CB 3041

Financial Statement Analysis

Lecture 1
 Why do we study
Financial Statement Analysis?
Value of Financial Statement Analysis
 The process of financial reporting, financial statement
analysis, and valuation helps investors and analysts
understand a firm’s profitability, risk, and growth.
 Use that information to forecast future profitability, risk,
and growth; and ultimately to value the firm, enabling
intelligent investment decisions.
 This process is central to the role of accounting, financial
reporting, capital markets, investments, portfolio
management, and corporate management in the world
economy.
 Profitability: (e.g.) comparing to last year
 Risk: (e.g.) liabilities
 Financial statements: past-oriented
 Value of Financial Statement Analysis
 When conducted with care and integrity, financial
statement analysis and valuation are fascinating and
rewarding activities that can create tremendous value for
society.
 However, as past financial crises in our capital markets
reveal, when financial statement analysis and valuation
are conducted carelessly or without integrity, they can
create enormous loss of value in the capital markets and
trigger deep recession in even the most powerful
economies in the world.
 The stakes are high.
 Lehman Brothers Case
Photograph: Linda Nylind/Guardian
 Lehman Brothers
Lehman Brothers was an international financial
company with divisions for investment banking,
proprietary trading, high-net-worth advising, etc.
It was founded in 1847

Throughout the 2000s, Lehman Brothers invested

heavily in collateralized debt obligations (CDOs)
and mortgage-backed securities (MBSs)
 Lehman Brothers
During this period, Lehman acquired companies
that focused on subprime mortgages
The US housing market’s decline did not stop
Lehman from increasing its exposure to the real
estate market
Lehman declared bankruptcy on 15 Sep. 2008
• It was the 4th largest investment bank in the US
• Largest bankruptcy in US history: US$691
billion in assets (~ HK$5.4 trillion)
Lehman Brothers_Subprime Mortgages
 Lehman Brothers_Subprime Mortgages
 Credit reports and credit scores affect the type of mortgage and the
mortgage’s terms

 Lower credit scores (subprime) usually indicate higher risk, so lenders

often require higher interest rates and specialized insurance

 In the 2000s, subprime mortgages (real estate loans to people with

lower credit scores) became increasingly common
• Often included adjustable interest rates after a low teaser rate; high
loan-to-value ratios
 The housing market declined in the mid-2000s while the interest rates
rose
• Borrowers stopped repaying their mortgages
Lehman Brothers_Mortgage-Backed Securities

Source: Vancouvereconomic.com
Lehman Brothers_Mortgage-Backed Securities
 An MBS is a financial instrument with a pool of mortgages (either
residential or commercial) as collateral

 An intermediary usually holds the mortgages and sells the cash flows to
investors
• Banks and other lenders sell the individual mortgages to the
intermediary and no longer service the loans
 Similar to a mortgage payment, the cash flows comprise principal and
interest
 If the real-estate owners fail to pay their mortgages, the MBSs lose
value
 Lehman Brothers_ Repurchase Agreements
 A repurchase agreement is a financial transaction in which
the initial seller of a financial asset agrees to purchase the
same financial asset from the initial buyer within a short
time period.

 Why do investment banks and other financial institutions

engage in repos?
• Financial institutions often need immediate cash and
still want to maintain ownership of financial securities.
Counterparties view agreements as low-risk.
 Lehman Brothers_ Repurchase Agreements
 Typical REPO: Method of borrowing fund

• The banks that borrows the funds promises to pay back

the short-term loan with a small amount of interest; the
collateral typically never changes hands.
• Typically, banks would take REPO loans with 102%.
• Under accounting rules, the assets a bank uses in repo
deals stay on the bank's balance sheet.
• On balance sheet: ↑Cash, ↑Liabilities
 Lehman Brothers_ Repurchase Agreements
 Lehman’s REPO 105

• Lehman took REPO loans with 105%.

• Record the transaction as if it had been a true sale of the
assets (MBS)
• On balance sheet: ↑Cash, MBS↓
• Effectively lowered the leverage ratio, fooled investors
Course Information
 General Course Objectives
 To develop the ability to interpret and analyze financial
statements.
 Including strategic profitability and risk analysis.
 To become more sophisticated (and skeptical) users of
financial information.
 The identification of red flags to watch out for and understand
financial terms (EBITDA, etc.)

