Introduction to Financial Analysis

• Accounting:

  • “Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by the users of the information” - American Accounting Association

  • “A process that helps a business measure its profitability and solvency” - Language of business

  • Process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by the user’s information. A process that helps a business measure its profitability and solvency.

• Types of Accounting

  1. Bookkeeping: Collected info, systematically

  2. Financial Accounting: Cash flow, balance sheet, income statement

  3. Managerial Accounting: Strategic info, budget, marginality, competition

  4. Tax Accounting: Taxes a company has to pay

• Types of business according to the purpose or objective of the organization

  • Profit Making: Offers goods or services to obtain an economic benefit known as income that is distributed amongst the owners (individual or stockholders)

  • Non-for-profit: Offer goods or services but does not expect to generate income

  • Governmental: Government agencies that belong to the state

• Characteristics of the three forms of business organizations

  1. Individual: Unincorporated business owned by a single owner and often managed by the same person

  2. Partnership: Unincorporated business owned by two or more individuals associated as partners

  3. Corporation: Business incorporated under the laws of a state and owned by a few stockholders. “Separate legal entity”

• According to they types of activities performed by business organizations

  • Service Companies: Perform services for a fee. For example, accounting firms, legal firms, consultancy firms, dry cleaning establishments, etc.

  • Merchandising Companies: Purchase goods ready for sale and then sell them to customer, I.E, department stores, supermarkets, auto dealers, clothing stores, etc.

  • Specialized Sectors: Financial services, primary sector, agriculture, mining, oil, etc.

• Primary objectives of any business

  • Profitability: Ability to generate income

  • Solvency: Ability to pay debts as they become due

• Balance Sheet

  • Assets (property): Inventory, cash property of the company

    • Current Assets: Inventory, cash, banks (Activos circulantes, se pueden convertir en dinero mas rapido)

    • Fixed Assets: Buildings, estate, trucks (Activo no circulante)

  • Liability

    • Short-term liabilities: Provedores, cuentas (Deudas a pagar en menos de un año)

    • Long-term liabilities: Cuentas por pagar, L.P

  • Equity: Dinero de reserve

• The Four Basic Financial Statements

  1. Balance Sheet: Statement of financial position, lists the company’s assets, liabilities, and stockholders equity as at a particular point in time

  2. Income Statement: Also known as profit and loss statement, is a financial report that shows the profitability of a business organization for a stated period of time

  3. Statement of Cash Flows: Shows the chas inflows and outflows from operating, investing and financing activities

  4. Statement of Retained Earnings: This report connect the balance sheet and the income statement. It shows the difference between net income and dividends paid to stockholders

• Business Entity

  • A business organization that exists as an economic unit

  • A business organization that has an existence of its own, separate from its owners, creditors, etc.

• A set of resources with a common goal that is achieved through a decision-making process

  Financial Analysis

  • Financial Analysis is a process of reviewing the financial performance of an enterprise

  • By looking to this financial performance one can determine the viability, stability, and profitability of the company

  • This analysis involves breaking down financial data into meaningful insights using financial ratios, trends, and forecasts

  • The goal is to determine how well an organization is performing, identify areas for improvement, and predict future financial outcomes

