FINANCIAL STATEMENT ANALYSIS

INTRODUCTION
Analysts are employed in a number of functional areas. Generally, analysts evaluate investment in security. The investment is either equity (representing an ownership position) or debt (representing a lending position). Investment decisions are arrived at based on the evaluation of: 1. Performance; 2. Financial position; 3. Value of the company issuing the securities.
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SCOPE OF FINANCIAL STATEMENT ANALYSIS

The role of financial reporting by companies is to provide: 1. Information about their performance; 2. Financial position; and 3. Changes in financial position that is useful to a wide range of users in making economic decisions. The role of financial statement analysis is to take financial reports prepared by companies, combined with other information: 1. To evaluate the past, current, and prospective performance and financial position of a company for the purpose of making investment, credit, and other economic decisions.
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REASONS FOR ECONOMIC DECISIONS ANALYST

BY

1. Evaluating an equity investment for inclusion in a portfolio. 2. Evaluating a merger or acquisition candidate. 3. Evaluating a subsidiary or operating division of a parent company. 4. Deciding whether to make a venture capital or other private equity investment. 5. Determining the creditworthiness of a company that has made a loan request. 6. Extending credit to a customer. 7. Examining compliance with debt covenants or other contractual arrangements. 8. Assigning a debt rating to a company or bond issue. 9. Valuing a security for making an investment recommendation to others. 10. Forecasting future net income and cash flow.
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An examination of performance can include:

An assessment of a company s profitability (the ability to earn a profit from delivering goods and services), Its cash flow generating ability (the ability to produce cash receipts in excess of cash disbursements).

Distinction Between Profit and Cash Flow

Profit and cash flow are not equivalent. Profit 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). Cash flow refers to receipts and payments. The ability to generate positive cash flow is important because, ultimately, cash is needed to pay employees, suppliers, and others to continue as a going concern. Additionally, cash flow is the source of returns to providers of capital.
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Liquidity and Solvency

The expected magnitude of future cash flows is important in valuing corporate securities and in determining the companys ability to meet its obligations. The ability to meet short - term obligations is generally referred to as liquidity, and the ability to meet longterm obligations is generally referred to as solvency .

EXAMPLE 1 Profit versus Cash Flow

Bed Mate (BM) sells imported furniture on a retail basis. BM began operations during December 2006 and sold furniture for cash of GH250,000. The furniture that was sold by BM was delivered by the supplier during December, but the supplier has granted BM credit terms, according to which payment is not due until January 2007. BM is obligated to pay GH 220,000 in January for the furniture it sold during December. 1. How much is BMs profit for December 2006 if no other transactions occurred? 2. How much is BMs cash flow for December 2006? Solution to 1. BMs profit for December 2006 is the excess of the sales price (GH250,000) over the cost of the goods that were sold (GH220,000), or GH30,000. Solution to 2. The December 2006 cash flow is GH 250,000.
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Profit versus Cash Flow continued

Profits reflect the ability of a company to deliver goods and services at prices in excess of the costs of delivering the goods and services. Profits also provide useful information about future (and past) cash flows.

Corporate earnings announcements places corporate results in the context of analysts expectations. Furthermore, analysts frequently use earnings in valuation, for example, when they value shares of a company on the basis of the price - to - earnings ratio (P/E) in relation to peer companies P/Es or when they use a present value model of valuation that is based on forecasted future earnings.
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MAJOR FINANCIAL STATEMENTS AND OTHER INFORMATION SOURCES

A great deal of information is collected to enable analyst perform equity or credit analysis of a company. The nature of the information will vary based on the individual task but will typically include information about the economy, industry, and company as well as information about comparable peer companies. Much of this information will come from outside the company, such as economic statistics, industry reports, trade publications, and databases containing information on competitors. The company itself provides some of the core information for analysis in its financial reports, press releases, and conference calls and webcasts.
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MAJOR FINANCIAL STATEMENTS AND OTHER INFORMATION SOURCES continued Financial reports are prepared to report to investors and creditors about the financial performance and the financial strength at regular intervals (annually, semi-annually and quarterly). The reports include: 1. Financial statements and supplementary information; i.e., income statement, balance sheet, statement of cash flows, and statement of changes in owners equity (provides additional information regarding the changes in a companys financial position).
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MAJOR FINANCIAL STATEMENTS AND OTHER INFORMATION SOURCES continued

