A Framework For Financial Statement Analysis

A Framework for Financial Statement Analysis
Chapter 11
Why Financial Statements Are Analyzed

In order for financial information to be useful, it must be interpreted.
Why Financial Statements Are Analyzed

A comprehensive set of ratios allows the user to make sense of all the financial information reported in the financial statements.
Users of Financial Information

Users of financial information may be current or future users.
Users of Financial Information

Some of the users of financial information are the following:
Investors Managers Customers Potential suppliers and creditors Government regulators Employee unions Public interest and community groups
Sources of Financial Information

The major source of financial information is a firm's annual report.
The following are elements of most annual reports:

Management discussion and analysis Independent auditor's report Primary financial statements Secondary financial statements Notes to the financial statements
Other Sources of Information

Reports filed with regulatory agencies (special, quarterly, and annual) Business periodicals (magazines, newspapers, newsletters) Investment advisory services (Standard & Poor, Moody's, etc.)
Basis of Comparison
When analyzing financial reports, one of the first decisions is to identify the basis of comparison.
Data may be compared with the following:

The firm's own data from prior years Data from another firm in the same industry Data from another firm in which the analyst may invest Industry averages Benchmarks or targets
Restatements May Be Necessary

The statements may need to be restated when significant unusual events have occurred which would distort comparisons.
Restatements May Be Necessary

Such events include, among others, mergers or acquisitions, discontinued operations, changes in accounting principles, and extraordinary items.
More Comparability Is Better

Comparability is enhanced when firms' size, capital structure, and product mix are similar.
A summary of the steps:

Identify the purpose and objectives of analysis.

Review the financial statements, notes, and audit opinion to identify any unusual events or characteristics and to become familiar with the nature of the firms operation.

Determine whether any restatements due to mergers, discontinued operations, etc., are necessary to enhance comparability of the firms financial statements.

Determine whether the firms size, capital structure, and product mix are sufficiently comparable (between firms or time periods) to proceed with the ratio calculations.
Financial Statement Analysis Ratios & Framework

The analyst usually performs horizontal and vertical analyses of the financial statements.

Horizontal analysis focuses on changes or growth, year to year, for each major element on the income statement and the balance sheet.

Vertical analysis examines the percentage composition of the income statement and the balance sheet: It uses commonsize financial statements for this analysis.
Categories of Financial Ratios

Ratios are usually grouped into broad categories.
Categories of Financial Ratios

Four widely used major headings are liquidity, profitability, capital structure, and investor.
Liquidity Ratios
Liquidity ratios indicate the shortterm solvency of the firm.
Liquidity Ratios
They also indicate how effectively the firm is managing its working capital.
Liquidity Ratios
The following are commonly used liquidity ratios:
Liquidity Ratios
Liquidity Ratios
Liquidity Ratios
Liquidity Ratios
Profitability Ratios
Profitability ratios measure how profitable a firm is.
This is very important for investors who want to invest in a firm which can return their investment to them.
The following are commonly used profitability ratios:
Capital Structure Ratios

Capital structure ratios help in assessing a firm's strategies for financing its assets.

Capital structure indicates the relative amounts of debt and equity capital.

Percentage composition analysis is the starting point for any analysis of capital structure.

Percentage composition analysis describes the relative amounts of capital obtained from each major source of financing.

Current liabilities, long-term debt, deferred taxes and other similar liabilities, and shareholders' equity all will be divided by the total of total liabilities and shareholders' equity.





The following capital structure ratios are also computed:

The following capital structure ratios are also computed:
Investor Ratios
Investor ratios all relate to an external dimension of ownership interest. Most indicate how a firm is performing with regard to the market value of its shares.
Investor Ratios
The following are commonly used investor ratios:
Investor Ratios
Investor Ratios
Financial Statement Analysis Framework

The financial statement analysis framework includes the following steps.

Identify the purpose and objectives of the analysis.

Review the financial statements, notes and audit opinion.

Determine whether restatements are necessary to enhance the comparability of the statements.

Determine whether the firm's size, capital structure, and product mix are appropriate to proceed with the ratio calculations.

Conduct horizontal and vertical analyses of each financial statement, with special emphasis on the income statement.

Calculate the basic liquidity ratios.

Calculate profitability ratios based on net income and on cash flow from operating activities. Evaluate trends.

Evaluate the firm's capital structure with special emphasis on trends in the percentage composition ratios.

Examine the firm's market performance using the investor ratios.

Examine any inconsistencies in the ratio results, review notes, and recalculate the ratios.
Limitations of Financial Statement Analyses

Financial statement analysis is limited due to several items.

GAAP presents some limits.

GAAP presents some limits. Managers often have the ability to select favorable accounting methods.

Many major factors affecting profitability and survival of the firm are not included in the financial statements.

A perfect example is human resources.

While employees are often a firm's most important asset, a value for employees does not appear on the balance sheet.

"Real" events are often hard to distinguish from the effects of alternative accounting methods or principles.

Financial statement analysis relies on past numbers, and the past may not be a reliable indication of the future.
A Framework for Financial Statement Analysis

End of Chapter 11

A Framework For Financial Statement Analysis

Uploaded by

Copyright:

Available Formats

A Framework For Financial Statement Analysis

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

A Framework For Financial Statement Analysis

Uploaded by

Copyright:

Available Formats

A Framework for Financial Statement Analysis

Why Financial Statements Are Analyzed

Why Financial Statements Are Analyzed

Users of Financial Information

Users of Financial Information

Sources of Financial Information

The following are elements of most annual reports:

Other Sources of Information

Data may be compared with the following:

Restatements May Be Necessary

Restatements May Be Necessary

More Comparability Is Better

A summary of the steps:

A summary of the steps:

A summary of the steps:

A summary of the steps:

Financial Statement Analysis Ratios & Framework

Financial Statement Analysis Ratios & Framework

Financial Statement Analysis Ratios & Framework

Categories of Financial Ratios

Categories of Financial Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Capital Structure Ratios

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Financial Statement Analysis Framework

Limitations of Financial Statement Analyses

Limitations of Financial Statement Analyses

Limitations of Financial Statement Analyses

Limitations of Financial Statement Analyses

Limitations of Financial Statement Analyses

Limitations of Financial Statement Analyses

Limitations of Financial Statement Analyses

Limitations of Financial Statement Analyses

A Framework for Financial Statement Analysis

You might also like