Financial Statement Analysis

Study Guide

Introduction to Financial Statement Analysis

Financial Statement Analysis (FSA) involves using financial information to make economic decisions. The primary goal is to evaluate a company's past performance, current financial position, and future prospects.

• Key Financial Statements:
  • Balance Sheet: A snapshot of a company's financial position (Assets, Liabilities, Equity) at a single point in time.
  • Income Statement: Reports a company's financial performance (Revenues, Expenses, Profits) over a period of time.
  • Cash Flow Statement: Shows the sources and uses of cash over a period, categorized into operating, investing, and financing activities.
  • Statement of Changes in Equity: Details the changes in owners' equity over a period.
• Standard-Setting Bodies & Regulatory Authorities:
  • IASB (International Accounting Standards Board): Issues International Financial Reporting Standards (IFRS).
  • FASB (Financial Accounting Standards Board): Issues U.S. Generally Accepted Accounting Principles (U.S. GAAP).
  • Regulatory Authorities (e.g., SEC in the U.S.): Enforce financial reporting requirements.
• The Audit Report: An independent auditor's opinion on the fairness and conformity of financial statements with accounting standards.
  • Unqualified Opinion: The statements are presented fairly. This is the best type of report.
  • Qualified Opinion: There is some material departure from standards, but not pervasive.
  • Adverse Opinion: The statements are not presented fairly and are materially misstated.
  • Disclaimer of Opinion: The auditor is unable to form an opinion.

Analyzing Income Statements

The income statement shows a company's profitability over a period.

• Key Components: Revenue - Cost of Goods Sold (COGS) = Gross Profit - SG&A = Operating Profit (EBIT) +/- Non-operating items = Earnings Before Tax (EBT) - Tax = Net Income.
• Revenue Recognition: Both IFRS and U.S. GAAP use a 5-step model: 1) Identify the contract, 2) Identify performance obligations, 3) Determine transaction price, 4) Allocate price to obligations, 5) Recognize revenue when (or as) obligations are satisfied.
• Expense Recognition (Matching Principle): Expenses are recognized in the same period as the revenues they help generate.
• Earnings Per Share (EPS):
  • Basic EPS: Measures profit available to each common share. $\text{Basic EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Common Shares Outstanding}}$
  • Diluted EPS: Considers the impact of all potential dilutive securities (e.g., stock options, convertible bonds). Diluted EPS must be less than or equal to Basic EPS.
• Comprehensive Income: Includes all changes in equity except for owner transactions. $\text{Comprehensive Income} = \text{Net Income} + \text{Other Comprehensive Income (OCI)}$ OCI includes items like unrealized gains/losses on certain securities and foreign currency translation adjustments.

Analyzing Balance Sheets

The balance sheet presents a company's resources (assets) and claims on those resources (liabilities and equity). The fundamental accounting equation must always hold: Assets = Liabilities + Equity.

• Assets:
  • Current Assets: Expected to be converted to cash or used up within one year or operating cycle (e.g., Cash, Accounts Receivable, Inventory).
  • Non-Current Assets: Held for long-term use (e.g., Property, Plant & Equipment (PP&E), Intangible Assets, Goodwill).
• Liabilities:
  • Current Liabilities: Obligations due within one year (e.g., Accounts Payable, Short-term Debt).
  • Non-Current Liabilities: Obligations due after one year (e.g., Long-term Debt, Lease Liabilities).
• Equity: The owners' residual claim on assets after deducting liabilities.
  • Contributed Capital: Amount invested by shareholders.
  • Retained Earnings: Cumulative net income not distributed as dividends.
  • Treasury Stock: Shares repurchased by the company (a contra-equity account).
  • Accumulated Other Comprehensive Income (AOCI): Cumulative OCI.

Analyzing Statements of Cash Flows I

This statement reconciles the beginning and ending cash balance by showing all cash inflows and outflows.

• Categories of Cash Flow:
  • Cash Flow from Operations (CFO): Cash generated from the principal revenue-producing activities.
  • Cash Flow from Investing (CFI): Cash used for or generated from the acquisition and disposal of long-term assets and other investments.
  • Cash Flow from Financing (CFF): Cash transactions with owners (issuing stock, paying dividends) and creditors (issuing debt, repaying debt).
• CFO Calculation Methods:
  • Indirect Method (most common): Starts with Net Income and adjusts for non-cash items (like depreciation) and changes in net working capital accounts.
  • Direct Method: Reports actual cash receipts and payments.
  • Note: If a company uses the direct method, it must also disclose a reconciliation to net income (the indirect method).