Additional information that must be read by analyst for assessment of financial reports includes: Notes to the financial statements (also known as footnotes) and supplementary schedules. Managements discussion and analysis (MD& A). The external auditors report(s).
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THE MAJOR FINANCIAL STATEMENTS

1. Income Statement The income statement presents information on the financial results of a companys business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. Net income (revenue minus all costs) on the income statement is often referred to as the bottom line because of its proximity to the bottom of the income statement. 2 Income statements are reported on a consolidated basis, meaning that they include the revenues and expenses of affiliated companies under the control of the parent (reporting) company. The income statement is sometimes referred to as a statement of operations or profit and loss (P & L) statement. The basic equation underlying the income statement is Revenue - Expenses = Net income.
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Balance Sheet
The balance sheet (also known as the statement of financial position or statement of financial condition) presents a companys current financial position by disclosing resources the company controls (assets) and what it owes (liabilities) at a specific point in time. Owners equity represents the excess of assets over liabilities. This amount is attributable to the owners or shareholders of the business; it is the residual interest in the assets of an entity after deducting its liabilities. The three parts of the balance sheet are formulated in an accounting relationship known as the accounting equation: Assets Liabilities Owners equity (that is, the total amount for assets must balance to the combined total amounts for liabilities and owners equity).
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Cash Flow Statement

The income statement and balance sheet provide a measure of a companys success in terms of performance and financial position, cash flow is also vital to a companys long-term success. Disclosing the sources and uses of cash helps creditors, investors, and other statement users evaluate the companys liquidity, solvency, and financial flexibility. Financial flexibility is the ability to react and adapt to financial adversities and opportunities. The cash flow statement classifies all company cash flows into operating, investing, and financing activity cash flows. Operating activities involve transactions that enter into the determination of net income and are primarily activities that comprise the day to day business functions of a company. Investing activities are those activities associated with the acquisition and disposal of long-term assets, such as equipment. Financing activities are those activities related to obtaining or repaying capital to be used in the business.
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Statement of Changes in Owners Equity

Statement of changes in owners equity, statement of shareholders equity, or statement of retained earnings. This statement primarily serves to report changes in the owners investment in the business over time and assists the analyst in understanding the changes in financial position reflected on the balance sheet.

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Financial Notes and Supplementary Schedules

Financial notes and supplementary schedules are an integral part of the financial statements. By way of example, the financial notes and supplemental schedules provide explanatory information about the following: Business acquisitions and disposals Commitments and contingencies Legal proceedings Stock option and other employee benefit plans Related - party transactions, i.e., associates Significant customers Subsequent events Business and geographic segments Quarterly financial data
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Managements Discussion and Analysis

Companies floated on a stock exchange are often required to include in their financial reports a section called Managements Discussion and Analysis (MD &A). In it, 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. The MD &A must also provide information about the effects of inflation, changing prices, or other material events and uncertainties that may cause the future operating results and financial condition to materially depart from the current reported financial information.
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Auditors Reports
Financial statements presented in company annual financial reports are often required to be audited (examined) by an independent accounting firm that then expresses an opinion on the financial statements. There are standards for auditing and for expressing the resulting auditors opinion. International standards for auditing have been developed by the International Auditing and Assurance Standards Board of the International Federation of Accountants.
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Sarbanes - Oxley Act 2002

In response to the collapse of Enron, Worldcom, and other corporations, the U.S. Congress passed the Sarbanes-Oxley Act of 2002.
The Sarbanes - Oxley Act specifically requires managements report on internal control to: State that it is managements responsibility to establish and maintain adequate internal control. Identify managements framework for evaluating internal control. Include managements assessment of the effectiveness of the companys internal control over financial reporting as of the end of the most recent year, including a statement as to whether internal control over financial reporting is effective. Include a statement that the companys auditors have issued an attestation report on managements assessment. Certify that the companys financial statements are fairly presented.
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Other Sources of Information

Interim reports are also provided by the company either semiannually or quarterly. Interim reports generally present the four key financial statements and footnotes but are not audited. These interim reports provide updated information on a companys performance and financial position since the last annual period.

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