AN OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

ACC5212 Financial Statement Analysis

BASIC CONSIDERATIONS
To evaluate financial statements, you must: 1. Be acquainted with business practices, 2. Understand the purpose, nature, and limitations of accounting, 3. Be familiar with the terminology of business and accounting, 4. Have a working knowledge of the fundamentals of finance, and 5. Be acquainted with the tools of financial statement analysis.

Financial analysis examination of Financial Statements Disclosure Notes Auditors Report

Disclosure Notes
Summary of Significant Accounting Policies
Conveys valuable information about the companys choices from among various alternative accounting methods.

Subsequent Events

A significant development that occurs after the companys fiscal year-end but before the financial statements are issued or available to be issued. Transactions or events that are potentially important to evaluating a companys financial statements, e.g., related parties, errors and irregularities, and illegal acts.

Noteworthy Events and Transactions

Management Discussion and Analysis

Provides a biased but informed perspective of a companys operations, liquidity, and capital resources.

Managements Responsibilities

Preparing the financial

statements and other information in the annual report.

Maintaining and assessing

the companys internal control procedures.

Auditors Report
Expresses the auditors opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles.

Auditors Opinions
Unqualified
Issued when the financial statements present fairly the financial position, results of operations, and cash flows are in conformity with GAAP. Issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole.

Qualified

Adverse

Issued when the exceptions are so serious that a qualified opinion is not justified.

Disclaimer

Issued when insufficient information has been gathered to express an opinion.

Compensation of Directors and Top Executives

Proxy Statement Information Summary Compensation Table
Salary Bonus Stock Awards Option Awards Other Compensation

A proxy statement is sent each year to all shareholders, usually in the same mailing with the annual report.

Using Financial Statement Information

Comparative Financial Statements
Allow financial statement users to compare year-to-year financial position, results of operations, and cash flows. Expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount). Involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, within the same year. Allows analysts to control for size differences over time and among firms.

Horizontal Analysis

Vertical Analysis

Ratio Analysis

Horizontal Analysis
Horizontal (or trend analysis) enables comparison of

data for a single company or single industry over a period of time. It indicates in which direction a company is headed. Trend percentages are computed by taking a base year and assigning its figures as a value of 100. Figures generated in subsequent years are expressed as percentages of base-year numbers.

 With 20x1 taken as the base year, its numbers are divided

into those from subsequent years to yield comparative percentages. For example, net sales in 20x1 ($775,000) is divided into 20x5s net-sales figure ($910,000).

 Net sales shows an upward trend after a downturn in

20x2. Cost of goods sold shows a sharp increase between 20x4 and 20x5 after a small drop in costs between 20x1 and 20x2. There appears to be a substantial drop in gross profit between 20x4 and 20x5 which is attributable to the increased cost of goods sold.

 Trend percentages show horizontally the degree of increase or

decrease, but they do not indicate the reason for the changes. They do serve to indicate unfavorable developments that will require further investigation and analysis. A significant change may have been caused by a change in the application of an accounting principle or by controllable internal conditions, such as a decrease in operating efficiency.

Vertical Analysis
Vertical analysis involves the conversion of items

appearing in statement columns into terms of percentages of a base figure to show the relative significance of the items and to facilitate comparison. For example, individual items appearing on the income statement can be expressed as percentages of sales. On the balance sheet, individual assets can be expressed in terms of their relationship to total assets. Liabilities and shareholders equity accounts can be expressed in terms of their relationship to total liabilities and shareholders equity.

 On the retained earnings statement, beginning retained

earnings is 100 percent. Note: The percentages for the company in question can be compared with industry norms.

Common-Size Financial Statements

Vertical analysis (also called common-size financial

statements) makes it possible to compare the performance of companies of different sizes during the same period of time.

Ratio Analysis
A ratio is an expression of a mathematical relationship

between one quantity and another. The ratio of 400 to 200 is 2:1. Ratio analysis can disclose relationships which reveal conditions and trends that often cannot be noted by inspection of the individual components of the ratio.

Ratios are generally not significant of themselves but assume significance when they are compared with 1. previous ratios of the same firm, 2. some predetermined standard (managements expectations), 3. ratios of other enterprises in the same industry, or 4. ratios of the industry within which the company operates. When used in this manner, ratios serve as benchmarks against which the company can evaluate itself.

SUMMARY OF FINANCIAL RATIOS

 Ratios are based on accounting data.

Ratios are not ends in themselves but help investors

provide answers to questions concerning specific issues and insights into the operations of a business enterprise.

INVESTORS NEEDS
Investors and potential investors are primarily interested in Return on investment Return of investment

In particular: The relationship of the current value of a stock or bond to expectations of its future value is basically involved in the evaluation of investment opportunities. Investors are also interested in the safety of their investment as reflected in the financial condition of the company and its operating performance.

 The dividend policy of a company is usually a major

concern of investors. Investors are also interested in the operating income of the firm in order to evaluate the normal earnings trend of the firm. Since many investors are interested in growth potential they look for information concerning how the company obtained its resources and how it uses them. What is the capital structure of the company? What risks and rewards does it hold out for equity investors? Investment evaluation also involves predicting the timing, amounts, and uncertainties of future cash flows of the firm.

 Bondholders and other creditors of a company are

primarily concerned with the companys ability to meet its obligations. Lenders want to know the reasons for a companys borrowings. Are they short or long-term needs? How has the company handled its debt in the past? Investment analysts and financial advisors have a major interest in the tools and techniques of financial statement analysis. Such persons have the same basic information needs as investors and creditors. Analysts frequently adjust the financial statements prepared by accountants for items they do not consider significant or for items they consider significant but which do not appear on the statements.

OBJECTIVES OF FINANCIAL REPORTING

Financial reporting should provide information that is

useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensive to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.

 Financial reporting should provide information to help

present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sales, redemption, or maturity of securities or loans. Since investors and creditors cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.

 Financial reporting should provide information about the

economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources.

HOW THE FINANCIAL STATEMENTS TIE TOGETHER

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

Constraints
Materiality. Information is material if it can have an effect

on a decision made by users. One consequence of materiality is that GAAP need not be followed if an item is immaterial. The threshold for materiality will depend principally on the relative dollar amount of the transaction. Cost vs Benefit (cost effectiveness). Information is cost effective only if the perceived benefit of increased decision usefulness exceeds the anticipated costs of providing that information.

User-Specific Quality
Understandability means that users must understand the

information and its significance. This is a user-specific quality because users will differ in their ability to comprehend information. The overriding objective of financial reporting is to provide comprehensible information to those who have a reasonable understanding of business and economic activities and are willing to study information.

Primary Qualities
Relevance. The capacity of information to make a

difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations. Reliability. The quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent.

Relevance
Predictive Value. The quality of information that helps

users to increase the likelihood of correctly forecasting the outcome of past or present events. Feedback Value. The quality of information that enables users to confirm or correct prior expectations. Timeliness. Having information available to a decision maker before it loses its capacity to influence decisions.

Reliability
Verifiability. The ability through consensus among

measures to ensure that information represents what it purports to represent or that the chosen method of measurement has been used without error or bias. Representational Faithfulness. Correspondence or agreement between a measure or description and the phenomenon that it purports to represent (sometimes called validity). Neutrality. Information presented should not to favor particular groups or companies.

Secondary Qualities
Comparability. The quality of information that enables

users to identify similarities in and differences between two sets of economic phenomena. Consistency. Conformity from period to period with unchanging policies and procedures.

Underlying Assumptions and Accounting Principles

Term Project!