Financial Statement Analysis - Note

Chapter 1: FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION

Financial Reporting and Financial Statement Analysis

• Financial Reporting

  • Providing financial information about an entity to enable users to make decisions.

  • Includes financial statements and other reports.

• Financial Statement Analysis

  • Using financial information to assess prior and likely future performance for decision-making.

  • Typical decision: capital allocation.

Financial Statements

• Statement of Financial Position (Balance Sheet)

• Statement of Comprehensive Income (Income Statement)

• Statement of Changes in Equity

• Statement of Cash Flows

• Notes

Statement of Financial Position (Balance Sheet)

• Basic Equation: $\text{Assets} = \text{Liabilities} + \text{Owners' Equity}$

• Alternatively: $\text{Assets} - \text{Liabilities} = \text{Owners' Equity}$

• Represents a "point in time".

Statement of Comprehensive Income

• Also known as the income statement, statement of earnings, or profit and loss statement.

• Comprehensive Income: All items affecting owners’ equity but not from transactions with shareholders.

• $\text{Comprehensive Income} = \text{Net Income} + \text{Other Comprehensive Income}$

• Presentation formats:

  • Single statement of comprehensive income.

  • Two consecutive statements.

• $\text{Net Income} = \text{Income} - \text{Expenses}$

• Covers a period of time.

Statement of Changes in Equity

• Also known as statement of changes in owners’ equity or statement of shareholders’ equity.

• Covers a period of time.

• $\text{Beginning Equity} + \text{Changes in Equity} = \text{Ending Equity}$

• Basic components: paid-in capital and retained earnings.

• $\text{Beginning Common Stock} + \text{Issuances} - \text{Repurchases} = \text{Ending Common Stock}$

• $\text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends} = \text{Ending Retained Earnings}$

• $\text{Beginning AOCI} + \text{OCI} = \text{Ending AOCI}$

Statement of Cash Flows

• Covers a period of time.

• $\text{Beginning Cash} + \text{Changes in Cash} = \text{Ending Cash}$

• Changes in cash from:

  • Operating activities

  • Investing activities

  • Financing activities

Accompanying Notes

• Required and integral part of financial statements.

• Includes information on:

  • Significant accounting choices (policies, methods, estimates).

  • Explanatory detail about line items.

  • Other disclosures (commitments, contingencies).

• Analysts use notes to compare accounting choices between companies and make adjustments for comparability.

Management Commentary (MD&A)

• A narrative report providing context for interpreting financial position, performance, and cash flows.

• Explains amounts in the financial statements.

• Details a company’s prospects.

• Provides management’s objectives and strategies.

• Encompasses reporting described as MD&A, OFR, or management’s report.

Contents of Management Commentary

• The IFRS practice statement Management Commentary states that the management commentary should include information that is essential to an understanding of:

  • the nature of the business;

  • management’s objectives and its strategies for meeting those objectives;

  • the entity’s most significant resources, risks, and relationships;

  • the results of operations and prospects; and

  • the critical performance measures and indicators that management uses to evaluate the entity’s performance against stated objectives.

• In the United States, the SEC requires listed companies to provide an MD&A and specifies the content. Management must highlight any favorable or unfavorable trends and identify significant events and uncertainties that affect the company’s liquidity, capital resources, and results of operations.

Auditor's Reports

• Financial statements are generally required to be audited by an independent accounting firm.

• An audit report is a written opinion on the financial statements.

• Objectives of an audit:

  • To obtain reasonable assurance that the financial statements are free from material misstatement.

  • To enable the auditor to opine on whether the statements are prepared in accordance with the applicable financial reporting framework.

  • To report on the financial statements.

Types of Auditor’s Reports

• Unqualified Audit Opinion: States that the financial statements give a “true and fair view” or are “fairly presented” in accordance with applicable accounting standards.

• Other types of opinions:

  • Qualified Audit Opinion: Some scope limitation or exception to accounting standards.

  • Adverse Audit Opinion: The financial statements materially depart from accounting standards and are not fairly presented.

  • Disclaimer of Opinion: Auditors cannot issue an opinion due to some limitation.

Internal Control System

• Designed to ensure that the company’s process for generating financial reports is sound.

• Some countries require an additional audit opinion on the company’s internal control systems.