• Financial Analysis Provides

  • Decision Making

  • Performace Evaluation

  • Investment Assessment

  • Risk Management

  • Strategic Planning

• Key Components of Financial Analysis

  1. Financial Statements

  2. Financial Ratios

  3. Financial Planning and Forecasting

  4. Investment Analysis

  5. Cost Management

Financial Statements	Financial statements are the primary sources of data for financial analysis They provide a picture of a company’s financial health and performance over time
4 Main Financial Statements	Income Statement (Profit & Loss Statement) Balance Sheet (Statement of Financial Position) Cash Flow Statement Statement of Changes in Equity
Income Statement (Profit & Loss Statement)	The income statement, also known as the Profit & Loss Statement, is a vital financial document that summarizes a company’s revenues, expenses, and profits or losses over a specific period It provides insights into the organization’s operational efficiency and profitability
Balance Sheet (Statement of financial Position)	A balance Sheet, also known as the Statement of Financial Position, gives a snapshot of a company’s financial health at a specific point in time (it is usually a year)
Cash Flow Statement	The cash flow statement is a financial statement that gives a detailed summary of how cash flows into and out of a company over a specific period It is one of the core financial statements, along with the Balance Sheet and Income Statement, and offers valuable insights into an organization’s liquidity, solvency, and overall financial health	3 segments: Operating activities: These activities show cash flows from the enterprise’s core business operations. It includes cash received from customers and cash paid to suppliers and employees Investing Activities: These activities include cash flows related to the acquisition and disposal of long-term assets Financing Activities: These activities cover cash flows associated with the company’s capital structure and financial decisions
Statement of Changes in Equity	The statement of Changes in Equity (also known as the Statement of Stockholders’ Equity or Statement of Retained Earnings) deliver a detailed account of the changes in an organization’s equity over a specific period. It captures how various transactions affect the owner’s equity, helping stakeholders understand movements in the components of equity	4 sections: Opening Balances: This part reflects the equity balances at the beginning of the reporting period Additions: This part details transactions that increase equity Deductions: This part includes transactions that decrease equity Closing Balances: This part reflects the equity balances at the end of the reporting period, after all additions and deductions have been accounted for

Financial Ratios

• Financial ratios are crucial tools used for analyzing an organization’s financial performance and stability

• They provide insights into several aspects of a company’s profitability, liquidity, solvency, efficiency, and leverage

• Financial ratios are generally derived from the financial statements: the Balance Sheet, the Income Statement, and the Cash Flow Statement

Profitability Ratios

• Profitability Ratios are financial metrics used to evaluate an organization’s ability to generate profit relative to its revenue, assets or equity

• These ratios help stakeholders understand how well a company is performing in terms of profit generation and are vital for assessing the financial health of a business

Gross Profit Margin	It measures the percentage of revenue that surpasses the cost of good sold (COGS)
Operating Profit Margin	It measures the percentage of revenue remaining after covering operating expenses but before interest and taxes
Net Profit Margin	It measures the percentage of revenue remaining after all costs, including interest, taxes, and operating costs
Return on Assets (ROA)	It measures how efficiently an organization uses its assets to generate profit
Return on Equity (ROE)	It measures the return on shareholders’ equity and indicates how effectively management is using shareholders’ resources
Return on Investments (ROI)	It measures the return generated as investments to their

Liquidity Ratios

• Liquidity Ratios measure an organization’s ability to meet its short-term obligations and are essential for assessing financial health

• These ratios reflect the company’s capacity to transform assets into cash to cover liabilities

Current Ratio	It measures an organization’s ability to pay short-term liabilities with short-term assets (cash, security, rent)
Quick Ratio (Acid-Test Ratio)	The quick ratio assesses an organization’s ability to meet short-term liabilities without relying on inventory sales
Cash Ratio	The cash ratio evaluates an organization’s ability to pay off short-term liabilities with cash and cash equivalents
Operating Cash Flow Ratio	This ratio measures a company’s ability to cover short-term liabilities with cash generated from operating activities
Net Working Capital Ratio	The net working capital ratio measures the amount of liquid assets available after paying current liabilities

Solvency Ratios

• Solvency ratios measure an organization’s ability to meet its long-term obligations and assess its overall financial stability

• These ratios help investors and creditors understand whether an enterprise can sustain operations over the long term and manage its debt

Debt to Equity Ratio	The debt-to-equity ratio measures the proportion of a company’s total debt to its shareholders’ equity. It shows how much debt an organization is using to finance its assets compared to the equity
Debt Ratio	The debt ratio measures the proportion of a company’s assets that are financed through debt. It shows the company’s leverage and financial risk
Equity Ratio	The equity ratio measures the proportion of a company’s assets that are financed by shareholders equity. It reflects the percentage of assets funded by equity
Interest Coverage Ratio	The interest coverage ratio measures an organization’s ability to pay interest expenses on its debt. It indicates how many times an enterprise can cover its interest obligations from its operating income
Cash Flow to Debt Ratio	The cash flow to debt ratio measures the ability of a company’s cash flow from operations to cover its total debt. It shows how well a company can manage its debt obligations using cash flow

Efficiency Ratios

• Efficiency ratios measure how effectively a company uses its assets and resources to generate revenue and profits

• These ratios give insights into operational performance and management efficiency

• Understanding and analyzing efficiency ratios can help investors, creditors, and management evaluate an enterprise’s operational effectiveness and identify areas for improvement

