Introduction to Financial Statement Analysis.
In this reading, we'll talk about the roles of financial statement
analysis. Then we will discuss the primary financial
statements such as the balance sheet, income statement,
the cash flow statement as well as other information
sources that are used by financial analyst, and then
we will discuss the Financial Statement Analysis
Framework. Financial reports are one of the most
important sources of information available to
a financial analyst and therefore, it is necessary
that financial analyst have a strong understanding
of the information provided in a company's financial
reports, the associated notes, and supplementary
information. Rules of Financial Statement Analysis.
Let us understand the distinction between financial
reporting and financial statement analysis with
financial reporting. Companies provide information
on performance, financial position, and changes
in financial position. The report on performance
comes through income statement. The report on financial
position is through the balance sheet, and changes
in financial position generally are through the statement
of changes in stockholders equity. The information
that comes out of financial reporting is what feeds
the financial statement analysis process and not
only does financial statement analysis use the
reports that come from here, but other information
is also necessary. We'll talk about this in more
detail later. But essentially what the analyst
needs to do is evaluate the past, present, and future
performance of a company or subsidiary. Obviously,
the analysts studies the past and present performance
through financial reports and then needs to assess
the future performance and then make investment
decision which might either be a credit decision
in terms of whether or not to lent to the company
or whether or not to purchase shares in the company.
When we talk about performance, there are several
areas that we need to consider such as profits, profitability
which is a ratio of profits to either investment
or profits to revenue. We need to consider cash flows,
the liquidity of a company which is an indication
of how a company is able to meet short-term obligations,
and solvency which is the ability of a company to
meet long-term obligations. These are areas that
we will discuss in a lot more detail later in the course.
Here are the four major financial statements; the
income statement, balance sheet, cash flow statement,
and statement of changes in owner's equity. Let
us look at a simple version of the income statement
over here. Later in the course, there is a long reading
on the income statement so obviously details will
be covered there. But very briefly the income statement
is for a period. In this particular case, we are considering
the year ending 31st December 2012. So this is the
income statement for the entire 2012. We have a revenue
number which is the total money that came in, we subtract
the expenses then subtract taxes and end up with
the net income. The income statement is also called
the statement of operations. It is also called the
profit and loss statement or the P&L statement. You
also need to recognize the fact that there is a more
comprehensive definition of income and that is
covered in the statement of comprehensive income.
I will not cover comprehensive income at this stage,
I will cover it later when we discuss the income statement
and balance sheet, but just recognize that there
there is also a definition of income that goes beyond the
regular net income. Here is a simpler version
of a balance sheet. Note that the balance sheet is
depicted on a particular day here. We are looking
at a balance sheet as of 31st December 2012. This
is also called the statement of financial position
or the statement of financial condition. It shows
all the assets of the company, both tangible and intangible
assets, the liabilities, short-term and long-term,
and then stockholders equity. This is the cash flow
statement which is also for a given period. This cash flow
statement tells us what money has flowed in and what
has flowed out. The cash flow statement is divided
into three parts; operating activities, investing
activities, and financing activities. The financial
statement notes and supplementary schedules provide
a tremendous amount of additional information
that is not explicitly available in the balance
sheet, income statement, or cash flow statement and
examples of what you will see in the notes and supplementary
schedules is given right here. If you have not done so before,
I would strongly encourage you to look
at the financial statements of a few companies.
Management Discussion and Analysis, also called
MD&A, essentially provides a discussion and analysis
regarding a company's future outlook and prospects.
This can be thought of as subjective information
where management is presenting its view and interpretation
of the data that it has reported, and then also describing
the future outlook. Management should establish
and maintain adequate internal control over financial
reporting. The objective is to provide reasonable
assurance regarding the reliability of financial
reporting. Essentially, this means that when a company
is preparing financial reports, the company should
put in place process to ensure that the financial
reports adequately reflect the economic reality
of the company. Once a company has prepared its financial
reports and the reports have been audited internally
or have been through the appropriate internal control
process, then the financial reports need to be audited.
It means that an independent accounting firm
examines the financial statements and
express a opinion through an audit report. The audit
report needs to follow a particular format, but
what we need to recognize is that the audit report will
give one of three opinions, either a qualified, unqualified,
or adverse opinion. Unqualified opinion is what
we would like to see, this is where the accounting
firm provides reasonable assurance that the financial
statements are fairly presented. A qualified opinion
is where the accounting firm sees that there are some
mistreatments or exceptions to accounting standards.