Information Sources Besides Annual Financial Statements

• Annual report or proxy statement: Management compensation and governance information

• Interim reports: (Unaudited) financial statements with updated information on a company’s performance and financial position since the last annual period

• Press releases, particularly earnings announcements, and conference calls

• Presentations to analysts

• External data sources for information on:

  • the economy

  • the industry

  • the company and peer (comparable) companies

• Regulatory context, where applicable

• Direct experience of the company’s products and services

Steps in Financial Statement Analysis

• Articulate the Purpose and Context of the Analysis

• Collect Data

• Process Data

• Analyze/Interpret the Processed Data

• Develop and Communicate Conclusions and Recommendations

• Follow-Up

Chapter 2: FINANCIAL REPORTING STANDARDS

The Objective of Financial Reporting

• To provide financial information about the reporting entity that is useful to users in making decisions about providing resources to the entity.

• Decisions relate to equity and debt instruments, or loans and other forms of credit.

• Investors: Buy, sell, or hold.

• Lenders and other creditors: Lend or not, amount and terms.

Financial Reporting Use in Security Analysis and Valuation

• Decisions depend on expectations about returns (dividend yield and price appreciation).

• Expectations about returns depend on prospects for future cash flows.

• Assessing those prospects requires information about:

  • resources,

  • claims on resources, and

  • use of the resources by management and board.

• Financial reports provide information, not the value.

• Financial reports do not provide all information needed.

Importance of Financial Reporting Standards in Security Analysis and Valuation

• Complexity requires judgment by preparers.

• Judgment can vary, so standards are needed to achieve consistency.

• Standards limit approaches, preparers still make judgments and use estimates.

• Understanding standards, judgments, and estimates allows analysts to use information better.

Standard-Setting Bodies and Regulatory Authorities

• Generally, standard-setting bodies set standards and regulatory authorities enforce them.

• Regulators retain legal authority to establish financial reporting standards and can overrule private sector bodies.

Examples of Standard-Setting Bodies

• The International Accounting Standards Board (IASB) sets IFRS (International Financial Reporting Standards).

• The U.S. Financial Accounting Standards Board (FASB) sets U.S. GAAP (generally accepted accounting principles).

International Organization of Securities Commissions (IOSCO)

• Not a regulatory authority (international association of securities regulators).

• Objectives of IOSCO members:

  • Develop international standards of market regulation.

  • Exchange information and cooperate in enforcement.

  • Exchange information to assist in development of markets, infrastructure, and regulation.

Continuing Developments in Financial Reporting Standards

• Not all countries have adopted IFRS.

• Financial reporting standards continue to evolve due to:

  • Changes in economic activity (new types of products and transactions).

  • Improvements to existing standards.

  • Convergence between international and home-country standards.

  • Analysts need to understand how differences in financial reporting standards affect comparability.

Global Convergence of Accounting Standards: Differences Remain

• Different reporting systems are used in different countries.

• Despite convergence efforts, differences remain between U.S. GAAP and IFRS.

Inventory

• IFRS does not allow for the use of the LIFO (last in, first out) costing methodology for inventory, which is permitted under U.S. GAAP.

Measurement of Certain Asset Classes

• Under IFRS, certain assets are initially recognized at cost, but entities can choose to revalue the assets to fair market value.

• U.S. GAAP does not permit use of a revaluation model.

Impairment

• IFRS models allow for reversals of impairments. U.S. GAAP does not allow reversals of impairments.

Certain Non-financial Liabilities

• U.S. GAAP and IFRS differ in their definitions of what is “probable.”

• IFRS uses “more likely than not to occur,” while U.S. GAAP uses “the future event or events are likely to occur.”

IFRS Conceptual Framework

• Objective: To provide financial information useful in making decisions about providing resources to the entity.

Fundamental Qualitative Characteristics

• Relevance: Information that could potentially make a difference in users’ decisions.

• Faithful representation: Information that faithfully represents an economic phenomenon that it purports to represent. It is ideally:

  • complete,

  • neutral, and

  • free from error.

Enhancing Qualitative Characteristics

• Comparability: Companies record and report information in a similar manner.

• Verifiability: Independent people using the same methods arrive at similar conclusions.

• Timeliness: Information is available before it loses its relevance.

• Understandability: Reasonably informed users should be able to comprehend the information.

Reporting Elements

• Elements directly related to the measurement of financial position:

  • Assets: Resources controlled by the entity as a result of past events.

  • Liabilities: Present obligations of the entity as a result of past events.

  • Equity: Residual interest in the assets after deducting the entity’s liabilities.

• Elements directly related to the measurement of performance:

  • Income: Increases in assets or decreases in liabilities that result in increases in equity.

