Study Notes: Overview of Financial Statement Analysis

Role of Financial Statements

  • Financial statements are prepared primarily for decision-making and guide managerial decisions; they are not an end in themselves. Their value comes from analysis and interpretation to inform decisions.
  • Financial analysis identifies the firm’s financial strengths and weaknesses by establishing relationships between balance sheet items and the profit and loss account.
  • Methods/techniques used in financial statement analysis include:
    • comparative statements
    • trends analysis
    • common-size statements
    • schedule of changes in working capital
    • funds flow and cash flow analysis
    • cost–volume–profit analysis
    • ratio analysis
  • Learning Outcome: Explain how a company would use the financial statements to perform risk analysis and profitability analysis.
  • Pre-Assessment: What is a financial statement? What are the examples and parts of financial statements?
  • Activities/Task: Asynchronous activities via printed modules.

The role of the Financial Statements

  • Internal users (e.g., managers) rely on financial statements to plan, evaluate, and control operations.
  • External users (e.g., investors, creditors) use financial statements to gauge future profitability and liquidity.

Financial Statement Analysis

  • Involves reformulating reported financial statement information, analyzing the information, and adjusting for measurement errors.
  • After reformulation and adjustment, various calculations are performed on the reformulated/adjusted statements.
  • In practice, the first two steps (reformulation and adjustment) are often dropped; analysts may calculate financial ratios on reported numbers without thorough examination, though some adjustments might be made.
  • Example of reformulation on the income statement:
    • divide reported items into recurring/normal items and non-recurring/special items, separating normal earnings (core earnings) from transitory earnings.
  • Normal earnings are more permanent and therefore more relevant for prediction and valuation.
  • Normal earnings are separated into:
    • net operational profit after taxes (NOPAT)
    • net financial costs
  • On the balance sheet, group into:
    • net operating assets (NOA)
    • net financial debt (NFD)
    • equity (E)

Types of Analysis

  • Two types of ratio analysis:
    • analysis of risk (risk analysis)
    • analysis of profitability (profitability analysis)

Risk Analysis

  • Aims to detect underlying credit risks to the firm.
  • Components:
    • Liquidity analysis: evaluates whether the firm has enough liquidity to meet obligations.
    • Common ratios: current ratio; interest coverage.
    • Cash flow analysis is also useful in evaluating risk.
    • Solvency analysis: evaluates whether the firm is financed in a way that allows recovery from losses.

Profitability Analysis

  • Focuses on analysis of return on capital.
  • Example: Return on Equity (ROE) is defined as earnings divided by average equity.
  • ROE can be refined as:
    • ROE=(RNOA)+(RNOA−NFIR)⋅NFDEROE = (RNOA) + (RNOA - NFIR) \cdot \frac{NFD}{E}
    • where:
    • RNOA = return on net operating assets
    • NFIR = net financial interest rate
    • NFD = net financial debt
    • E = equity
  • This formula clarifies the sources of return on equity by linking operating performance with the financing structure.

Standardizing Financial Statements: Income Statement

  • An income statement (also called the profit and loss statement, revenue statement, operating statement, or statement of operations) shows how revenue is transformed into net income.
  • It indicates revenues recognized for a specific period and the associated costs/expenses, including depreciation and amortization, and taxes.
  • Purpose: to show managers and investors whether the company made or lost money during the reported period.
  • Key principle: the income statement covers a period of time; the balance sheet reflects a single moment in time.

Two Methods of Income Statement

  • Single-step income statement:
    • Totals revenues and subtracts expenses to determine the bottom line.
  • Multi-step income statement:
    • Starts with gross profit.
    • Subtracts operating expenses to yield income from operations.
    • Adds/subtracts other revenues and other expenses to obtain income before taxes.
    • Deduces taxes to produce net income for the period.

Key Concepts / Focus Points

  • By using a variety of methods, users can determine the risk and profitability of a company from the financial statements.
  • Financial statement analysis consists of reformulating reported information and adjusting for measurement errors.
  • Two types of ratio analysis: risk analysis and profitability analysis.
  • Analysis of risk aims to detect underlying credit risk of the firm.
  • Analysis of profitability refers to the analysis of return on capital.

Post-assessment

  • Why do we need to study financial analysis ?