Asset Turnover Ratio	The asset turnover ratio measures how efficiently an organization uses its assets to generate sales revenue
Inventory Turnover Ratio	The inventory turnover ratio measures how many times an enterprise’s inventory is sold and replaced over a period
Accounts Receivable Turnover Ratio	The accounts receivable turnover ratio measures how effectively an organization collects its receivables
Accounts Payable Turnover Ratio	The accounts payable turnover ratio shows how quickly a company pays off its suppliers

Leverage Ratios

• Leverage ratios are financial metrics used to assess the degree to which a relies on borrowed resources to finance its operations and growth

• These ratios provide insights into a company’s financial risk, stability, and ability to meet its long-term obligations

Capitalization Ratio	It shows the proportion of long-term debt relative to the total capitalization (long-term debt plus equity). It provides an indication of the long-term financial stability of the company
Net Debt-to-Equity Ratio	Considers net debt (total debt minus cash and cash equivalents) relative to equity, offering a clearer picture of a company’s debt position after accounting for its liquid assets
Debt-to-Assets Ratio	Like the debt ratio, this metric provides insight into the proportion of total assets financed through debt, highlighting the extent of financial leverage
Gross Debt-to-EBITDA Ratio	Compares total debt (including short-term and long-term) to EBITDA, showing how easily a company can cover its gross debt obligations with its earnings

Generation of Financial Information

• The “generation of financial information” refers to the process of creating and compiling several types of financial data and reports to support decision-making, analysis, and communication within an organization or to external stakeholders

• This process typically involves collecting, processing, and presenting financial data in a structured format

• What involves generating financial information?

  • Financial information has 6 stages to be created, which are the following:

    1. Data collection

    2. Data Processing

    3. Report Generation

    4. Analysis and Interpretation

    5. Communication

  • Compliance and Audit

  • Data Collection

  • For data collection we have three main aspects:

    1. Source Identification: Identifying and gathering data from various sources, such as financial transactions, accounting records, and operational data

    2. Data Entry: Recording financial transactions into accounting systems or spreadsheets

    3. Verification: Ensuring the accuracy and completeness of the collected data

• Data Processing

  For data processing it is important to follow this order:

  1. Classification: Sorting data into categories like revenue, expenses, assets, and liabilities

  2. Aggregation: Summarizing data to form financial statements and reports

  3. Analysis: Applying accounting principles and methods to process data (ex. adjusting entries, accruals)

• Report Generation

  For report generation financial experts elaborate:

  • Financial Statements:

    • Income statement: Summarizes revenue, expenses, and profits over a period

    • Balance Sheet: Provides a snapshot of assets, liabilities, and equity at a specific date

    • Cash Flow Statement: Shows cash inflows and outflows from operating, investing, and financing activities

  • Management Reports:

    • Detailed reports for internal use, such as budget vs. actual performance, variance analysis, and departmental financial performance

  • External Reports:

    • Annual Reports: Comprehensive reports for shareholder and the public, often including statements, management discussion, and analysis

    • Regulatroy Fillings: Reports required by regulatory bodies, such as SED filings for public companies

• Analysis and Interpretation

  For analysis and interpretation, we have the following:

  • Financial Analysis

    • Ratio analysis: Calculating financial ratios (ex. liquidity, profitability) to asses performance

    • Trend analysis: Analyzing historical data to identify patterns and trends

    • Variance analysis: Comparing actual performance to budgeted figures to understand deviations

  • Forecasting

    • Budgeting: Creating financial plans and projections for future periods

    • Scenario Planning: Developing different financial scenarios based on varying assumptions

• Communication

  A crucial aspect in generating financial information is how well it is communicated, there are two types of communications:

  1. Internal Communication: Sharing financial information with management and staff to support decision-making and operational planning

  2. External Communication: Presenting financial information to investors, regulators, and other stakeholders through formal reports and disclosures

• Compliance and Audit

  Financial information must have:

  1. Compliance: Ensuring that financial information adheres to accounting standards and regulatory requirements

  2. Audit: Reviewing financial information to verify accuracy and completeness, often performed by external auditors

• Different tools and techniques to generate financial information

  Three very important are:

  1. Accounting software

  2. Spreadsheet software

  3. Data visualization tools