  • Expenses: Decreases in assets or increases in liabilities that result in decreases in equity.

Constraints and Assumptions

• Constraint: Benefits of information should exceed costs.

• Underlying assumptions:

  • Accrual basis: Financial statements should reflect transactions when they actually occur, not necessarily when cash movements occur.

  • Going concern: Assumption that the company will continue in business for the foreseeable future.

General Features of Financial Statements

• Fair presentation

• Going concern

• Accrual basis

• Materiality and aggregation

• No offsetting

• Frequency of reporting

• Comparative information

• Consistency

Structure and Content Requirements for Financial Statements

• Classified statement of financial position: Balance sheet required to distinguish between current and non-current assets and between current and non-current liabilities unless a presentation based on liquidity provides more relevant and reliable information.

• Minimum information on the face of the financial statements: Minimum line item disclosures on the face of, or in the notes to, the financial statements are specified.

• Minimum information in the notes (or on the face of financial statements): Disclosures about information to be presented in the financial statements are specified.

• Comparative information: For all amounts reported in a financial statement, comparative information for the previous period is required.

Chapter 3: UNDERSTANDING INCOME STATEMENTS

Overview

• Income statement components and format.

• Accounting issues.

  • Revenue recognition.

  • Expense recognition.

  • Inventory

  • Depreciation

  • Non-recurring items

• Earnings per share.

• Income statement analysis.

• Comprehensive income.

Income Statement Components

• Also called the “statement of earnings,” “statement of operations,” and “profit and loss statement (P&L)”.

• Presents results of operations for the accounting period.

• $\text{Revenues} - \text{Expenses} = \text{Net Income}$

• $\text{Revenue} + \text{Other Income} + \text{Gains} - \text{Expenses} - \text{ Losses} = \text{Net Income}$

Income Statement Format

• Subtotals:

  • Gross profit (i.e., revenue less cost of sales).

  • Operating profit (i.e., revenue less all operating expenses).

  • Profits before deducting taxes and interest expense and before any other non-operating items.

  • Operating profit and EBIT (earnings before interest and taxes) are not necessarily the same.

  • Expense grouping

General Principles of Revenue Recognition and Accrual Accounting

• New standards for revenue recognition became effective at the start of 2018.

• Revenue recognition can occur independently of cash movements.

• A fundamental principle of accrual accounting is that revenue is recognized (reported on the income statement) in the period in which it is earned.

When to Recognize Revenue

• IFRS and US GAAP were converged so revenue recognition principles are identical using a five-step model:

  • Identify the contract(s) with a customer;

  • Identify the separate or distinct performance obligations in the contract;

  • Determine the transaction price;

  • Allocate the transaction price to the performance obligations within the contract; and

  • Recognize revenue when (or as) the entity satisfies a performance obligation.

Factors to consider in assessing whether a customer has obtained control at a point in time include:

1. The entity has a present right to payment.

2. The customer has legal title.

3. Customer has physical possession.

4. Significant risks and rewards of ownership have passed.

5. Customer has accepted the asset.

General Principles of Expense Recognition

• A company recognizes expenses in the period in which it consumes (i.e., uses up) the economic benefits associated with the expenditure.

• Matching principle: Costs are matched with revenues.

• As with revenue recognition, expense recognition can occur independently of cash movements.

Specific Expense Recognition Applications: Inventory

Inventory Cost Flow

• Goods Purchased

• Beginning Inventory

• Goods Available for Sale

• Ending Inventory (Balance Sheet)

• Cost of Goods Sold (Income Statement)

Specific Expense Recognition Applications: Depreciation

• Depreciation: Process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits.

  • Depreciation: term commonly applied for physical long-lived assets, such as plant and equipment (NOT land)

  • Amortization: Term commonly applied to this process for intangible long-lived assets with a finite useful life

Depreciation Methods:

• Straight line

• Accelerated (i.e., diminishing balance)

• Units of production

Non-Recurring Items and Changes in Accounting Standards

• Separating non-recurring from recurring items of income and expense can help an analyst assess a company’s future earnings.

• Discontinued operations should be reported separately.

• Unusual or infrequent items may be reported separately.

• Changes in accounting policies/standards.

Earnings Per Share

• Earnings per share (EPS) is the net earnings available to common stockholders for the period divided by the weighted average number of common stock shares outstanding

• If firm has a “complex” capital structure, it will report basic and diluted EPS.

• EPS is extensively used by analysts in evaluating a firm.

