CHAPTER 1 FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION

FINANCIAL REPORTING AND FINANCIAL STATEMENT ANALYSIS

Financial Reporting
Providing financial information about an entity to enable users to make decisions Financial information includes financial statements and other types of reports

Financial Statement Analysis

Using financial information to assess prior performance and likely future performance to make decisions Typical decision: capital allocation

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FINANCIAL REPORTING WHAT THE COMPANY REPORTED (EXCERPT)

Apple Reports Second Quarter Results Record March Quarter Sales of iPhones, iPads and Macs Net Profit Increases 94% Year-over-Year CUPERTINO, CaliforniaApril 24, 2012Apple today announced financial results for its fiscal 2012 second quarter ended March 31, 2012. The Company posted quarterly revenue of $39.2 billion and quarterly net profit of $11.6 billion, or $12.30 per diluted share. These results compare to revenue of $24.7 billion and net profit of $6.0 billion, or $6.40 per diluted share, in the year-ago quarter. Gross margin was 47.4 percent compared to 41.4 percent in the year-ago quarter. International sales accounted for 64 percent of the quarters revenue.

Excerpt from Apples earnings announcement (2Q2012)

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FINANCIAL ANALYSIS ANALYSTS RESPONSE (EXCERPT)

On April 24, 2012, Apple (AAPL) reported results that blew past everyone's expectations, including our expectations. Apple reported quarterly revenue of $39.2B and quarterly profit of $11.6B, or $12.30 EPS. This surpassed the $10.07 consensus estimates from the analyst community. Apple saw growth due to strong sales growth from all of its product lines. Revenue enjoyed a mammoth 59% increase versus Q2 2011 and EPS grew by over 92%. EPS Growth was also aided by a higher gross margin, which was aided by lower commodity input costs associated with Apple's products.
Saibus Research , Seeking Alpha (25 April 2012)

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FINANCIAL STATEMENTS
Statement of Financial Position Statement of Comprehensive Income Statement of Changes in Equity Statement of Cash Flows Notes

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FINANCIAL STATEMENTS STATEMENT OF FINANCIAL POSITION

Statement of Financial Position (the Balance Sheet) Assets = Liabilities + Owners equity

Assets Liabilities = Owners equity

Point in Time

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Assets of Lindt & Sprngli Group

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Liabilities and Equity of Lindt & Sprngli Group

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FINANCIAL STATEMENTS: STATEMENT OF COMPREHENSIVE INCOME

Also known as the income statement, statement of earnings, or profit and loss statement Comprehensive income: All items that affect owners equity but are not the result of transactions with shareholders Comprehensive income = Net income + Other comprehensive income Presentation permitted Single statement of comprehensive income Two consecutive statements Net Income = Income Expenses Period of time

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Lindt & Sprngli Group Income Statement

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Lindt & Sprngli Group Statement of Comprehensive Income

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FINANCIAL STATEMENTS: STATEMENT OF CHANGES IN EQUITY

Also known as statement of changes in owners equity or statement of shareholders equity Period of time Beginning equity + Changes in equity = Ending equity Basic components of owners equity are paid-in capital and retained earnings. Beginning common stock + Issuances Repurchases = Ending common stock Beginning retained earnings + Net Income Dividends = Ending retained earnings Beginning AOCI + OCI = Ending AOCI

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Lindt & Sprngli Group Statement of Changes in Equity

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FINANCIAL STATEMENTS STATEMENT OF CASH FLOWS

Period of time Beginning Cash + Changes in cash = Ending cash Changes in cash from Operating Investing Financing

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Portions omitted

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ACCOMPANYING NOTES
The notes (also sometimes referred to as footnotes) that accompany the four financial statements are required and form an integral part of the statements. Notes include information on - Significant accounting choices (policies, methods, and estimates). - Explanatory detail about line items on the face of the financial statements. - Other disclosures, such as commitments and contingencies. Based on notes disclosures, analysts can understand whether accounting choices are similar for the companies being compared. If the policies differ, an analyst can often make necessary adjustments so that the financial statement data used are more comparable.

