CHAPTER ONE

INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

 Explain business analysis and its relation to

financial statement analysis
 Describe component analyses that constitute
financial statement analysis
 Describe the purpose of each financial
statement
 Apply two basic financial statement analysis
techniques
What is financial statement
analysis?
 Business Analysis
Business analysis is the evaluation of a
company’s prospects and risks for the
purpose of making business decisions.
Component Processes of

Business
Analysis Business
Environment &
Strategy Analysis

Accounting Financial Prospective

Analysis Analysis Analysis

Intrinsic Value
 Financial Statement Analysis

Financial Prospective
Accounting
Analysis Analysis
Analysis

• Accounting analysis is a process of evaluating the extent to

which a company’s accounting reflects economic reality.
• Financial analysis is the use of financial statements to
analyze a company’s financial position and performance,
and to assess future financial performance.
• Prospective is the forecasting future payoffs
 Business Activities
Planning
Investing Activities Financial
Activities Activities

Operating Activities
Revenues and expenses from providing
goods and services
Planning activities:
• Business plan
• Information on company objectives and
tactics, market demands, competitive
analysis, sales strategies (pricing,
promotion and distribution),
management performance and financial
projection.
• Differentiate business analysis from
financial statements analysis
Financing activities refer to
methods that companies use to
raise the money to pay for the
company’s needs.
 Investing Activities
Investing activities refer to a
company’s acquisition and
maintenance of investment for
purposes of selling products and
providing services, and for the
purpose of investing excess cash.
Operating assets vs. financial assets
 Operating Activities
• Operating activities represent the carrying out
of the business plan given its financing and
investing activities.
• Operating activities involve at least five
possible components: research and
development, procurement, production,
marketing and administration.
 Financial
Balance Sheet Statements Reflect

Business
Income Statement
Activities

Statement of Shareholders’ Equity

Statement of Cash Flows

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3
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 Balance Sheet
Links between financial statements
Income Statement • Revenues and expenses
affect earnings and adjusted
earnings are reported in
retained earnings account on
the balance sheet.
Statement of Cash Flows • Cash transactions in the
statement of cash flows are
summarized in the cash
balance on the balance
sheet.
• All revenue and expense
accounts affect one or more
balance sheet accounts.
 Additional Information
(Beyond Financial Statements)
 Annual Report
A comprehensive report on a company’s activities throughout the preceding year.
Annual reports are intended to give shareholders and other interested people
information about the company's activities and financial performance.
 Management Report
The purposes of this report are to reinforce:
- Senior management’s responsibilities for the company’s financial and internal control
system
- The shared roles of management, directors, and the auditor in preparing financial
statements.
 Auditor Report
- An opinion on whether or not the company’s financial statements are prepared in
conformity with generally accepted accounting principles.
- A review of the auditor’s report to ascertain whether the company received an
unqualified opinion
 Additional Information
(Beyond Financial Statements)
 Explanatory Notes
- Notes are a means of communicating additional information regarding items
included or excluded from the body of the statements.
- Explanatory notes include information on: Accounting Principles and methods
employed; detailed disclosures regarding individual financial statement items;
commitments and contingencies; business combinations, transactions with related
parties, legal proceedings, significant customers; stock options..
 Proxy Statements
A proxy statement contains information necessary for shareholders in voting on matters
for which the proxy is solicited. Proxy statements contain a wealth of information
regarding a company including
- The identity of shareholders owning 5% or more of outstanding shares
- The biographical information on the board of directors
- Compensation arrangements, employee benefit plans
 Prospectus
A prospectus is a disclosure document that describes a financial security for potential
buyers.
 Analysis Tools
• Comparative financial statement analysis
• Common-size financial statement analysis
 Comparative analysis
• Year-to-Year Change Analysis
• Index-Number Trend Analysis
Year-to-Year Change Analysis

Comparing financial
statements over relatively
short time periods – two to
three years – is usually
performed with analysis of
year-to-year changes in
individual accounts. It has
the advantage of presenting
changes in absolute dollar
amounts as well as in
percentages.
 Why do analysts usually compute
both changes in absolute dollar
amounts and percentages?
 Index-Number Trend Analysis
The company’s cash balance at December
31, Year 1, is $12,000. Its cash balances at
December 31, Year 2 and Year 3, are
$18,000 and $9.000 respectively. Compute
index numbers for three years and make
comparison between them.

.
Comparative financial statement analysis

 Review consecutive balance sheets,

income statements or statements of
cash flows from period to period.
 Direction, speed, & extent of a
trend
 Comparing trends in related items
 Horizontal analysis
Common-Size Analysis
 Common-Size Analysis
1. Sources of financing – including the
distribution of financing across current
liabilities, noncurrent liabilities, and
equity
2. Composition of assets – including
amounts for individual current and
noncurrent assets
*Common-size analysis of a balance sheet
is often extended to examine the accounts
that make up specific subgroups
Common-Size Analysis
 Common-Size Analysis

• Understanding internal makeup of financial

statements
• Intercompany comparisons
• Failure to reflect the relative sizes of the
companies under analysis
• Time comparisons of a company’s common-
size statements
 2006 2005
Key: Sales 100% 100%
Cost of good sold 66.0 52.4
Gross profit 34.0 47.6
Operating expenses 21 19.4
Net income 13.0% 28.2%
Key:
 Key:

Exercise 1-11:
The situation is unfavourable, because sales improved, but COGS and Accounts
Receivable have increased drastically and very high as compared to Sales, big
problem in cost management and credit policy. Thus the situation appears to be
unfavourable.
 Key:

Ex 1-12:
Percent of Increase or Decrease = (Year 2 - Year 1) / Year 1
Short Term Investments = ($217800 - 165000) / 165000 = 32%
Accounts Receivable = ($42120 - 48000) / 48000 = (12.25%) i.e. negative
Notes Payable = ($57000-0) / 0 = Cant be calculated since base is 0