Financial Statement Analysis Introduction

Financial Statement Analysis Introduction

• Financial Statement Analysis is being introduced
• The introduction is described as drinking from a firehose
• Finance is about assessing the value of an asset/good
• Finance is also about examining the efficiency of how money is invested by those who have it into companies/people that need it

Why a Course in Financial Statement Analysis is Needed

• Standardized financial statements can be read and found by Googling any company
• Financial accounting focuses on the past and depicts history
• Finance is about the future
• Financial statement analysis uses the past to predict the future
• Financial accounting is a reporting system with judgment left to management
• Financial analysis evaluates the reasonableness of management's judgment
• Financial reports are sales documents that attract capital
• The reports are prepared by the company to attract capital
• It is important to examine the veracity of explicit and implicit claims made by a company
• This includes forward looking statements
• Financial accounting has limitations for investors

Limitations of financial accounting for investors

• Accrual vs. cash accounting (profits vs cash flow)
• Treatment of intangibles
• Discrepancies between the 20th and 21st centuries regarding these limitations
• Information raises questions such as, "What does that mean?" and "Why is that happening?"
• Financial analysis answers the questions above in relation what it all means for the future
• Financial analysis facilitates an investor's decision to commit capital to a particular investment opportunity

Financial Reporting vs. Analysis

• Financial reporting provides info about an entity to enable users to make decisions
• Financial reporting includes financial statements and other reports
• Financial statement analysis uses financial information to assess past and future performance
• A typical analysis decision is capital allocation

Origin of Modern Financial Accounting and Reporting

• Securities Act of 1933 and Securities and Exchange Act of 1934 are where it began
• Focus on disclosure of material information to ensure access to accurate and consistent data
• This facilitates a "fair" securities market
• Examples of filing forms are S-1, 10-K, 10-Q, 8-K

Bedrock of Financial Disclosure

• Standardized accounting practices and Generally Accepted Accounting Principals (GAAP) are important
• International Financial Reporting Standards (IFRS) are also important
• Relevant groups include the SEC (National Regulators), FASB (National Accounting Standards Organizations), AICPA (Accountants), Reporting Companies, Congress….

Financial Statements

• Statements include these items:
• Financial Position
• Comprehensive Income
• Changes in Equity
• Cash Flows
• Notes

Statement of Financial Position

• Also known as the Balance Sheet
• Assets = Liabilities + Owners' equity
• A second formulation is Assets – Liabilities = Owners' equity
• This is a "Point in Time" statement

Consolidated Balance Sheet: Hershey and Lindt & Sprüngli Group

• Total assets for The Hershey Company were $7,703,020 in 2018, and $5,553,726 in 2017
• Total liabilities and shareholders' equity were $7,703,020 in 2018, and $5,553,726 in 2017 .
• Lindt & Sprüngli Group total assets were CHF 7,249.8 million in 2018 and CHF 6,975.6 million in 2017
• Lindt & Sprüngli Group total liabilities and shareholders' equity was CHF 7,249.8 in 2018, and CHF 6,975.6 in 2017

Statement of Comprehensive Income

• Also known as income statement, statement of earnings, or profit and loss statement
• Comprehensive income: All items that affect equity but are not the result of transactions with shareholders
• It equals Net income + Other comprehensive income
• Display can be single or two consecutive statements
• Net Income is Income – Expenses
• This covers a period of time

Consolidated Statement of Income: Hershey and Lindt & Sprüngli Group

• Hershey net sales was $7,791,069 in 2018, $7,515,426 in 2017, $7,440,181 in 2016
• Lindt & Sprüngli Group sales was CHF 4,313.2 million in 2018 and CHF 4,088.4 million in 2017
• Lindt & Sprüngli Group net income was CHF 487.1 million in 2018 and CHF 452.5 million in 2017

Other Financial Statements:

• Statement of Changes in Equity
• Statement of Cash Flows

Statement of Changes in Equity summary

• Also known as statement of changes in owners' equity or statement of shareholders' equity
• This covers a Period of time
• Beginning equity + Changes in equity = Ending equity
• Basic components of owners' equity are paid-in capital and retained earnings

Components of Owners' Equity

• Beginning common stock + Issuances – Repurchases = Ending common stock
• Beginning retained earnings + Net Income - Dividends = Ending retained earnings
• Beginning AOCI + OCI = Ending AOCI

Statement of Cash Flows

• Period of time
• Beginning Cash + Changes in cash = Ending cash
• Changes in cash from:
  • Operating
  • Investing
  • Financing

Accompanying Notes

• The notes (footnotes) that accompany the financial statements are required and form an integral part of the statements
• Notes include information on:
  • Significant accounting choices (policies, methods, and estimates).
  • Explanatory detail about line items on the face of the financial statements.
  • Other disclosures, such as commitments and contingencies
• Analysts can discern accounting choice similarities across companies on this basis

Management Commentary or MD&A Information

• A narrative report on entity's financial position, performance, and cash flows
• Provides explanations of the amounts in the financial statements
• Informs on a company's prospects
• Explains management’s objectives and strategies
• This may be called MD&A, operating and financial review (OFR), or management's report

