purpose: Evaluation of consecutive financial statements
Output: Direction, speed, & extent of any trend(s)
Types: Year-to-year Change Analysis
Index-Number Trend Analysis
Comparative AnalysisComparative Analysis
Yr2Yr1 Yr3
Analysis Preview
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Analysis Preview
Purpose : Evaluation of internal makeup
of financial statements
Evaluation of financial statement accounts across companies
Output: Proportionate size of assets, liabilities, equity, revenues, & expenses
Purpose : Evaluation of internal makeup
of financial statements
Evaluation of financial statement accounts across companies
Output: Proportionate size of assets, liabilities, equity, revenues, & expenses
Common-Size AnalysisCommon-Size Analysis
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Analysis Preview
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Analysis Preview
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Analysis Preview
Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis)
Output: Mathematical expression of relation between two or more items
Cautions: Prior Accounting analysis is important
Interpretation is key - long vs short term & benchmarking
Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis)
Output: Mathematical expression of relation between two or more items
Cautions: Prior Accounting analysis is important
Interpretation is key - long vs short term & benchmarking
Ratio AnalysisRatio Analysis
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Analysis Preview
Purpose: Estimate intrinsic value of a
company (or stock)
Basis: Present value theory (time value of
money)
Purpose: Estimate intrinsic value of a
company (or stock)
Basis: Present value theory (time value of
money)
ValuationValuationValuation - an important goal of many types
of business analysisValuation - an important goal of many types
of business analysis
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Analysis Preview
Debt (Bond) ValuationDebt (Bond) Valuation
Bt is the value of the bond at time tIt +n is the interest payment in period t+nF is the principal payment (usually the debt’s face value)r is the investor’s required interest rate (yield to maturity)
Bt is the value of the bond at time tIt +n is the interest payment in period t+nF is the principal payment (usually the debt’s face value)r is the investor’s required interest rate (yield to maturity)
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Analysis Preview
Equity ValuationEquity Valuation
Vt is the value of an equity security at time tDt +n is the dividend in period t+nk is the cost of capitalE refers to expected dividends
Vt is the value of an equity security at time tDt +n is the dividend in period t+nk is the cost of capitalE refers to expected dividends
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Analysis Preview
Equity Valuation - Free Cash Flow to Equity Model
Equity Valuation - Free Cash Flow to Equity Model
FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures]
k is the cost of capitalE refers to an expectation
FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures]
k is the cost of capitalE refers to an expectation
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Analysis Preview
Equity Valuation - Residual Income ModelEquity Valuation - Residual Income Model
BVt is the book value at the end of period tRit+n is the residual income in period t + n [defined as
net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital E refers to an expectation
BVt is the book value at the end of period tRit+n is the residual income in period t + n [defined as
net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital E refers to an expectation
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Analysis in an Efficient Market
Three assumed forms of market efficiencyThree assumed forms of market efficiency
Weak Form - prices reflect information in past prices
Semi-strong - prices reflect all public
Form information
Strong Form - prices reflect all public and private information
Weak Form - prices reflect information in past prices
Semi-strong - prices reflect all public
Form information
Strong Form - prices reflect all public and private information
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Book Organization