Basic EPS

$\text{Basic EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Number of Shares Outstanding}}$

Diluted EPS

If-Converted Method for Convertible Preferred Stock

$\text{Diluted EPS} = \frac{\text{Net Income}}{\text{Weighted Average Number of Shares Outstanding + New Shares Issued at Conversion}}$

If-Converted Method for Convertible Debt

$\text{Diluted EPS} = \frac{\text{Net Income + After-Tax Interest on Convertible Debt - Preferred Dividends}}{\text{Weighted Average Number of Shares Outstanding + Additional Common Shares that Would Have Been Issued at Conversion}}$

Treasury Stock Method for Stock Options

$\text{Diluted EPS} = \frac{\text{Net Income - Preferred Dividends}}{\text{Weighted Average Number of Shares Outstanding + New Shares Issued at Option Exercise - Shares that Could Have Been Purchased with Cash Received Upon Exercise}}$

Common-Size Income Statements

• Each line item is expressed as a percentage of the company’s sales.

Income Statement Ratios

• Net profit margin = Net income/Revenue

  • Net profit margin measures the amount of income that a company was able to generate for each dollar of revenue.

  • Higher level of net profit margin indicates higher profitability (generally more desirable).

  • Net profit margin can also be found directly on the common-size income statements.

• Profitability ratios found directly on the common-size income statement.

  • Gross profit margin = Gross profit/Revenue.

  • Operating profit margin = Operating profit/Revenue

Comprehensive Income

$\text{Beginning Equity} + \text{Change} = \text{Ending Equity}$

Retained earnings

$\text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends}$

Accumulated other comprehensive income

$\text{Beginning Accumulated other comprehensive income} + \text{Other comprehensive income} - \text{Other comprehensive loss}$

Stock Contributed by Owners

$\text{Beginning Stock} + \text{Issuances} - \text{Repurchases}$

Components of OCI

1. Foreign currency translation adjustments

2. Unrealized gains or losses on derivatives contracts accounted for as hedges

3. Unrealized holding gains and losses on available-for-sale securities

4. Certain costs of a company’s defined benefit post-retirement plans that are not recognized in the current period

Chapter 4: UNDERSTANDING BALANCE SHEETS

Overview

• Balance sheet elements and format

• Accounting issues

  • Current and non-current assets and liabilities

  • Measurement bases of different assets and liabilities

• Components of shareholders’ equity

• Balance sheet analysis

• Liquidity and solvency

Balance Sheet Contents

• The balance sheet is also known as the statement of financial position or statement of financial condition.

• The balance sheet discloses, at a specific point in time:

  • what an entity owns (or controls),

  • what it owes, and

  • what the owners’ claims are.

• $\text{Assets} = \text{Liabilities} + \text{Owners’ Equity}$

Balance Sheet Elements

• Assets (A): resources controlled by the company as a result of past events and from which future economic benefits are expected to flow to the entity.

• Liabilities (L): obligations of a company arising from past events, the settlement of which is expected to result in a future outflow of economic benefits from the entity.

• Equity (E): represents the owners’ residual interest in the company’s assets after deducting its liabilities.

Balance Sheet Format

• Liquidity: Ability to pay short-term obligations; nearness to cash.

• The balance sheet is ordering according to liquidity:

  • Companies using U.S. GAAP order items on the balance sheet from most liquid to least liquid.

  • Companies using IFRS order balance sheet information from least liquid to most liquid.

Current and Non-Current Assets and Liabilities

• Balance sheet must distinguish between current and non-current assets and liabilities.

• Exception to the current and non-current classifications requirement, under IFRS:

  • Current and non-current classifications are not required if a liquidity-based presentation provides reliable and more relevant information.

  • Liquidity-based presentations are often used by banks.

• Classified balance sheet: Balance sheet with separately classified current and non-current assets and liabilities.

Definitions

• Current assets: Assets expected to be sold, used up, or otherwise realized in cash within one year or one operating cycle of the business, whichever is greater.

• Non-current assets: Assets not classified as current. Also known as long-term or long-lived assets.

• Current liabilities: Liabilities expected to be settled within one year or within one operating cycle of the business.

• Non-current liabilities: All liabilities not classified as current.

• Working capital: The excess of current assets over current liabilities.

Measurement Bases of Current Assets: Cash and Cash Equivalents

• Cash Equivalents: Highly liquid, short-term investments that are so close to maturity that the risk of significant change in value from changes in interest rates is minimal.

