Financial Statement Analysis PDF
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Università Cattolica del Sacro Cuore
Martina Marazzi
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This document provides a detailed overview of financial statement analysis and managerial accounting concepts. It explores the fundamentals of accounting, focusing on financial statements like the balance sheet, income statement, and statements of cash flow. It also explains the importance of annual reports and the role of external auditors.
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lOMoARcPSD|11350337 Financial Statement Analysis Financial statement analysis and managerial accounting (Università Cattolica del Sacro Cuore) Studocu is not sponsored or endorsed by any college or university Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial State...
lOMoARcPSD|11350337 Financial Statement Analysis Financial statement analysis and managerial accounting (Università Cattolica del Sacro Cuore) Studocu is not sponsored or endorsed by any college or university Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi FINANCIAL STATEMENT ANALYSIS FUNDAMENTALS OF ACCOUNTING: A USERS’ PERSPECTIVE The annual report: a fundamental document An annual report is a nancial document to report on company's acvies throughout the past year, which is bigger than the nancial statements and can go up to 600 pages or more – usually the more complex the company is, the more pages the annual report is composed of. If the company is listed, the company has to publish the annual report, since there might be people who want to know everything about the company or want to join the company; on the other hand, if the company is a familyowned business, there is no need to publish the annual report. Annual reports are intended to give shareholders (that are the owners of the company) and other interested people informaon about the company's acvies and nancial performance. Most jurisdicons require companies to prepare and disclose annual reports, and many require the annual report to be led at the company's registry. The minimum content of the nancial report depends on the legal status of the company, and it’s disciplined by the regulaons in place where the legal enty is located. The voluntary disclosure of nancial informaon in listed companies mainly is determined by nancial communicaon choices or taccs. For listed companies the annual report includes specicaon of: – Financial result highlight – – – – – – Governance and ownership structure Discussion and analysis of recent economic events Financial Statements (Consolidated and separate enty parent company) • Balance sheet (or Statement of Financial Posion) – shows the nancial posion on a given day • Income statement – shows the economic performance over a given period • Statement of cash ows – shows the nancial performance over a given period Footnotes to explain elements of nancial statements The report of independent auditors Statement of management responsibility for preparaon of nancial statements The main items of the annual report are: – Management report to the board of directors (address the board of directors in order to know what the business is about) – – – – Financial statements (numbers) Notes to the consolidated nancial statements (the notes are important to know where the nancial statements, that is the numbers, come from) Other disclosures Independent auditor’s report The notes to the consolidated nancial statements are actually given because the number that come from the nancial statements cannot be created out of the blue, but there are instuonal frameworks that needs to be followed. The OIC (Organismo Italiano di Contabilità) is the accountancy body that is composed by professionals who work in the world of accounng and sets rules, which means that they formulate the accounng principles that apply, and especially sets standards in Italy for small naonal businesses. Standards are accounng principles that 1 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi apply, and they are needed in order to compare one company to another, otherwise the comparison would not be possible. But in order to compare companies at an internaonal level there is another instuon of seng, which is called IASB (Internaonal Accounng Standards Board), and is an independent, private-sector body that develops and approves IFRSs (so the accounng principle that it issues in order to assure comparability is called IFRS (Internaonal Financial Reporng Standard)). Another item of the annual report is the auditor’s report: the independent auditors are individuals who inspect and verify the accuracy of a company's nancial records, so the auditor’s report is a compliance report, and it’s important to note that the company is in charge of paying for the auditor’s report. Public companies are required to use a public accounng rm for the conduct of an audit of their nancial statements. At the end of the auding process the auding rm (or the independent auditor) issues an auding report an opinion on the quality of nancial measurement. THE THREE MAIN FINANCIAL STATEMENTS AND THEIR LINKS – Balance Sheet – – Income Statement Statement of Cash Flows The three main nancial statements and their links: the Balance Sheet The main components of the Balance Sheet are: – Assets - economic resources of the rm that can be turned into cash – – Liabilies - economic obligaons of the rm which will use cash Owners’ Equity - the residual interest in, or remaining claims against, the rm’s assets aer deducng liabilies (rights of the owners). Generally, it reects the amount of capital the owners invested plus any prot that the company