Chapter 29 – Introduction to FS analysis

Chapter 29 – Introduction to FS analysis

· Profit – It represents the excess of the prices at which goods or services are sold over all the costs of providing those goods and services (regardless of when cash is received or paid)

· Importance of cash flow - Ultimately cash is needed to pay employees, suppliers, and others to continue as a going concern.

· Liquidity – The ability to meet short term obligations

· Solvency – The ability to meet long term obligations

· The financial position (BS) can be measured by comparing the resources controlled by the company in relation to the claims against those resources.

Financial Statements

Income Statement (IS)

· Profit & Loss Statement / Statement of Operations (* for a particular period only)

· Net Income = Revenue – Cost = Profit or Bottom Line

· IS indicates how much revenue the company is generating during a period & what costs it is incurring while generating the revenue.

· Income is reported when earned, not necessarily when cash is received

· Net revenue is called bottom line because of its proximity to the bottom of the income statement.

· Consolidated basis reporting of IS statement – It includes the revenue and expenses of affiliated companies under the control of the parent (reporting) company.

· EBIT = Operating Income

Ø It reflects a company’s profit from its usual business activities before deducting interest expense or tax.

Ø It reflects the company’s underlying performance independent of the use of financial leverage.

· Minority Interest expense – Interest earned by the minority shareholders from subsidiaries of a company (MIE shown on the company’s consolidated BS)

· EPS = Net Income or Profit / Number of shares outstanding during the period

Ø Basic EPS = Shares (wt shares) standing in actual

Ø Diluted EPS = When dilutive claims on common shares are exercised by share holders

Ø Diluted Shares >= Basic shares & Basic EPS >= Diluted EPS

· Revenue may go up if

Ø Prices go up

Ø Number of units sold goes up

Ø Both goes up (in totality)

Balance Sheet (BS)

· Statement of Financial Position / Statement of financial condition

· It is at a particular point in time, unlike IS, which is for a particular period.

· Balance Sheet represents a company’s current financial position by disclosing resources the company controls (assets) and what it owes (liabilities) at a specific point in time

· Owner’s equity

Ø Partner’s capital / Shareholder equity

Ø It represents the excess of assets over liabilities

Ø It is the residual interest in the assets of an equity after deducting its liabilities (Owner’s Equity = Assets – Liabilities, called the accounting equation). It is incorrect to show Liabilities = Assets - Owner’s Equity

· Assets = Liabilities + Owner’s Equity …………………………… (Accounting Equation)

Statement of Cash Flows (CFS)

· Purpose of CFS – Disclosing the sources and uses of cash helps creditors, investors and other statement users to evaluate the company’s liquidity, solvency & financial flexibility.

· Financial Flexibility – It is the ability to react and adapt to financial adversities and opportunities.

· All cash flows are divided into 3 types based on following 3 activities –

Ø Operating Activities

§ It involves transactions that enter into the determination of net income (profit)

§ It comprises primarily of activities that comprise the day-to-day business functions of a company.

Ø Investing Activities

§ They are associated with acquisition and disposal of long term assets (like equipments)

Ø Financing Activities

§ They are those activities related to obtaining or repaying capital to be used in the business

· Net change in cash flows = Change in (Investing + Operating + Financing) CFS + Change in exchange rates

· CFS represents ability of a company to generate cash flow from running its business.

· Primary source of cash flow is from operating activities (as opposed to investing or financing activities)

Statement of Changes in Owner’s / Statement of Shareholder’s equity / Statement of Retained earnings

It serves to report the changes in the owner’s investment in the business over time.

Financial Notes and Supplementary Schedules

They are integral part of the financial statements and provides information about the following –

Ø Business acquisition and disposals

Ø Commitments and contingencies

Ø Legal proceedings

Ø Stock Option and other employee benefits

Ø Related-party transactions

Ø Significant customers

Ø Subsequent events

Ø Business and geographic segments

Ø Quarterly financial data

Footnotes – Contains information about the methods, estimates & assumptions used to prepare the financial statements.

IASB, London (International Accounting Standards Board, London) – They set standards (IFRS) under which the international financial statements should be prepared. FASB USA (Financial accounting standard board) performs the same task as that of IASB. Their principles are called US-GAAP (Generally accepted accounting principles)

Management’s Discussion and Analysis (material events & uncertainties)

· In MD&A, management must highlight any favorable or unfavorable trends and identify any significant events and uncertainties that affect the company’s liquidity, capital, resources and results of operations

· It should provide the information (like inflation) that would cause the future operating results to depart from current reporting

· Company’s disclosure in MD&A – Disclosure should discuss the critical accounting policies that require management to make subjective judgments and that have significant impact on reported financial results.