*Do not fully trust the financial

statement
 General Course Objectives
 To evaluate the quality of financial information and
appropriateness of specific revenue and asset recognition.
 To adjust, if necessary, financial information and analyze
the profitability and risk of firms.
 To make recommendations for investment and credit
decisions
 Investment decisions (buy & sell)
 Credit decisions (whether to lend money or not)
 General Course Objectives

 This course WILL NOT focus on the following areas:

 The technical process of financial accounting from
journal entry to the preparation of final accounts.
 Detailed consideration of the portfolio of accounting
choices that could be adopted in accordance with the
rules and regulations (such as Hong Kong Accounting
Standards).
 General Course Objectives

 Calculation of a comprehensive set of accounting ratios

other than those broadly adopted ratios.
 Non-financial analysis (such as business analysis or
personal objective analysis)
 Analysis of corporate performance by methods other than
the basic financial analysis models (such as the market
analysis models or venture capitalist evaluation models)
 Difficulties in This Course
Need a reasonable level of accounting and finance
background
The course introduces structured tools for analysis,
but there is still judgment and flexibility in the
application of the tools
Microeconomic analysis of firms and industries
can be affected by macroeconomic, legal, and
political factors
 Difficulties in This Course
New industries, advancements, and threats (e.g.,
technology, artificial intelligence, and climate) are
different than historical trends
Highly firm-specific and even manager-specific
characteristics can impact financial statement
analysis
Practical application of insights might be difficult
for short-term trading (algorithmic trading, high-
frequency trading, hedge funds, etc.)
 Break

Framework for Analysis and

Valuation
 Learning Objective

 Understand the roles of financial reporting

 Discuss the regulatory framework of financial
reporting
 Apply accounting concepts to the preparation
and presentation of financial statements
Financial Statement Analysis & Valuation
FSA:
Extracting information from financial statements to better understand
companies’ current (and future) performance and financial condition.
• Interpretation & analysis of financial information.
• Time-series (comparing with previous years (not only last year))
and/or cross-sectional analyses (compare info with other
competitors in the same industry/ other companies in the business
world) -> conclusion: do we have more profit/ revenue/ assets/
liabilities than competitors?
• To perform meaningful analyses, must first evaluate the quality of
information used.
Valuation:
Estimating companies’ intrinsic “worth.”
• Valuation of equity and/or debt shares.
 The more you know about financial reporting, the better you will be at
financial statement analysis & valuation.
Overview of Financial Statement
Analysis
 Overview of Financial Statement
Analysis
 Identify the economic characteristics of the industries in
which a firm competes and map those characteristics into
determinants of profitability, growth, and risk.
 Describe the strategies that a firm pursues to differentiate
itself from competitors as a basis for evaluating a firm’s
competitive advantages, the sustainability and potential
growth of a firm’s earnings, and its risks.
 Evaluate the firm’s financial statements, including the
accounting concepts and methods that underlie them and
the quality of the information they provide.
Six Interrelated Sequential Steps in
Financial Statement Analysis
How Do the Six Steps Relate to Share
Pricing
in the Capital Markets?
 Market prices reflect accounting information based on four
links:
• The accounting system mapping a firm’s transactions
and events into accounting fundamentals, such as
earnings, cash flows, and book value of equity, reported
on financial statements
• Analysts and investors analyzing financial statement
information to get a deep understanding of the firm’s
profitability, growth, and risk
How Do the Six Steps Relate to Share
Pricing
in the Capital Markets?
• Analysts and investors mapping accounting fundamentals
into expectations of future earnings and cash flows, and
then into estimates of share value
• Trading activities mapping share value estimates into
stock prices
 Step 1: Identify the Industry
Economic Characteristics
• The economic characteristics and competitive
dynamics of an industry play a key role in
influencing the strategies employed by the firms in
the industry.
• Profitability, growth, and risk factors are
relationships that can be observed in financial
statements.
• Porter suggests that five forces influence the level
of competition and the profitability of firms in an
industry.
 Porter’s Five Forces Framework

**

High =
sensitive to
price, if
there are
other
substitutes,
they can
shift to
other
supplier
 Porter’s Five Forces Framework
 Porter argues that although the relative strengths of the five
forces will vary from industry to industry and may change
over time, the collective strength of these five forces will
determine whether organizations in an industry can earn
rates of return greater than their cost of capital.
 The five forces are critical to industry profitability because
they influence the prices, costs, and required investment in
an industry. We can illustrate the inverse relationship
between the strength of all the forces and the profitability
of the industry with the following simple graph:
Porter’s Five Forces Framework

