Financial Statement Analysis

Part 1 Financial Accounting Review

• Source of information

• Company website: annual report, press release, management conference call, investor presentation
• SEC filings: 10-K (annual), 10-Q (quarterly), 8-K (current report), DEF 14A (proxy statement)
• 10-K: item 1 business; item 7 management discussion & analysis; item 8 financial statements & notes; segment reporting

• Financial statements

• Users: analysts, shareholders, creditors, employees, customers, regulators
• Income statement: accrual basis

Revenue recognition (earned-goods/services delivered + collection reasonably assured);

Expense recognition (match revenue or consumption of asset)

• Balance sheet:

Assets: possible future economic benefit (quantifiable) controlled by a firm from past transactions (exchange); classification – current/non-current (if can be converted to cash within a year); valuation – historical cost/depreciated historical cost/net realizable value/market value

Liabilities: future sacrifice of economic benefit (quantifiable & probable) from obligation to transfer assets/provide services from past transactions (must occur); classification – current/non-current (if require payment within a year)

Equity: residual interest in net assets remains after deducting liabilities; classification – contributed (raised from shares)/earned (retained earnings)

• Statement of shareholders’ equity:

Shares: authorized (approved by court)—issued (at some point been sold)—outstanding (currently held by investors); issued=outstanding + treasury stock

Return cash to shareholders: dividends (reduce retained earnings); repurchase shares (add treasury stock/reduce retained earnings/reduce common stock)

• Statement of cash flow: operating activities (net income + depr. - increase in current assets + increase in current liabilities); investing activities; financing activities

•  Additional notes

• PPE not depreciated: land, construction-in-progress
• Market-to-book ratio=market cap./book value of equity

Most>1, value not reflected on B/S; <1, uncertain on financial statements

• Debt v.s. equity

Debt – retain ownership, contractual obligation to pay, lower cost (more secure), tax shield

Equity – no obligation, less risky for company, easier for volatile companies, incentive alignment

Part 2 Trend Analysis

• Ratio analysis

• Pro: time series/cross-sectional comparison, profitability & risk assessment
• Con: no correct way to compute, not account for accounting differences, not provide answers
• Principle: match in scope; flow v.s. avg. stock

• Common-size analysis [vertical: cross-sectional→identify trends]

• Balance sheet: divided by total assets/total liabilities & equity
• Income statement: divided by revenues

Gross profit margin / operating profit margin / net profit margin

• Percentage change analysis [horizontal: time-series→identify unexpected large changes of individual items]

• %change=(current-previous)/previous

• Additional notes

• Firm size criteria: revenues/market cap./EBIT
• EPS-not useful for cross-firm comparison, no. of shares manipulative

Part 3 Profitability Analysis

• Earnings per share

• Basic EPS[pic 1]
• DilutedEPS=[pic 2]
• Not useful: not consider asset injected; arbitrary no. of shares

• Return on Assets (ROA)

• ROA= (measure managerial effectiveness independent of capital structure)[pic 3]
• Profit Margin x Asset Turnover=[pic 4]
• Analysis: cost leader-low profit margin, high asset turnover; product differentiation-high profit margin, low asset turnover

• Return on Common Equity (ROCE)

• ROCE= (measure success in generating return for common shareholders)[pic 5]
• Dupont analysis

Leverage increase/decrease ROCE in magnitude

• Penman analysis (reformulate balance sheet & income statement)

Net Operating Assets=Net Financing Obligations + Common Equity

NNE=NNO*(1-T) + preferred dividend