Financial

Statement
Analysis
K R Subramanyam
John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview of Financial
Statement Analysis

1
CHAPTER

1-2

1-3

Business Analysis
Evaluate Prospects

Evaluate Risks
Business Decision Makers

Equity investors
Creditors
Managers
Merger and Acquisition Analysts
External Auditors
Directors
Regulators
Employees & Unions
Lawyers

1-4

Information Sources for Business

Analysis
Quantitative
Financial Statements

Qualitative
Management discussion & Analysis
Chairpersons Letter

Industry Statistics
Press Releases

Economic Indicators
Financial press

Regulatory filings
Vision/Mission Statement

Trade reports

Web sites

1-5

Credit Analysis

Equity Analysis

Management &
Control

Regulation

Financial
Management

Labor Negotiations
Types of
Business
Analysis

Director Oversight

External Auditing
Mergers, Acquisitions
& Divestitures

1-6

Credit Analysis

Trade
Creditors

Non-trade
Creditors

Provide
goods or
services

Bear risk of
default

Provide
major
financing

Bear risk of
default

Most shortterm

Usually
implicit
interest

Most longterm

Usually
explicit
interest

1-7

Credit Analysis
Credit worthiness: Ability to honor credit obligations
(downside risk)

Liquidity
Ability to meet shortterm obligations
Focus:
Current cash flows
Make up of current
assets and liabilities
Liquidity of assets

Solvency
Ability to meet longterm obligations
Focus:
Long-term profitability
Capital structure

1-8

Equity Analysis
Assessment of downside risk and upside potential

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

1-9

Component Processes of
Business Analysis

Business
Environment &
Strategy Analysis
Industry
Analysis

Strategy
Analysis

Financial
Analysis

Accounting
Analysis

Analysis
of cash
flows
Risk
Profitability
Analysis
Analysis

Cost of Capital Estimate

Prospective
Analysis

Intrinsic Value

1-10

Accounting Analysis
Process to evaluate and adjust financial
statements to better reflect economic reality
Comparability problems across firms and across time
Manager estimation error

Distortion problems

Earnings management
Accounting Standards

Accounting
Risk

1-11

Financial Analysis
Process to evaluate financial position and
performance using financial statements
Profitability analysis Evaluate return
on investments
Risk analysis Evaluate riskiness
& creditworthiness
Analysis of
cash flows

Evaluate source &

deployment of funds

Common tools

Ratio
analysis

Cash
flow
analysis

1-12

Prospective Analysis
Process to forecast future payoffs
Business Environment
& Strategy Analysis
Accounting Analysis

Financial Analysis

Intrinsic Value

1-13

Dynamics of Business Activities

Business Activities

Time
Beginning of period

Investing

Financing
Planning

Operating

Planning
Investing

Financing
End of period

1-14

Business Activities
Pricing

Competition

Market demands

Distribution

Tactics
Planning
Activities:
Goals
& Objectives

Promotion
Projections

Managerial performance
Opportunities

Obstacles

1-15

Business Activities

Financing activities
Owner (equity)
Nonowner (liabilities)

Financing

1-16

Business Activities

Investing activities
Buying resources
Selling resources

Investing

Financing

Investing = Financing

1-17

Business Activities
Investing
Activities

Planning
Activities

Financial
Activities

Operating Activities
Revenues and expenses from providing
goods and services

1-18

Financial Statements Reflect Business Activities

Planning
Investing

Operating

Current:

Cash
Accounts Receivable
Inventories
Marketable Securities

Noncurrent:

Land, Buildings, &

Equipment
Patents
Investments

Sales
Cost of Goods Sold
Selling Expense
Administrative Expense
Interest Expense
Income Tax Expense

Balance Sheet

Current:

Net Income

Cash Flow

Statement of
Cash Flows

Notes Payable
Accounts Payable
Salaries Payable
Income Tax Payable

Noncurrent:

Income statement
Assets

Financing

Bonds Payable
Common Stock
Retained Earnings

Liabilities & Equity

Balance Sheet

Statement of
Shareholders Equity

1-19

Financial Statements
Balance Sheet
Income Statement
Statement of Shareholders
Equity
Statement of Cash Flows

1-20

1-21

Balance Sheet
Total Investing = Total Financing
= Creditor Financing + Owner
Financing

Colgate Financing
(in $billions)
$9.138 = $7.727 + $1.410

1-22

1-23

Income Statement
Revenues Cost of goods sold = Gross Profit
Gross profit Operating expenses = Operating Profit

Colgates Profitability
(in $billions)

$12.238 - $5.536 = $6.701 Gross Profit

$6.701 - $4.5411 = $2.160 Operating profit

1-24

1-25

Statement of Cash Flows

Net Cash Flows from
Operating Activities
Net Cash Flows from
Investing Activities
Net Cash Flows from
Financing Activities

1-26

1-27

Additional Information
(Beyond Financial Statements)
Managements Discussion & Analysis (MD&A)
Management Report
Auditor Report
Explanatory Notes to Financial Statements
Supplementary Information
Proxy Statement

1-28

Analysis Preview
Yr1

Yr2

Yr3

Comparative 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

1-29

Analysis Preview

1-30

Analysis Preview
Common-Size Analysis
Purpose : Evaluation of internal makeup
of financial statements
Evaluation of financial statement
accounts across companies
Output:
Proportionate size of assets,
liabilities, equity, revenues, &
expenses

1-31

Analysis Preview

1-32

Analysis Preview

1-33

Analysis Preview
Ratio Analysis
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

1-34

Analysis Preview
Valuation
Valuation - an important goal of many types
of business analysis

Purpose: Estimate intrinsic value of a

company (or stock)
Basis:
Present value theory (time value of
money)

1-35

Analysis Preview
Debt (Bond) Valuation

Bt is the value of the bond at time t

It +n is the interest payment in period t+n
F is the principal payment (usually the debts face value)
r is the investors required interest rate (yield to maturity)

1-36

Analysis Preview
Equity Valuation

Vt is the value of an equity security at time t

Dt +n is the dividend in period t+n
k is the cost of capital
E refers to expected dividends

1-37

Analysis Preview
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 capital
E refers to an expectation

1-38

Analysis Preview
Equity Valuation - Residual Income Model

BV is the book value at the end of period t

Rit+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
t

1-39

Analysis in an Efficient Market

Three 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

1-40

Book Organization
Financial Statement Analysis
Part I
Introduction and Overview

Chapter 1: Overview of
Financial Statement
Analysis
Chapter 2: Financial
Reporting and
Analysis

Part II
Accounting Analysis
Chapter 3: Analyzing
Financial Activities
Chapter 4: Analyzing
Investing Activities
Chapter 5: Analyzing
Investing Activities:
Special topic
Chapter 6: Analyzing
Operating Activities

Part III
Financial Analysis
Chapter 7: Cash Flow
Analysis
Chapter 8: Return on
Invested Capital
Chapter 9: Profitability
Analysis
Chapter 10: Prospective
Analysis
Chapter 11: Credit
Analysis
Chapter 12: Equity
Analysis and Valuation