More Profitable

Profitability of the
industry

Less Profitable
Collective strength of the five forces

Weaker Stronger
 Value Chain Analysis and
Economic Attributes Framework
• The value chain for an industry sets forth the sequence or
chain of activities involved in the creation, manufacture,
distribution, and sale of its products and services.
• To the extent prices are available for products or services at
each stage in the value chain, you can determine where value
is added within an industry.
• These items in economics attributes framework can also be
useful in studying an industry:
• Demand
• Supply
• Manufacturing
• Marketing
• Investing and financing
 Industry Economic Characteristics
The economic characteristics and competitive
dynamics of an industry play a key role in
influencing firm’s strategies, profitability, growth,
and risk.
Therefore, industry economic characteristics affect
the types of financial statement relations.
Common size analysis
-> tries to tell the relative importance of each financial statement item in the corresponding financial statements
-> e.g. cost of sales in the income statement

-> we have to calculate the common size percentage

-> income statement: total revenue as a base, e.g. common size percentage of cost of sales = cost of sales/ (divided by)
total revenue = 35,000/ 100.000 = 35%
-> balance sheet: use total asset as a base, e.g. common size % of machine
Industry Economic Characteristics
Firm A Firm B Firm C Firm D
 Industry Economic Characteristics
 Use the ratios to match which company is 1) Pharmaceutical
Company, 2) Electric Utility, 3)Grocery Store Chain, and 4)
Commercial Bank.
 Industry Economic Characteristics
 Pharmaceutical Company
• Pharmaceutical companies must invest significant
amounts in research and development to create new
drugs.
• The R&D outcomes are highly uncertain with very few
projects succeed into new drugs.
• Hence, pharmaceutical industry has high entry barriers.
• Higher Profit margins than other industries.
 Industry Economic Characteristics
 Electric Utility
• The major assets of electric utility companies are power-
generating plants, hence very high portion of PP&E.
• To finance the large amount of capital in long-lived
assets, they take high proportion of debt in their capital
structure.
• Traditionally, electric utility firms have monopoly
positions due to the large investments in PP&E, hence
relatively high profit margin. This has changed
dramatically in recent years with gradual elimination of
monopoly positions.
 Industry Economic Characteristics
 Grocery Store Chain
• Non-differentiated products and low barriers to entry,
hence intensive competition
• Relatively low profit margin
• Relatively few assets compared to revenue, high asset
turnover
 Industry Economic Characteristics
 Commercial Bank
• The major assets of commercial banks are investment in
financial securities and loans to business and individuals.
• The major liabilities of commercial banks are customers’
deposits and short-term borrowings. Because customers
can withdraw deposits at anytime, commercial banks
invest in securities that they can quickly convert into
cash.
• The assets of commercial banks are much higher than
their revenues, which are from interest revenues and fees
from financial services.
 Industry Economic Characteristics
 Use the ratios to match which company is 1)
Pharmaceutical Company, 2) Electric Utility, 3)Grocery
Store Chain, and 4) Commercial Bank.

• Firm A • 1)Pharmaceutical
Company
• Firm B • 2) Electric Utility
• Firm C • 3)Grocery Store Chain