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EXAMPLE OF DISCLOSURE OF ACCOUNTING PRINCIPLES IN NOTES

Property, plant, and equipment Property, plant, and equipment are valued at historical cost, less the accumulated depreciation. The assets are depreciated using the straight-line method over the period of their expected useful economic life. Historical cost includes all costs associated with the acquisition. Subsequent costs increasing the value of an asset are, depending on the case, either recorded in the book value of the asset or as a separate asset, to the extent that it can be assumed that it is likely that the Group will benefit from it in the future and that its costs can be calculated in a reliable manner. All other repair or maintenance costs are reflected in the income statement in the year of their occurrence. Land is not depreciated. Depreciation on other assets is calculated using the straight-line method to write down their cost to their residual values. The following useful lives have been applied: Buildings (incl. installations): 5 40 years Machinery: 10 15 years Other fixed assets: 3 8 years Profits and losses from disposals are recorded in the income statement. Excerpt from Lindt & Sprngli Group, Annual Report (2011)
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EXAMPLE OF DISCLOSURE OF LINE ITEM DETAIL IN NOTES

Excerpt from Lindt & Sprngli Group, Annual Report (2011)

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EXAMPLE OF DISCLOSURE IN NOTES

Excerpt from Lindt & Sprngli Group, Annual Report (2011)

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MANAGEMENT COMMENTARY OR MD&A

Management commentary - Is a narrative report that provides a context within which to interpret the financial position, financial performance, and cash flows of an entity. - Provides explanations of the amounts in the financial statements. - Provides information on a companys prospects. - Provides management with an opportunity to explain its objectives and its strategies for achieving those objectives. - Encompasses reporting that jurisdictions may describe as managements discussion and analysis (MD&A), operating and financial review (OFR), or managements report.

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CONTENTS OF MANAGEMENT COMMENTARY

The IFRS practice statement Management Commentary states that the management commentary should include information that is essential to an understanding of: 1) the nature of the business; 2) managements objectives and its strategies for meeting those objectives; 3) the entitys most significant resources, risks, and relationships;

4) the results of operations and prospects; and

5) the critical performance measures and indicators that management uses to evaluate the entitys performance against stated objectives. In the United States, the SEC requires listed companies to provide an MD&A and specifies the content. Management must highlight any favorable or unfavorable trends and identify significant events and uncertainties that affect the companys liquidity, capital resources, and results of operations.

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EXAMPLE OF MD&A EXPLANATION OF AMOUNTS IN FINANCIAL STATEMENTS

Net Sales 2011 compared with 2010

Net sales increased 7.2% in 2011 compared with 2010 due to net price realization and sales volume increases in the U.S. and for our international businesses. Net price realization contributed approximately 3.5% to the net sales increase primarily due to the impact of list price increases, offset somewhat by higher promotional rates. Sales volume increased net sales by approximately 3.4% due primarily to sales of new products in the U.S. The favorable impact of foreign currency exchange rates increased net sales by approximately 0.3%.
Excerpt from Hersheys MD&A, Annual Report (2011)

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EXAMPLE OF MD&A INFORMATION ON THE COMPANYS PROSPECTS

OUTLOOK The outlook section contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially..... Excluding the Brookside acquisition, we expect volume to be slightly up for the full year 2012, resulting in net sales growth of about 5% to 7%, including the impact of foreign currency exchange rates. We expect reported gross margin to increase approximately 90 basis points in 2012. We expect full-year adjusted earnings per share-diluted, including the adjustment for non-service related pension expenses, to increase 9% to 11%.... Cash Flows from Investing Activities We anticipate total capital expenditures, including capitalized software, of approximately $280 million to $295 million in 2012 Excerpt from Hersheys MD&A, Annual Report (2011)

