Financial Statement Analysis - D366

Complete to the end of Recording 2.

Financial Analysis

Allows us to:

• Standardize numbers and facilitate comparisons

  • Compare firms to each other

  • Compare to industry averages

  • Compare to own historical performance

• Forecast

• Valuation

• Operational firm health

  • Liquidity/capital expansion

Step 1 (Six-Step Framework for Financial Analysis)

Identify Economic Characteristics and Competitive and Competitive Dynamics in the Industry

Step 2 (Six-Step Framework for Financial Analysis)

Identify Company Strategies

Step 3 (Six-Step Framework for Financial Analysis)

Assess the Quality of the Financial Statements

Step 4 (Six-Step Framework for Financial Analysis)

Analyze Profitability, Growth, and Risk

Step 5 (Six-Step Framework for Financial Analysis)

Project Future Financial Statements

Step 6 (Six-Step Framework for Financial Analysis)

Value the Firm

Porter’s “Five Forces” Framework

Asserts there are five forces that help analyze competition and potential profitability in an industry.

• Threat of new entry

• Supplier power

• Buyer power

• Threat of substitution

• Competitive rivalry

Accounting Quality

Information should provide:

1. A fair and complete representation of a company's financial performance, financial position, and associated risk

2. Relevant information to forecast a firm's expected future earnings and cash flows

About more than mere technical accuracy

Income Statement

Provides insights into:

• A company's operations

• Management's efficiency

• Under performing sectors

• Performance relative to industry peers

Revenue

• Recognized when earned

• Matched with expenses (matching principle)

• Recurring vs. non-recurring income

• Manipulation:

  • Phantom/ghost customers

  • Over/understating Invoice amounts

  • Improper timing of revenue recognition

Cost of Goods Sold (COGS)

• Recognized when product is sold/service is complete

• Matched with revenues (matching principle)

• Manipulation:

  • Phantom/ghost vendors/suppliers

  • Over/understating vendor invoice amounts

  • Improper inventory valuation

  • Improper timing of expense recognition

Operating Expenses

• Selling expenses

  • Commissions to salespeople

  • Advertising

  • Displays

• Administrative expenses

  • Corporate office salaries and wages

  • Executive salaries and wages

• General expenses

  • Rent

  • Utilities

  • Insurance

• Manipulation:

  • Improper expense/capitalization of long-term assets

  • Report fictitious or too low expense

Depreciation and Amortization

• Largest non-cash expenses of an organization

• Depreciation is the expensing of fixed assets with a life longer than one year

  • Asset is reported on Balance Sheet in "Fixed Assets"

  • Depreciation expense is reported on the Income Statement

  • Accumulated Depreciation is a contra asset account

• Amortization is the expensing of intangible assets

  • Asset is reported in Balance Sheet in "Intangible Assets" section

  • Amortization expenses is reported on the Income Statement and also reduces the balance in the asset account

Earnings Before Interest and Taxes (EBIT)

Focuses on operating profit.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Identifies cash flows from operations.

Other Income (Expense)

Reports income and expense items that are not part of the company's regular operations and are not part of the company's regular operations and are not applicable to predicting future income. Potential items in this section include:

• Gain or loss on sales of equipment or other long-term assets

• Gain or loss on fair value of investment securities available for sale

• Asset impairment

Note: When removing items included in other income/expense, the analyst should also remove the tax effects related to these items.

Common-Sized Financial Statements

• Used to compare a firm's performance over time

• Used to compare a firm's performance with others in the same industry

• Identifies firm's strengths and weakness regarding operation

• Two types:

  • Horizontal Analysis: Analyzes each line item's change from one period to another

  • Vertical Analysis: Analyzes as a percentage of another item.

    • Income Statement: All lines are a percentage of sales

    • Balance Sheet: All assets are a percentage of total assets. All liability and equity accounts are also a percentage of total assets (which is the same as total liabilities and shareholder's equity.)