Adverse opinion, is where the accounting firm
is saying that the financial statements are materially
misstated. The audit report also includes a discussion
of key audit matters. Key audit matters are defined
as issues that the auditor considers to be most important
such as those that have a high risk of misstatement,
involve significant management judgment or report
the effects of significant transactions during
the period. Now, the term 'Key Audit Matters' is used in an international
context. In the US context, the corresponding term
is critical audit matters. Critical audit matters,
are defined as issues that involve 'especially challenging,
subjective, or complex auditor judgment.' Other
sources of information include interim financial
reports and proxy statements. Generally companies
present interim reports every quarter and these contain
the four key financial statements along with footnotes.
Interim financial reports are generally not audited.
Proxy statements are distributed to shareholders
and describe matters that are to be put to a vote,
an example would be voting for a new director.
The proxy statements also contain other useful information,
such as management and director compensation, stock
performance and potential conflicts of interest
between management board and shareholders. Financial
Statement Analysis Framework is perhaps
the most testable part of the reading. Imagine you
are a financial analyst, what we are going to discuss
is the framework which is recommended by the CFA
Institute. The first phase is to articulate the
purpose and context based on your function, client
input and organizational guidelines. Just at a
high-level, if you are an equity analyst looking for
a long-term investment, your purpose will be very
different from somebody else who is a credit analyst
looking to make a short-term debt based investment.
So before you get into the details of your analysis,
you need to clearly articulate your purpose, your
objective and document what your objective is. Document
the questions that need to be answered, document the ultimate
content of the report so you need to be clear about what
your report will eventually contain. You should
also document the timeline and budget so this is
phase one of your analysis. In phase two, you collect
data, the most important information is typically
the financial statements or financial reports.
You also collect other financial data, industry
and economic data. You might have discussions with
management suppliers, customers and competitors.
So you collect this information and organize it. Your
output here consists of the financial statements
you've collected, any financial tables that you create
and the question is that you create through this
process. You then process the data, and the output
from this exercise would be Adjusted Financial
Statements, Common Size Statements, which we will
discuss later, ratios, graphs, and forecast. Imagine that
you are analyzing three different auto companies
in different parts of the world and they follow slightly
different Accounting Standards which we will
talk about in the next reading. In order to compare
these companies you need to make adjustments to
the financial statements so that you can make apples-to-apples
comparison, this is called processing the data.
Once the data has been processed, you analyze and
interpret the data and come up with your analytical
results. Finally, you develop and communicate
your conclusions and recommendations. If you are
conducting an analysis for whether or not to make
a long-term Equity investment, your recommendation
would be whether to buy or not to buy, in other words,
whether to make the investment or not. Obviously,
your recommendation needs to be justified so you
create a report which answers the questions that
you listed in Phase 1. Given that, you are making a
long-term investment decision you should periodically
follow up because circumstances change. So every
quarter as an example, you might reconsider the
situation and update recommendations or update
your recommendation if necessary. That's the end
of this brief reading. I will summarize the most important
points. First, you need to understand the distinction
between financial reporting and financial analysis.
Financial reporting is about looking at existing
and past data related to a company and then reporting
against that information. Financial analysis is
a much broader field which looks at financial reports
as well as other information to assess whether or
not to make an investment. There are four key financial
statements, the income statement, balance sheet, cash
flow statement, and statement of changes in shareholder
equity. These four statements are backed up by a
tremendous amount of information in the footnotes
and supplementary schedules. Audit report is
important, because this represents an independent
third party's' view on the financial reports that
have been presented by the company, and finally, you
need to be on top of the financial statement analysis
framework that we just talked. This perhaps
is the most important item from a testability perspective.
Read the summary in the curriculum related to this
reading, it's very good. Review the learning objectives
and make sure that you can say something sensible
about every single learning objective. The examples
within the curriculum are few and they are somewhat
complicated. If you don't have time to completely
understand then that's okay but if you go to them
that is a bonus. Do the practice problems at the end,
because they are extremely good. They are relatively
simple, but a reasonable indication of what you might
see on the exam. Unfortunately, there are not too
many questions at the end. So you will have to practice
questions from other sources as well. That is it
for this reading.