generates that is subsequently reinvested in the company So, Assets and Liabilies are the elements that we record and recognize, while the equity is the dierence between them. Owner’s equity is composed of Share Capital and Retained Earnings and is the result of their sum. The three main nancial statements and their links: the Income Statement The main components of the Income Statement are: – Revenues - gross increases in Equity – Expenses - gross decreases in Equity – Net Income = Revenues – Expenses or net increase or decrease in the Equity • If Net Income > 0 there is a Prot • If Net Income < 0 there is a Loss The three main nancial statements and their links: the Statement of Cash Flow The main components of the Statement of Cash Flow are: – Cash inows - correspond to cash receipts (+) – Cash oulows - correspond to cash payments (-) These are the three most important nancial statements, and they are telling a story to the users of these nancial statements. They describe the nancial performance of a company, so they describe its: – Protability: a company is protable when its revenues are higher than expenses, but it is also a way to broaden its Equity (if the company is protable, it can feed its Retained Earnings and consequently its Equity) 2 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – Credibility: the higher is the dierence between the assets and the liabilies, the more solid the company is and there is a strong link between protability and credibility because the more protable the company is, the more solid it can become, and being soldi for a company means that it is able to meet long-term obligaons. The liquidity producon of a company tells whether the company has enough cash (not assets) to be able to meet the long-term obligaons (liquidity is about “pure cash”) and it is associated with protability because revenues sooner or later will become cash inows and expenses will become cash oulows, and we say “sooner or later” because of the accrual principle, which is an accounng concept that requires transacons to be recorded in the me period in which they occur, regardless of when the actual cash ows for the transacon are received. So, according to the accrual system revenues are recognized only when the services or the goods are delivered. The statements are not always forced into a framework, but actually there are frameworks, formats that especially for listed companies are recurring. So, the framework, that is to say how we present assets and liabilies (etc.), the revenues and the expenses, the cash inows and the cash oulows is more or less informave. The Balance Sheet presentaon Before investing in any company, an investor can use the balance sheet to examine the following: – can the rm meet its nancial obligations? – how much money has already been invested in this company? – is the company overly indebted? – what kind of assets has the company purchased with its nancing? Typically, the balance sheet is represented in 2 secons, even though in the UK the Balance Sheet is typically organized into 1 secon, so there is a list of assets and liabilies that combines. However, we will see a balance sheet represented in 2 secons and there are 2 criteria to classify assets and liabilies: the rst criterium is liquidity, that is to say how fast the assets can be liquidated and when the liability is due, while the second one is the acvity-related criterium 1- Liquidity: the criterium is related to the fact that there are assets and liabilies that can be liquidated within the year and others that cannot, therefore they are divided into: • Short Term or Current: assets that can be liquidated (=concerted into cash) in the short term (in operang cycle), typically one year and liabilies that are due within the operang cycle or within the year → Short Term Assets: Account Receivable, Inventory → Short Term Liabilies: Account Payable, Wages Payable, Interest Payable and all the payables within the year • Long Term or Non-Current: assets that are liquidated beyond the operang cycle and liabilies that are due beyond the operang cycle → Long Term Assets: Notes Receivable, Property, Plant and Equipment → Long Term Liabilies: Notes Payable, Loans, Bonds 2- Acvity-related: this criterion refers to the fact that there are assets and liabilies that are related to the core business and others that are not (nancing and invesng) • Related to the operang cycle – Operang • Nonrelated to operang cycle – Non Operang → Invesng acvity → Financing acvity 3 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi The rst criterium of presenng assets and liabilies in the Balance Sheet, that is liquidity, is the criterium that is used to check the synchronizaon of the duraon of the assets and the duraon of the liabilies, because the assets are supposed to generate cash and the liabilies are supposed to absorb cash, so we want to see whether with the generaon of cash (which is implicit) into the assets the company is able to cover the obligaons and these mings are in some way synchronized. But there is also another way of looking at the assets and the liabilies of a company, which is the acvity – related criterium, according to which assets and liabilies are spied not based on the duraon but based on the link that they have with pure operaons (core business). The Income Statement presentaon Before invesng in any company, an investor can use the income statement to examine the following: – how much are sales? – what kind of expenses the company pays? – how is interesng the economic result compared with competors? – is the operang income posive? The typical presentaon of the income statement is a single secon with mulple steps. Steps are intermediate results, and they are like paragraphs in the overall chapter that describes how the prot is generated. This is how a typical consolidated income statement is organized: 1. The rst step calculates the gross prot, which tells what the dierence between the revenues and the cost of goods sold is. 2. 