Analyzing Statements of Cash Flows II

This section focuses on using the cash flow statement for analysis.

• Free Cash Flow (FCF): Cash available to the company after making investments to maintain or expand its asset base. It is a key metric for valuation.
  • Free Cash Flow to the Firm (FCFF): Cash available to all capital providers (debt and equity). $\text{FCFF} = \text{CFO} + \text{Interest Expense} \times (1 - \text{Tax Rate}) - \text{Capital Expenditures}$
  • Free Cash Flow to Equity (FCFE): Cash available to common shareholders after all expenses and debt obligations are paid. $\text{FCFE} = \text{CFO} - \text{Capital Expenditures} + \text{Net Borrowing}$
• Cash Flow Ratios: These ratios measure a company's ability to generate cash to cover its debts, investments, and dividends.
  • Cash Flow to Revenue: $\frac{\text{CFO}}{\text{Net Revenue}}$
  • Cash Return on Assets: $\frac{\text{CFO}}{\text{Average Total Assets}}$

Analysis of Inventories

Inventory is a key current asset for many companies. The accounting method chosen can significantly impact reported financial results.

• Inventory Costing Methods: | Method | Description | IFRS/GAAP | | :--- | :--- | :--- | | FIFO | First-In, First-Out. Assumes first units purchased are first ones sold. | Permitted | | Weighted-Average | Uses weighted-average cost of all goods available for sale. | Permitted | | LIFO | Last-In, First-Out. Assumes last units purchased are first ones sold. | U.S. GAAP only |

• Impact of Methods in a Period of Rising Prices: | Item | FIFO | LIFO | | :--- | :--- | :--- | | Ending Inventory | Higher | Lower | | COGS | Lower | Higher | | Net Income | Higher | Lower | | Taxes | Higher | Lower |

• LIFO to FIFO Conversion: For comparability, analysts often adjust LIFO firms to FIFO.

  • $\text{FIFO Inventory} = \text{LIFO Inventory} + \text{LIFO Reserve}$
  • $\text{FIFO COGS} = \text{LIFO COGS} - \text{Change in LIFO Reserve}$

• Inventory Write-Downs: Inventory must be reported at the lower of cost or net realizable value (IFRS) or lower of cost or market (U.S. GAAP).

Analysis of Long-Term Assets

These assets are used for more than one year and include tangible assets (PP&E) and intangible assets.

• Capitalizing vs. Expensing:
  • Capitalizing: The cost is recorded as an asset on the balance sheet and depreciated over time. Results in higher assets, higher equity, and initially higher net income.
  • Expensing: The cost is recorded as an expense on the income statement in the period incurred.
• Depreciation Methods:
  • Straight-Line: $\frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$. Constant expense each year.
  • Double-Declining Balance: An accelerated method with higher expense in early years.
  • Units-of-Production: Expense is based on asset usage, not time.
• Intangible Assets:
  • Finite Life: Amortized over their useful life (e.g., patents, copyrights).
  • Indefinite Life: Not amortized, but tested annually for impairment (e.g., goodwill, trademarks).
• Impairment: A write-down is required if the asset's carrying value exceeds its recoverable amount. Impairment losses reduce net income. Under U.S. GAAP, write-downs cannot be reversed; under IFRS, they can be (except for goodwill).

Topics in Long-Term Liabilities and Equity

This section covers financing through debt (liabilities) and equity.

• Bonds:
  • Carrying Value: Bonds are recorded at their issue price. The carrying value is adjusted over time towards the par value using the effective interest method.
  • Interest Expense: $\text{Interest Expense} = \text{Carrying Value} \times \text{Market Rate at Issuance}$
  • Cash Payment: $\text{Cash Payment} = \text{Face Value} \times \text{Coupon Rate}$
• Leases: For most leases, the lessee recognizes a Right-of-Use (ROU) Asset and a Lease Liability on the balance sheet.
  • Finance Lease (Lessee): Both depreciation on the ROU asset and interest expense on the liability are recognized.
  • Operating Lease (Lessee): A single lease expense is recognized.
• Defined Benefit Pension Plans: The company bears the investment risk. A net pension asset or liability is reported on the balance sheet.

