Annual Report Analysis (Chapter 20)

Financial Statement Analysis

General information
Three methods of analysis
o Horizontal analysis changes in one financial statement over time
o Vertical analysis shows each item on a financial statement as a
percent of a total
o Ratio analysis two or more selected items on the statements in
relation to each other
Activity
Liquidity and solvency
Debt
Profitability
Market
Studying financial statements
Carefully read the comparative financial statements
Evaluate over time look at trends
Returns in the past do not guarantee returns in the future
The more we know about a companys past the greater the change of
predicting the future accurately
Industry analysis
Provides a standard for judgment
Good additional source of information
Various sources for industry data
o Moodys
o Standard & Poors
o Robert Morris Associates
Vertical analysis
Shows relative size of selected items to a base item within one statement
Income statement total sales
Balance sheet total assets
Common sized analysis avoids distortion caused by the size of the
company
Horizontal analysis
Shows the comparison of each item on a financial statement with that same
item on statements from previous periods
Compares one item to itself over time on a percentage basis to indicate
changes over time
(P1 P0)/P0
Helpful for discovering trends in financial statement relationships
Can be used to predict short term results

Other information
Managements letter to shareholders
o Highlights company performance over the past period
o Highlights key operating data
Segment and quarterly data
o Disclose financial information for key segments of the business
o External financial statements issued quarterly data
Auditors report
External audit provide an unbiased opinion
Four types of opinions
o Unqualified
Financial statements are a fair representation of business
financial position, cash flows, and reported income
In auditors opinion company has applied GAAP appropriately
o Qualified opinion
Either auditor found parts of company financial statements that
are not in conformance with GAAP
Or auditors ability to examine the underlying financial records
was limited
Statements are a fair representation of a companys financial
position
However, certain parts, as indicated in the auditors report, are
not disclosed as specified by GAAP
o Adverse opinion
Financial statements are not a fair representation of the
companys financial position or income
Fair as defined by GAAP standards
Statements do not comply with GAAP
o Disclaimer
Auditor was not able to gather sufficient evidence to support an
opinion
Or auditor was not sufficiently independent of the company to
issue an opinion
Auditors report does not guarantee that the company is a good investment
Auditors report does not guarantee that the company will not declare
bankruptcy