CHAPTER # 1

OVERVIEW OF FINANCIAL
STATEMENTS

INAM-UL-HAQUE
 F I N A N C I A L S T AT E M E N T S —
B A S I S O F A N A LY S I S
• Business Activities
A company pursues a number of activities in a
desire to provide a salable product or service
and to yield a satisfactory return on investment
• Planning Activities
• Financing
• Investing
• Operating
 Planning Activities
• A company’s goals and objectives are captured
in a business plan that describes the company’s
purpose, strategy, and tactics for its activities. A
business plan assists managers in focusing their
efforts and identifying expected opportunities
and obstacles. Insight into the business plan
considerably aids our analysis of a company’s
current and future prospects is part of the
analysis of business environment and strategy.
 Financing Activities
• A company requires financing to carry out its
business plan.
• Financing activities refer to methods that
companies use to raise the money to pay for
their needs.
1. Equity investors
2. Creditors
 Equity Investors
• Return is the equity investor’s share of company
earnings in the form of either earnings distribution or
earnings reinvestment.
• Earnings distribution is the payment of dividends to
shareholders.
• Dividend payout refers to the proportion of earnings
distributed.
• Earnings reinvestment (or earnings retention) refers to
retaining earnings within the company for use in its
business; this is also called internal financing.
 Equity Investors
• Equity financing can be in cash or any asset or
service contributed to a company in exchange
for equity shares.
• Private offerings of shares usually involve
selling shares to one or more individuals or
organizations.
• Public offerings involve selling shares to the
public.
 Creditors
• Debt Creditors
• Operating Creditors
 Investing Activities
• Investing activities refer to a company’s
acquisition and maintenance of investments
for purposes of selling products and providing
services, and for the purpose of investing
excess cash.
 Operating Assets
• Investments in land, buildings, equipment,
legal rights (patents, licenses, copyrights),
inventories, human capital (managers and
employees), information systems, and similar
assets are for the purpose of conducting the
company’s business operations.
 Financial Assets
• Companies often temporarily or permanently
invest excess cash in securities such as other
companies’ equity stock, corporate and
government bonds, and money market funds.
 Operating Activities
• Operating activities represent the “carrying out” of the
business plan given its financing and investing activities.
• Operating activities involve at least five possible
components: research and development, procurement,
production, marketing, and administration.
• A proper mix of the components of operating activities
depends on the type of business, its plans, and its input
and output markets. Management decides on the most
efficient and effective mix for the company’s
competitive advantage.
 Financial Statements Reflect Business
Activities
• Balance Sheet:
• Assets = Liabilities + Equity
• Current Assets
• Current Liabilities
• Working Capital
 Income Statement
• An income statement measures a company’s financial
performance between balance sheet dates. It is a representation
of the operating activities of a company. The income statement
provides details of revenues, expenses, gains, and losses of a
company for a time period.
• Gross profit (also called gross margin) is the difference
between sales and cost of sales
• Earnings from operations refers to the difference between
sales and all operating costs and expenses.
• Earnings before taxes, as the name implies, represents earnings
from continuing operations before the provision for income tax.
Statement of Shareholders’ Equity
• The statements of retained earnings,
comprehensive income and changes in capital
accounts are often called the statements of
changes in shareholders’ equity.
 Statement of Cash Flows
• The statement of cash flows reports cash
inflows and outflows separately for a
company’s operating, investing, and financing
activities over a period of time.
 Additional Information
• Management’s Discussion and Analysis (MD&A).
Companies with publicly traded debt and equity securities
are required by the Securities and Exchange Commission to
file a Management’s Discussion and Analysis (MD&A).
Management must highlight any favorable or unfavorable
trends and identify significant events and uncertainties that
affect a company’s liquidity, capital resources, and results of
operations. They must also disclose prospective information
involving material events and uncertainties known to cause
reported financial information to be less indicative of future
operating activities or financial condition.
 Additional Information
• Management Report:
• The purposes of this report are to reinforce:
(1) senior management’s responsibilities for
the company’s financial and internal control
system and
• (2) the shared roles of management, directors,
and the auditor in preparing financial
statements.
 Additional Information
• Auditor Report:
• An external auditor is an independent certified
public accountant hired by management to
provide an opinion on whether or not the
company’s financial statements are prepared in
conformity with generally accepted accounting
principles. Financial statement analysis requires a
review of the auditor’s report to ascertain whether
the company received an unqualified opinion.
 Additional Information
• Explanatory Notes:
• Notes are a means of communicating additional
information regarding items included or excluded from
the body of the statements.
• accounting principles and methods employed
• Detailed disclosures regarding individual financial
statement items
• Commitments and contingencies,
• Legal proceedings
• Significant customers
 Additional Information
• Proxy Statements:
• A proxy is a means whereby a shareholder
authorizes another person to act for him or
her at a meeting of shareholders.
• A proxy statement contains information
necessary for shareholders in voting on
matters for which the proxy is solicited.
 Analysis Tools
1.Comparative financial statement analysis
2. Common-size financial statement analysis
3. Ratio analysis
4. Cash flow analysis
5. Valuation
 Comparative Financial Statement Analysis
(horizontal analysis)
• Individuals conduct comparative financial
statement analysis by reviewing consecutive
balance sheets, income statements, or statements
of cash flows from period to period. This usually
involves a review of changes in individual account
balances on a year-to-year or multiyear basis.
• A comparison of statements over several periods
can reveal the direction, speed, and extent of a
trend.
Common-Size Financial Statement Analysis

• Financial statement analysis can benefit from knowing

what proportion of a group or subgroup is made up of a
particular account. Specifically, in analyzing a balance
sheet, it is common to express total assets (or liabilities
plus equity) as 100%. Then, accounts within these
groupings are expressed as a percentage of their respective
total. In analyzing an income statement, sales are often set
at 100% with the remaining income statement accounts
expressed as a percentage of sales. Because the sum of
individual accounts within groups is 100%, this analysis is
said to yield common-size financial statements.
Common-Size Financial Statement Analysis

• Common-size financial statement analysis is useful in

understanding the internal makeup of financial
statements.
• For example, in analyzing a balance sheet, a common-
size analysis stresses two factors:
1. Sources of financing—including the distribution of
financing across current liabilities, noncurrent
liabilities, and equity.
2. Composition of assets—including amounts for
individual current and noncurrent assets.
Ratio Analysis
Ratio Analysis
Ratio Analysis
Ratio Analysis
Ratio Analysis
Ratio Analysis
 Cash Flow Analysis
• Cash flow analysis is primarily used as a tool to
evaluate the sources and uses of funds. Cash
flow analysis provides insights into how a
company is obtaining its financing and
deploying its resources. It also is used in cash
flow forecasting and as part of liquidity
analysis.
 Valuation Models
• Debt Valuation: The value of a security is
equal to the present value of its future payoffs
discounted at an appropriate rate. The future
payoffs from a debt security are its interest
and principal payments
Example:
 Equity Valuation
Dividend Discount Model:
 Free Cash Flow Model

Free cash flows to equity are defined as cash flows from

operations less capital expenditures plus increases (minus
decreases) in debt.
Residual Income Model
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