Examples:

• Demand deposits at banks

• Highly liquid investments with original maturities of three months or less

Measurement Bases of Current Assets: Trade Receivables

• Amounts owed to a company by its customers for products and services already delivered.

• Aspects often relevant to an analyst:

  • Overall level of accounts receivable relative to sales

  • Allowance for doubtful accounts

  • Concentration of credit risk

Measurement Bases of Current Assets: Inventory

U.S. GAAP

• Lower of cost or market (LCM)

• Reversals of prior write-downs are NOT allowed.

• Permits last in, first out (LIFO).

IFRS

• Lower of cost or net realizable value (LCNRV)

• Reversals of prior write-downs can be made and recognized in income.

• Does not permit LIFO.

Measurement Bases of Non-Current Assets: Property, Plant, and Equipment

• Property, plant, and equipment (PP&E): Tangible assets that are used in company operations over more than one fiscal period.

• Under the cost model, PP&E is reported at historical cost less any accumulated depreciation and impairment losses.

  • Depreciation: Systematic allocation of cost over an asset’s useful life.

  • Land is not depreciated.

  • Impairment losses reflect an unanticipated decline in value.

  • Reversals of impairment losses are permitted under IFRS but not under U.S. GAAP.

• Under the revaluation model, PP&E is reported at fair value at the date of revaluation less any subsequent accumulated depreciation.

  • The revaluation model is NOT permitted under U.S. GAAP.
    Measurements for PP&E

U.S. GAAP

• Permit only the cost model for reporting PP&E.

• Reversals of prior impairment losses are NOT allowed.

IFRS

• Permit either cost model or revaluation model.

• Can use different models for different classes of assets.

• Must apply the same model to all assets within a particular class.

• Reversals of impairment losses are permitted.

Measurement Bases of Non-Current Assets: Intangible Assets

• Identifiable non-monetary assets without physical substance (e.g., patents, licenses, trademarks).

• IFRS allow either a cost model or a revaluation model for intangible assets.

• U.S. GAAP allow only the cost model.

• Measurement of intangible assets subsequent to acquisition:
  Intangible asset with finite useful life: Amortize over useful life and assess for impairment when indicated.
  Intangible asset with indefinite useful life: Do not amortize, but assess for impairment.

Measurement Bases of Non-Current Assets: Goodwill

• Arises when a company acquires another company for a price in excess of fair market value of net identifiable assets acquired.

• Accounting goodwill does not equal economic goodwill.

Common Types of Current Liabilities

• Trade payables, also known as accounts payable: Amounts that a company owes its vendors for purchases of goods and services

• Notes payable: Financial liabilities owed by a company to creditors, including trade creditors and banks, through a formal loan agreement.

• Accrued expenses: Expenses that have been recognized on a company’s income statement but that have not yet been paid as of the balance sheet date.

• Deferred income: Arises when a company receives payment in advance of delivery of the goods and services associated with the payment.

Common Types of Non-Current Liabilities

• Long-term financial liabilities: Include loans and notes or bonds payable.
  Reported at amortized cost, but in certain cases, be reported at fair value.

• Deferred tax liabilities: Amount of income taxes payable in future periods with respect of taxable temporary differences.

Components of Shareholders’ Equity

• Capital contributed by owners (or common stock or share capital)

• Preferred shares

• Treasury shares (or treasury stock)

• Retained earnings

• Accumulated other comprehensive income (or other reserves, items recognized directly in equity)

• Non-controlling interest (or minority interest)

Analysis of Balance Sheets

• Liquidity: A company’s ability to meet its short-term financial commitments.

• Solvency: A company’s ability to meet its financial obligations over the longer term.

Analytical Tools

• Common-size analysis.

• Balance sheet ratios.

Balance Sheets Ratios (Liquidity)

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

$\text{Quick Ratio} = \frac{\text{Cash + Marketable Securities + Receivables}}{\text{Current Liabilities}}$
$\text{Cash Ratio} = \frac{\text{Cash + Marketable Securities}}{\text{Current Liabilities}}$

Balance Sheets Ratios (Solvency)

$\text{Long- term debt to equity} = \frac{\text{Total Long Term Debt}}{\text{Total Equity}}$

$\text{Debt to Equity} = \frac{\text{Total Debt}}{\text{Total Equity}}$

$\text{Debt to Capital} = \frac{\text{Total Debt}}{\text{Total Debt + Total Equity}}$

$\text{Financial Leverage} = \frac{\text{Total Assets}}{\text{Total Equity}}$