Auditor’s Report

· Company’s financial statements audited (examined) by an independent accounting firm.

· Audits may be required by contractual arrangements, law or regulation.

· IAASB of IFA sets accounting standard (Int. Auditing & Assurance Std. Board of Int. Federation of Accountants). In US, it is PCAOB (US Audit board) taking into consideration SOX (Public Company Accounting Oversight board)

· Because of Audit Sampling Techniques, independent auditors can’t express opinion that provides absolute assurance about the accuracy and precision of the financial statements.

· Independent audit report provides reasonable assurance that financial statements are fairly presented, meaning that there is a high degree of probability that the audited financial reports are free from material error, fraud, or illegal acts that have direct effect on the financial statements.

· Paragraphs in the audit report –

Ø Introductory paragraph –

§ It describes the Financial statements that were audited

§ It states responsibilities of both the management and the independent auditors.

Ø Scope –

§ It describes the nature of the audit process

§ It provides the basis for the auditor’s expression about reasonable assurance on the fairness of the financial statements.

Ø Opinion Paragraph – It expresses the auditor’s opinion on the fairness of the audited financial statements.

§ Unqualified / Clean Audit Opinion (Auditors want to see) – It states that financial statements gives a “true and fair view” (international) or are “fairly presented” (international & US) in accordance with applicable accounting standards.

§ Qualified Audit Opinion – It is the one in which there is some limitation or exception to accounting standards. Exception is described in the audit report with additional explanatory paragraphs so that the analyst can determine the importance of exception.

§ Adverse Audit Opinion –

· It occurs when the financial statements materially departs from accounting standards & are not fairly presented.

· It makes analysis of FS easy as company’s FS can’t be relied upon.

§ Disclaimer of opinion – It occurs when, for some reason, the auditors are unable to issue an opinion.

· In US under SOX, the auditors must also express an opinion on the company’s internal control system. The ICS is company’s internal system that is designed to ensure company’s process for generating financial report is sound.

· Requirement to be met by publically traded company in US –

Ø Accept responsibility for the effectiveness of internal control

Ø Evaluate the effectiveness of IC using suitable control criterion.

Ø Support the evaluation with sufficient competent evidence

Ø Provide a report on internal control

· What SOX do –

Ø States management’s responsibility to establish and maintain adequate internal control.

Ø Identify management’s framework for evaluating internal control.

Ø Certify that the company’s financial statements are fairly presented

Ø Include a statement that the company’s auditors have issued an attestation report on management’s assessment

Ø Include management’s assessment of the effectiveness of the company’s IC over financial reporting as of the end of the most recent year, including a statement as to whether IC over financial reporting(ICFR) is effective.

§ ICFR – It is a process designed to provide reasonable assurance regarding reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in US.

Other Sources of Information (apart from financial statements)

1) Interim Report –

a. They are also provided by the company semi-annually or quarterly

b. The generally present the 4 financial statements & footnotes are not audited.

c. It provides updated information on a company’s performance & financial position since the last annual period

2) Proxy Statements –

a. Prepared for distribution to share-holders on matter that are to be out to vote at the company’s annual (or special) meeting of shareholders

b. It provides useful information like –

i. Management and Director’s compensation

ii. Company’s stock performance

iii. Potential conflict of interest that may exist between management, board & shareholders.

3) Company also provides relevant information on their websites & in press releases

Financial Statement Analysis Framework

1) Articulate the purpose & context of analysis –

a. Outputs are –

i. Timetable & budgeted resource for completion

ii. SOP

iii. List of unanswered questions

iv. Nature & content of report provided

2) Collect Data –

a. Key focus is obtaining an understanding of the company’s business. Financial performance and financial position (including trends over time & in comparison with peer companies)

b. Analyst to use the top down approach (From Economy to industry)

c. Outputs are –

i. Organized financial statements

ii. Financial data tables

iii. Completed questionnaires, if applicable

3) Process Data –

a. Using appropriate analytical tools.

b. Outputs are –

i. Adjusted financial statements

ii. Common size statements

iii. Ratios and graphs

iv. Forecasts

4) Analyze / interpret the processed data – To support any buy/sell/hold decision by an equity analyst (Target value, relative performance, future performance etc is cited).

5) Develop and communicate conclusions / recommendations – Whether to make an investment or not.

a. Summary & Investment conclusion

b. Business Summary

c. Risks

d. Valuation

e. Historical & pro forma tables

6) Follow-up – To ensure that proper analysis is done & refined from time to time.