Overview of Financial Statement Analysis

Chapter 1
 Learning Objectives
Nature and purpose of Financial Analysis
Accounting standards and processes
underlying financial reports
Role of professional financial analysts

No need to read appendix 1A, 1B, and p12-

17.
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 Goal
Financial statement analysis is a tool for
making complex investment and credit
decisions. Specifically, its basic goal is to
value a firm by estimating its future cash
flows and determining its financial health.

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 Estimating cash flows requires
Current and relevant information
An evaluation of the firms profit and
growth potential
An assessment of the firms survival
likelihood

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 Analysis Techniques
Starting point is to use publicly available
data from financial statements including
Income Statement
Statement of Owners Equity
Balance Sheet
Statement of Cash Flows
Notes to Financial Statements

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 Analysis Techniques
Time series analysis
Compare a firm to itself over time
Firms provide at least two periods of
comparable data in each set of financial
statements

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 Analysis Techniques
Cross-sectional Analysis
Compare several firms over the same time
period
Designed to hold economic effects constant
Enables analyst to determine how a firm is
doing given the prevailing macroeconomic
conditions

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 Financial Statements and
Performance
Financial statements are prepared in a
consistent manner (enabling cross-sectional
and time series comparisons)
Accounting rules are designed to reflect
firm performance

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 Development of US Accounting Standards
1900
No mandated reporting requirements even though the
professions of accounting and auditing existed.
1933/34
Securities Acts give the SEC authority to regulate
financial reporting.
1970s
Financial Accounting Standards Board is created as the
authority on financial reporting for publicly traded US
firms.

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 Environmental Factors
Unions AICPA Lenders
Securities and
Exchange Investors Politicians
Commission
Accountants Others

Provide input to

Financial Accounting Standards Board

Help set
Generally Accepted Accounting Principles
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 Regulatory Requirements

SEC filing requirements

Form 10-K audited annual report
Form 10-Q quarterly report
Form 8-K special informational reports

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 Financial Reporting
Environment
Regulators Industry Alternative Information
Practices Sources
Economy and Industry
Information

FASB GAAP Managers Voluntary

Disclosure
AICPA

Analysts
Statutory Financial Reports
(Financial Statements)

Investors
and
Corporate
SEC Litigation Auditors Creditors
Governance
Other
Users
Enforcement
Li and Monitoring Mechanisms
Chap 1 Users 12
 Form 10-K 10-Q
(Annual Report) (Quarterly Report)

20-F 8-K
(Registration Statement/ (Current Report)
Annual Report [Foreign])

Statutory Financial Reports

14-A Other
(Proxy Statement/
Prospectus) SEC Filings
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 Development of International Accounting
Standards
International Accounting Standards
Board(IASB)
14 member committee of auditors, accountants,
academics and financial statement users
Developed International Accounting Standards
(IAS) to help investors cope with financial
analysis in global capital markets
Rules are not used worldwide, but a number of
countries do use the framework

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 Basic Financial Statements
Income Statement
provides results of business activities
Balance Sheet
states assets and claims against them (liabilities and
owners equity)
Statement of Cash Flows
provides prior cash flow information
helps analyst assess the firms ability to pay interested
parties
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 Transactions and the Accounting Process

Remember, Assets = Claims

Original owners put $1,000 in corporate
checking account
Assets = Claims
Cash Common Stock
$1,000 = $1,000

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 Transactions and the Accounting Process

Change the previous transaction:

Corporation purchases $50 of inventory on credit

Assets = Claims
Cash Inventory Accts. Payable Common Stock
$1,000 = $1,000
$50 $50
$1,000 $50 = $50 $1,000

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 Transactions and the Accounting Process
Expanded Transaction Model

Purchase a $5,000 building for $500 cash and

$4,500 mortgage

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 Expanded Transaction Model
Assets = Claims
Cash Inventory Building Accounts Mortgage Common
Payable Payable Stock
$1,000 $1,000

$50 $50

($500) $5,000 $4,500

$500 $50 $5,000 = $50 $4,500 $1,000

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 Transactions and the Accounting Process
Expanded Transaction Model

The company pays rent of $2,000 for the

current month
The company sells inventory to a customer
on account (receivable) at a retail price of
$30,000
The portion of the inventory which was sold
cost $15,000 to purchase

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 Expanded Transaction Model
Assets = Claims
Cash A/R Inventory Accounts Common Retained
Payable Stock Earnings
($2,000) ($2,000)

$30,000 $30,000

($15,000) ($15,000)

($2,000) $30,000 ($15,000) = $13,000

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 Using recorded information the
Balance Sheet
Reports totals of assets and claims on the date ending
the reporting period
Statement of Cash Flows
Reports all cash inflows and outflows (more in chapter
4)
The cash column of the transaction model
Statement of Shareholders Equity
Reports changes in the owners claim accounts during
the period
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 The Professional Analyst
Buy-Side and Sell-Side Analysts
Buy-side
Provide information within the investment firm
Information is rarely available to outsiders
Sell-side
Provide information to brokers who work with
external clients
Reports are created with external clients in
mind
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 Role of the Analysts
Financial analysts do not believe in semi-
strong form of market efficiency.
However, their job makes the market price
more efficient.

If interested in becoming a CFA, visit

http://cfainstitute.org/cfaprogram/

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