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AUDITORS REPORTS
Financial statements presented in companies annual reports are generally required to be audited (examined) by an independent accounting firm in accordance with specified auditing standards. An audit report is a written opinion on the financial statements prepared by the independent auditor. Objectives of the independent auditor in conducting an audit:

- To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement (whether due to fraud or error), enabling the auditor to opine on whether the statements are prepared in accordance with applicable financial reporting framework
- To report on the financial statements

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TYPES OF AUDITORS REPORTS

Unqualified audit opinion: Clean opinion. States that the financial statements give a true and fair view (international) or are fairly presented (international and U.S.) in accordance with applicable accounting standards. This opinion is the one that analysts would like to see in a financial report. Other types of opinions: - Qualified audit opinion: One in which there is some scope limitation or exception to accounting standards. Exceptions are described in the audit report with additional explanatory paragraphs so that the analyst can determine the importance of the exception. - Adverse audit opinion: Issued when an auditor determines that the financial statements materially depart from accounting standards and are not fairly presented. Generally, an analyst would not bother analyzing these statements. - Disclaimer of opinion: Issued when the auditors are unable to issue an opinion for some reason, such as a scope limitation.

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INTERNAL CONTROL SYSTEM

The internal control system is the companys internal system that is designed, among other things, to ensure that the companys process for generating financial reports is sound. Some countries (e.g., the United States) require an additional audit opinion on the companys internal control systems.

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INFORMATION SOURCES BESIDES ANNUAL FINANCIAL STATEMENTS

Annual report or proxy statement: Management compensation and governance information

Interim reports: (Unaudited) financial statements with updated information on a companys performance and financial position since the last annual period
Press releases, particularly earnings announcements, and conference calls Presentations to analysts

External data sources for information on

- the economy - the industry - the company and peer (comparable) companies

Regulatory context, where applicable

Direct experience of the companys products and services

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STEPS IN FINANCIAL STATEMENT ANALYSIS

Phase

1. Articulate the Purpose and Context of the Analysis 2. Collect Data

3. Process Data 4. Analyze/Interpret the Processed Data 5. Develop and Communicate Conclusions and Recommendations 6. Follow-Up

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ARTICULATE THE PURPOSE AND CONTEXT OF ANALYSIS

Purpose of analysis: evaluate the historical performance of a company (trend and cross sectional), prepare a forecast of future performance, value a companys equity or debt securities, prepare rating or recommendation Define the context - Intended audience - End product - Time frame - Resources and resource constraints

Based on purpose and context, formulate questions to be answered

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COLLECT DATA, PROCESS DATA, ANALYZE DATA

Collect data required to answer questions. Use analytical tools to process data: - Ratio analysis - Common-size financial statements Analyze data:

- Use financial ratios to assess a companys profitability, liquidity, leverage, and efficiency relative to its own past (trend analysis) and relative to peer/benchmark companies.
- Synthesize all available information to develop expectations about a companys likely future performance. - Develop forecasts and use as input to valuation.

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DEVELOP AND COMMUNICATE CONCLUSIONS/RECOMMENDATIONS

Communicate the conclusion or recommendation in an appropriate format. Appropriate format will vary by analytical task, by institution, and/or by audience. An equity analysts report would typically include the following components: - Summary and investment conclusion - Earnings projections - Valuation - Business summary

- Risk, industry, and competitive analysis

- Historical performance - Forecasts
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FOLLOW-UP
If an equity investment is made or a credit rating is assigned, periodic review is required to determine whether the original conclusions and recommendations are still valid. Follow-up may involve repeating all the previous steps in the process on a periodic basis.

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SUMMARY
Financial statements include - statement of financial position (balance sheet); - statement of comprehensive income; - statement of changes in equity; - statement of cash flows; and - notes. - Analysts use various information sources in financial statement analysis besides annual financial statements. - For example, MD&A, earnings announcements, external data sources, and direct experience. - Steps in financial analysis: - articulate purpose and context, - collect data, - process data, - analyze data, - develop and communicate conclusions and recommendations, and - follow-up.

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