Analysis of Income Taxes

Differences between accounting rules and tax law create deferred tax items.

• Key Equation: $\text{Income Tax Expense} = \text{Taxes Payable} + \Delta\text{DTL} - \Delta\text{DTA}$
• Deferred Tax Liability (DTL): Created when tax expense is greater than taxes payable. This means the company will have to pay more tax in the future. A common cause is using accelerated depreciation for tax purposes and straight-line for reporting.
• Deferred Tax Asset (DTA): Created when taxes payable is greater than tax expense. This implies a future tax benefit. A common cause is recognizing warranty expenses for reporting before they are tax-deductible.
  • A valuation allowance is a contra-asset account used to reduce a DTA if it is more likely than not that the future tax benefit will not be realized.

Financial Reporting Quality

Financial reports should be a faithful and relevant representation of a company's performance and position.

• Quality Spectrum: High-quality reporting is decision-useful and compliant with standards. Low-quality reporting can be biased or fraudulent.
• Earnings Quality: High-quality earnings are sustainable and adequate to cover the company's cost of capital. They are not inflated by aggressive or one-time accounting choices.
• Warning Signs of Low-Quality Reporting:
  • Aggressive revenue recognition policies.
  • Capitalizing expenses that should be expensed.
  • Large, unexplained accruals or changes in accounting policies.
  • Frequent changes in auditors or management.
  • CFO is consistently lower than net income.

Financial Analysis Techniques

These are the tools used to evaluate a company's performance and financial health.

• Ratio Analysis: | Category | Key Ratios | Formula | | :--- | :--- | :--- | | Activity | Inventory Turnover | $\frac{\text{COGS}}{\text{Average Inventory}}$ | | | Days of Sales Outstanding (DSO) | $\frac{365}{\text{Receivables Turnover}}$ | | Liquidity | Current Ratio | $\frac{\text{Current Assets}}{\text{Current Liabilities}}$ | | | Quick Ratio | $\frac{\text{Cash} + \text{Marketable Securities} + \text{Receivables}}{\text{Current Liabilities}}$ | | Solvency | Debt-to-Equity | $\frac{\text{Total Debt}}{\text{Total Equity}}$ | | | Interest Coverage | $\frac{\text{EBIT}}{\text{Interest Expense}}$ | | Profitability| Net Profit Margin | $\frac{\text{Net Income}}{\text{Revenue}}$ | | | Return on Equity (ROE) | $\frac{\text{Net Income}}{\text{Average Total Equity}}$ |

• DuPont Analysis: Decomposes Return on Equity (ROE) into its key drivers.

  • Traditional 3-Part DuPont: $\text{ROE} = (\frac{\text{Net Income}}{\text{Revenue}}) \times (\frac{\text{Revenue}}{\text{Average Assets}}) \times (\frac{\text{Average Assets}}{\text{Average Equity}})$ $\text{ROE} = (\text{Net Profit Margin}) \times (\text{Asset Turnover}) \times (\text{Financial Leverage})$

• Common-Size Analysis:

  • Vertical: Expresses all income statement items as a % of revenue, and all balance sheet items as a % of total assets.
  • Horizontal: Analyzes trends by showing each item as a % of its value in a base year.

Introduction to Financial Statement Modeling

Financial statement modeling involves forecasting a company's financial statements to be used in valuation and other analyses.

• Forecasting Process:
  1. Establish Purpose: Define the goal of the model (e.g., valuation, credit analysis).
  2. Gather Historical Data: Collect at least 3-5 years of financial statements.
  3. Make Assumptions: Forecast key drivers like revenue growth, profit margins, and capital expenditures. This is the most critical step.
  4. Build the Model: Project the income statement, then the balance sheet, and finally the cash flow statement.
  5. Check for Balance: Ensure the balance sheet balances ($A = L + E$) and the cash flow statement reconciles.
• Key Considerations:
  • Revenue forecast is the foundation of the model.
  • Assumptions should be clearly stated and justifiable.
  • Sensitivity and scenario analysis should be performed to test the model's robustness to changes in key assumptions.