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Financial

Statement
Analysis
K R Subramanyam
John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview of Financial
Statement Analysis

CHAPTER

1-2

1-3

Business Analysis
Evaluate
EvaluateProspects
Prospects

Evaluate
EvaluateRisks
Risks

1-4

Information Sources for Business


Analysis

1-5

1-6

Credit Analysis

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Credit Analysis
Credit
Creditworthiness:
worthiness:Ability
Abilityto
tohonor
honorcredit
creditobligations
obligations
(downside
(downsiderisk)
risk)

Liquidity
Liquidity
Ability
Abilityto
tomeet
meetshortshortterm
termobligations
obligations
Focus:
Focus:
Current
Currentcash
cashflows
flows
Make
Makeup
upof
ofcurrent
current
assets
assetsand
andliabilities
liabilities
Liquidity
Liquidityof
ofassets
assets

Solvency
Solvency
Ability
Abilityto
tomeet
meetlonglongterm
termobligations
obligations
Focus:
Focus:
Long-term
Long-termprofitability
profitability
Capital
Capitalstructure
structure

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Equity Analysis
Assessment
Assessmentof
ofdownside
downsiderisk
riskand
andupside
upsidepotential
potential

Technical
Technicalanalysis
analysis/ /
Charting
Charting
Patterns
Patternsin
inprice
priceor
or
volume
volumehistory
historyof
ofaa
stock
stock
Predict
Predictfuture
futureprice
price
movements
movements

Fundamental
FundamentalAnalysis
Analysis
Determine
DetermineIntrinsic
Intrinsicvalue
value
without
withoutreference
referenceto
to
price
price
Analyze
Analyzeand
andinterpret
interpret
key
keyfactors
factors
Economy
Economy
Industry
Industry
Company
Company

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1-10

Accounting Analysis
Process to evaluate and adjust financial
statements to better reflect economic reality

Accounting
Risk

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Financial Analysis
Process to evaluate financial position and
performance using financial statements
Profitability analysis Evaluate return
on investments
Risk analysis Evaluate riskiness
& creditworthiness
Analysis of
cash flows

Evaluate source &


deployment of funds

Common tools

Ratio
analysis

Cash
flow
analysis

1-12

Prospective Analysis
Process
Processto
toforecast
forecastfuture
futurepayoffs
payoffs
Business
BusinessEnvironment
Environment
&&Strategy
StrategyAnalysis
Analysis
Accounting
AccountingAnalysis
Analysis
Financial
FinancialAnalysis
Analysis

Intrinsic
IntrinsicValue
Value

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Dynamics of Business Activities


Business
BusinessActivities
Activities

Time
Time

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Business Activities

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Business Activities

Financing
Financingactivities
activities
Owner
Owner(equity)
(equity)
Nonowner
Nonowner(liabilities)
(liabilities)

Financing

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Business Activities

Investing
Investingactivities
activities
Buying
Buyingresources
resources
Selling
Sellingresources
resources

Investing

Financing

Investing
Investing==Financing
Financing

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Business Activities

Operating
OperatingActivities
Activities

Revenues
Revenuesand
andexpenses
expensesfrom
fromproviding
providing
goods
goodsand
andservices
services

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Financial Statements Reflect Business Activities

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Financial Statements

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Balance Sheet
Total Investing = Total Financing
= Creditor Financing + Owner Financing

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Income Statement
Revenues Cost of goods sold = Gross Profit
Gross profit Operating expenses = Operating Profit

Colgates Profitability
(in $billions)
$12.238 - $5.536 = $6.701 Gross Profit
$6.701 - $4.5411 = $2.160 Operating profit

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1-25

Statement of Cash Flows

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Additional Information
(Beyond Financial Statements)

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Analysis Preview
Yr1

Yr2

Yr3

Comparative Analysis
Purpose: Evaluation of consecutive
financial statements
Output: Direction, speed, & extent of any
trend(s)
Types:
Year-to-year Change Analysis

Index-Number Trend Analysis

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Analysis Preview

1-30

Analysis Preview
Common-Size Analysis
Purpose : Evaluation of internal makeup
of financial statements
Evaluation of financial statement
accounts across companies
Output: Proportionate size of assets,
liabilities, equity, revenues, &
expenses

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Analysis Preview

1-32

Analysis Preview

1-33

Analysis Preview
Ratio Analysis
Purpose :

Evaluate relation between two or more


economically important items (one
starting point for further analysis)
Output:
Mathematical expression of relation
between two or more items
Cautions: Prior Accounting analysis is important
Interpretation is key - long vs short
term & benchmarking

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Analysis Preview
Valuation
Valuation - an important goal of many types
of business analysis

Purpose: Estimate intrinsic value of a


company (or stock)
Basis:
Present value theory (time value of
money)

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Analysis Preview
Debt (Bond) Valuation

Bt is the value of the bond at time t


It +n is the interest payment in period t+n
F is the principal payment (usually the debts face value)
r is the investors required interest rate (yield to maturity)

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Analysis Preview
Equity Valuation

Vt is the value of an equity security at time t


Dt +n is the dividend in period t+n
k is the cost of capital
E refers to expected dividends

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Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model

FCFt+n is the free cash flow in the period t + n [often


defined as cash flow from operations less capital
expenditures]
k is the cost of capital
E refers to an expectation

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Analysis Preview
Equity Valuation - Residual Income Model

BV is the book value at the end of period t


Rit+n is the residual income in period t + n [defined as
net income, NI, minus a charge on beginning
book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital
E refers to an expectation
t

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Analysis in an Efficient Market


Three assumed forms of market efficiency
Weak Form - prices reflect information in
past prices
Semi-strong - prices reflect all public
Form
information
Strong Form - prices reflect all public and
private information

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Book Organization