• Firm D • 4) Commercial Bank

Industry Economic Characteristics
 Step 2: Identify the Company
Strategies
• When a firm creates a strategy that successfully
differentiates itself within its industry, it establishes
a competitive advantage.
• The framework for strategy analysis helps analyze
the choices a firm makes in establishing its
strategy within an industry, which includes:
• Nature of product or service
• Degree of integration in value chain
• Degree of geographical diversification
• Degree of industry diversification
 Quick Check Question 1
 Which of the following is a relationship that can be
observed in financial statements?
a. Marketing strategy
b. Profitability
c. Corporate social responsibility
d. Competitive product pricing
 Quick Check Question 2-3
 Effective financial statement analysis requires an
understanding of a firm’s economic characteristics. The
relations between various financial statement items provide
evidence of many of these economic characteristics.
 The worksheet (posted on Canvas) presents common-size
condensed balance sheets and income statements for 3
firms in different industries.
 Quick Check Questions 2-3
 These common-size balance sheets and income statements
express various items as a percentage of sales. (That is, the
statement divides all amounts by sales for the year.) The
worksheet also shows the ratio of cash flow from
operations to capital expenditures. A dash for a particular
financial statement item does not necessarily mean the
amount is zero. It merely indicates that the amount is not
sufficiently large for the firm to disclose it. A list of the 3
companies and a brief description of their activities follow.
 Quick Check Questions 2-3
 A. Hewlett-Packard: Develops, manufactures, and sells
computer hardware. The firm outsources manufacturing of
many of its computer components.
 B. HSBC Finance: Lends money to consumers for periods
ranging from several months to several years. Operating
expenses include provisions for estimated uncollectible
loans (bad debts expense).
 C. McDonald’s: Operates fast-food restaurants worldwide.
A large percentage of McDonald’s restaurants are owned
and operated by franchisees. McDonald’s frequently owns
the restaurant buildings of franchisees and leases them to
franchisees under long-term leases.
 Quick Check Question 2
 Which firm is HSBC Finance?
a. Firm 1
b. Firm 2
c. Firm 3
 Quick Check Question 3
 Which firm is McDonald’s?
a. Firm 1
b. Firm 2
c. Firm 3
 Quick Check Question 3
 Which firm is HP/ Apple?
a. Firm 1
b. Firm 2
c. Firm 3
 Quick Check Question 4
 Apple business strategy consists of the following elements:
• Focus on product design and functionality
• Strengthening Apple’s ecosystem
• Improving consumer service experience
 Dell’s make-to-order model:
• Customer place orders on Dell’s website. In this order, the customer
specifies their requirements, like the computer configuration and
specifications.
• The customer’s requirements are forwarded to the manufacturing
department.
• The assembly of the custom PC begins.
• The computer is ready and shipped to the customer.
 Quick Check Question 4
 Examine the following common-size income statements
of Apple Computer and Dell:
Firm
Firm A
B
Sales 100% 100%
Cost of goods sold (82.1) (59.9)
Selling and
administrative (11.6) (9.7)
expenses
Research and
(1.1) (3.1)
development
Income taxes (1.4) (8.9)
All other items 0.2 0.8
 Quick Check Question 4
 Which firm is Apple Computer?
a. Firm A
b. Firm B
 Quality and principles are the most
important
Step 3: Assess the Quality of the
Financial Statements

 Firms prepare four principal financial statements and

two additional items to report the results of their
activities:
• Balance sheet(Statement of financial position)
• Income statement(Statement of profit or loss
(Unrealised profit)
• Statement of comprehensive income
value added that not yet converted int
• Statement of cash flows
• Statement of shareholders’ equity
• Notes to the financial statements
 Accounting Quality and Accounting
Principles
• Accounting information should be a fair and
complete representation of the firm’s economic
performance, financial position, and risk.
• Accounting information should provide relevant
information to forecast the firm’s expected future
earnings and cash flows.
 Mandatory Financial Reporting
From legal perspective – Companies Ordinance
(Ch. 622) Section 380 :
 To present the accounts to the shareholders
that give a true and fair view of the state of
affairs of the company and the profit or loss of
the company for the financial year
 Mandatory Financial Reporting
Professional perspective – HKFRS Framework
 The objective of financial statements is to provide
information about the financial position,
performance and changes in financial position of
an entity that is useful to a wide range of users in
making economic decisions.
 Financial statements also show the results of the
stewardship of management, or the accountability
of management for the resources entrusted to it.
 Recognise (include in Financial
Statement) Revenue when earned, not
Accrual Basis of Accounting
based on cash receipt
Recognize expenses when incurred, not just need on
cash payment
• The accrual basis provides a better measure of operating
performance than the cash basis because it better captures
the economics of a firm’s periodic activities and
performance than does simply reporting cash flows.
• Under the accrual basis of accounting, a firm recognizes
revenue when it meets the following two criteria:
• It has completed all or substantially all of the
revenue-generating process by delivering
products or services to customers.
• It is reasonably certain it has satisfied a liability or
generated an asset that it can measure reliably.
 Quick Check Question 5
 Which financial statement presents a snapshot of a
company’s assets, liabilities, and shareholders’ equity as of
a specific date?
a. Balance sheet
b. Income statement
c. Statement of retained earnings
d. Statement of cash flows
Step 4: Analyze Profitability and Risk