Contents of Management Commentary

• According to IFRS, it should includes information that is essential to understanding:
  • The nature of the business, objectives and strategies, entity's most significant resources and risks, and relationships
  • The results of operations and prospects and the critical performance measures and indicators
• In the United States, the SEC requires listed companies to provide an MD&A and specifies what must be included
• Management must highlight favorable or unfavorable trends and identify significant events affecting liquidity, capital resources, and operations

Auditor's Reports

• Financial statements in annual reports generally require auditing by an independent accounting firm
• This is done in accordance with auditing standards
• An audit report is a written opinion on the financial statements
• Objectives of the independent auditor in conducting an audit:
  • Obtain reasonable assurance about financial statements' freedom from material misstatement
  • Report on the financial statements

Types of Auditor's Reports

• Unqualified audit opinion: “Clean” opinion. The financial statements give a “true and fair view” in accordance with applicable accounting standards
• Qualified audit opinion: Scope limitation or exception to accounting standards
• Adverse audit opinion: Issued when an auditor determines that the financial statements materially depart from accounting standards and are not fairly presented. Generally, an analyst would not analyze these statements
• Disclaimer of opinion: The auditors cannot issue an opinion for a reason such as scope limitation
• Key Audit Matters and Critical Audit Matters are included in the report for certain entities

Internal Control System

• It assures that the company's process for generating financial reports is sound.
• Some countries (e.g., the United States) require an audit opinion on the internal control systems.

Information Sources Besides Annual Financial Statements

• Annual report or proxy statement: Management compensation and governance
• Interim reports: (Unaudited) financial statements with updated information
• Press releases, particularly earnings announcements, and conference calls
• Presentations to analysts
• External data sources provide information on: the economy, the industry, the company and comparable companies
• Regulatory context, where applicable
• Direct experience of the company's products and services

Steps in Financial Statement Analysis

• There are 6 key stages that include:
  • Articulate the Purpose and Context of the Analysis
  • Collect Data
  • Process Data
  • Analyze/Interpret the Processed Data
  • Develop and Communicate Conclusions and Recommendations
  • Follow-Up

Steps Explained

-Purpose of analysis: evaluate the historical performance of a company, forecast future performance, value a company's equity or debt securities, prepare rating or recommendation

• Define the context including the audience, end product, time frame and resources
• Based on purpose and context, formulate questions to be answered
• Collect data required to answer questions, then analyze
• Analytical tools include Ratio analysis and Common-size financial statements
• Use financial ratios to assess a company's profitability, liquidity, leverage, and efficiency relative to its own past and relative to peer/benchmark companies
• Synthesize all available information to develop expectations about a company's likely future performance
• Develop forecasts and use as input to valuation

More Steps Explained

• Communicate the conclusion or recommendation in an appropriate format
• Format varies by analytical task, institution, and audience
• An equity analyst's report would typically include: Summary and investment conclusion, Earnings projections, Valuation, Business summary
• Also included is - Risk, industry, and competitive analysis, Historical performance, Forecasts
• For equity investment and credit ratings, periodic review is required
• Follow-up may involve repeating all the previous steps on a periodic basis

Goals of Financial Statement Analysis:

• For a fixed income(debt) investor, financial analysis answers:
  • What is the probability of default, what is my potential loss in the event of default, and am I earning a sufficient, fixed return for the risk
  • Liquidity, solvency and price/yield are key
• For a equity investor, financial analysis also answers:
  • What is the value of the equity and how does this relate to the market price

Determining Value?

• An asset's value is determined by the Present value of Cash flows it generates
• This is true with Bonds, Real estate, alternative investments and Equities in corporations
• The price of an asset is the agreement between a willing buyer and seller

Valuation Model

• Examination consists of a simple valuation model and the elements that drive value using the Gordon Constant Growth Model
• Key factors in the equation:
  • CF = Future cash flows
  • R = Cost of capital (particularly the Risk component)
  • G = Growth in connection with cash flow generation
• These are intrinsic valuations
• Intrinsic Valuation is central to value investing as utilized by big investors like Warren Buffet

Relative Valuation Analysis

• This analysis includes Profits, P/E ratios, forward earnings, TEV/EBITDA, ETC.
  • It is more correctly characterized as Price Seeking as opposed to Value seeking
• Relative is the most common “Valuation" method because it is simple in its focus on comparative analysis

Objective and Steps for Financial Statement Analysis

• Identify Factors impacting Cash Flow Generation, Risk, growth and cost of capital in the past
• Assess how these factors are likely to impact valuation factors Future.
• Steps begin by collecting financial statement material to be analyzed and spreading the financial statement material
• Convert the spread to common size
• Calculate common and specialized ratios and historical growth rates and exception analysis/adjustments
• Evaluate liquidity, solvency, profitability, cash flow generation & uses
• Read relevant information on industry and accompanying material
• Comparative Analysis, development of narrative and forecast future profits and cash flow
• Accounting analysis, Trend Analysis, and Intrinsic and relative valuation are also key stages