• Financial statements are useful for assessing the

profitability and risk of a firm.
• Tools to assist in analyzing profitability and risk
include:
• Common-size financial statements
• Percentage change financial statements
• Financial statement ratios
 i. Common-Size Financial Statements

• Common-size financials are very helpful in

comparing firms of different size and comparing
firms that prepare financials using different
currencies.
• Common-size percentages provide an insightful
overview of financial position and operating
performance:
• Common-size balance sheets express all amounts
as a percentage of total assets.
• Common-size income statements express all items
as a percentage of total revenues.
 ii. Percentage Change Financial
Statements

• Percentage change financial statements are helpful

in highlighting the relative rates of growth in
financial statement amounts from year to year and
over longer periods of time.
• The amount of percentage change in an item is
relative to its amount in the previous period and the
compounded average percentage change over
several prior periods.
• Another form of percentage change is the
compound annual growth rate (CAGR), which
measures the average of the annual rate of return
between two different years.
 iii. Financial Statement
Ratios
• Financial statement ratios express relations among
various items from the three financial statements.
• Ratios are effective indicators of various
dimensions of profitability, growth, and risk and
serve as useful signals of future profitability,
growth, and risk.
• Profitability ratios include earnings per share (EPS)
and return on common equity (ROCE).
• Risk ratios include the current ratio and calculating
the standard deviation on the return on common
equity (ROCE).
Step 5: Prepare Forecasted Financial
Statements
Step 6: Value the Firm
• The most difficult and crucial step is forecasting
future financial statements because the quality of
investment decisions rests on the reliability of
forecasts.
• Capital market participants most commonly use
financial statement analysis to value firms.
• Forecasts of future dividends, earnings, and cash
flows form the basis for the most frequently used
valuation models.
 Quick Check Question 6
 Which of the following is a tool to assist in analyzing
profitability and risk?

a. Corporate marketing plan

b. Type of accounting software used by a firm
c. Financial statement ratios
d. Management and discussion analysis (MD&A)
Role of Financial Statement Analysis
in an Efficient Capital Market
• Security prices represent the aggregate information
known by the capital markets about a firm.
• Market efficiency describes the degree to which the
capital market impounds information into security
prices.
• Research has shown that equity markets are not
perfectly efficient.
• With their expertise and access to information
about firms, financial analysts and investors do the
analysis and engage in the trading necessary to
increase market efficiency.
 Users of Financial Statement
Investors and analysts:
Use information about a company’s past performance to predict its future
performance (e.g., profitability and security prices).

Creditors:
Use information to assess risk: short-term liquidity (ability to meet current
obligations) or long-term solvency (ability to generate cash to repay principal on
long-term debt).

Managers and employees:

Raise capital, meet disclosure requirements
Contracting (executive compensation agreements linked to F/S)
Development of earnings forecasts & projections.
Monitor health of company and make investment decisions
 Users of Financial Statement
Customers and strategic partners:
Repeat purchases, product guarantees and warranties, assess financial strength, etc

Regulators:
Enact social, economic and tax policies, and to monitor compliance.
 Preparers vs Users
 Note that financial statements are prepared
by companies (in accordance with the
accounting standards).
 Financial Statement Analysis is Essentially
Information Consumption (by users).
 Thus, users must understand how such
financial statements are prepared!
• i.e., Incentives, legitimacy, truthfulness.
 Take Away
 Adequate information needed to properly judge
investment opportunities/risks.
 Financial statements are the first (often the best or the
only) source of information about a company’s past
performance, current health, and future prospects.
 Financial statement users should not accept numbers
at face value.
 Accounting is not an exact science!
 Tips
 Financial statement users should:
Understand current financial reporting standards and guidelines.
Recognize that management can shape financial information. Be skeptical,
especially of any information in the unaudited portions of the financial reports or
any information disclosed in press releases.
Consider the source of the data: is it accurate and reliable?
Use common size financial statements and financial ratios to help identify items to
further investigate.
Determine how individual figures were calculated.
E.g., whether figures include effects of nonrecurring items such as special items,
extraordinary items, and discontinued operations.
Study the footnotes to the financial statements.
Be thorough and consistent
Correct for differences in accounting methods and/or accounting standards when
comparing companies.