3. 4. 5. However, when a company sells a product, it has to endure high adversing and promoonal costs to keep the business alive The second step consists in calculang the contribuon margin: once you subtract the adversing and promoonal costs from the gross prot, you obtain the contribuon margin, which contributes to cover all the other overheads The third step shows the operang result (operang prot), obtained by subtracng all the overheads from the contribuon margin. The operang income is the company’s earnings from its core operaons aer it has deducted its cost of goods sold and its operang expenses. Operang income does not include interest expenses or other nancing costs Then, as a fourth step, you have to consider the impact of nancing and funding decisions (for example the interest expense), and if you subtract these expenses from the operang prot, you come to the prot before tax Eventually, by detracng the income tax expense from the prot before tax, you obtain the nal prot for the period The number of steps depends on the narraves: if the company wants to organize your income statement with more details, it breaks it up in more steps and vice versa. The Statement of Cash Flow presentaon Before investing in any company, an investor can use the cash ow statement to examine the following: – is this company able to pay interests, debts, dividends? – is this company able to generate cash for nancing new investments? – how has the management used the cash generated by the company? In the cash ow statement, there are: – (+) cash inows, which correspond to cash receipts – (-) cash outows, which correspond to cash payments and these items explain why there is a change in cash balance over a period of time. Cash ows are classied according to three reasons why the cash balance might change: 4 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – – – Cash ow from operations: cash inows and outows concerned with ordinary activities of the organization (related to the core business); you want this cash ow to be positive. Examples of cash ow from operations: • Collections from customers (+) • Cash payments to suppliers (-) • Cash payments to employees (-) • Tax payments (-) Cash ow from investing: cash inows and outows concerned with transactions to acquire or to dispose of long-lived assets; you expect this cash ow to be negative, because you expect a company to invest continuously. Examples of cash ow from investing: • Collections from sales of PPE or any long-term assets (+) • Payments on purchases of PPE or any long-term assets (-) Cash ow from nancing: cash inows and outows concerned with transactions to get cash or to repay debts. Examples of cash ow from nancing: • Borrowings of cash from creditors (+) • Issuance of debt securities (+) • Issuance of equity (+) • Repayments of loans (-) • Payments of dividends (-) and by summing these three cash ows together, what we obtain is the net cash ow. MAIN ASSETS EVALUATION PRINCIPLES We zoomed into the nancial statements: the framework is the annual report and now we look at the numbers. When we look at the numbers we have these evaluaon principles, so criteria, methods that are used to determine the value of Assets, Liabilies, and therefore the Equity. 1- The fundamental rules in assets evaluaon – Accounng Standards represent a set of concepts and techniques that are used to idenfy, measure and communicate nancial informaon about an economic unit to various users. – In parcular, IFRSs are designed as a common global language for business aairs, so that company accounts are understandable and comparable across internaonal boundaries. – Nevertheless, managers can exercise the so-called accounng discreon, that is the ability to make a judgment, a choice or a responsible decision, which ulmately impacts on the Financial Statements presentaon. – Therefore, it is important to be aware of which are some of the main valuaon issues that companies face during their day-by-day operaons. – General principles applicable to the asset evaluaon disnguish between: • Monetary assets, carry a xed value in terms of currency units. They are stated as a xed value in monetary terms even when macroeconomic factors such as inaon decrease the purchasing power of the currency. → Cash → Bank deposits → Trade receivables → Other receivables meant for selement through cash → Investments in debt capital markets instruments • Non-monetary assets, conversely speaking, non-monetary assets are those that do not have a value determinable in exact money terms. 5 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi The value assets that are non-monetary change or uctuate a lot over me and whose cash converbility is limited. Therefore, these assets are not that liquid. Examples include property, plant & equipment, intangible assets (including goodwill), equity shares (some companies treat shares issued in foreign currency as monetary assets due to the absence of clear-cut direcves), and Inventories. A non-monetary asset like plant & machinery can see its value decline as the technology becomes obsolete. Its value depends upon certain factors such as changes in technology, supply-demand factors, etc. These factors are not relevant when it comes to the valuaon of monetary assets. The evaluaon rules are dierent for monetary (fair value) o non-monetary assets (cost), but assets that can either be Monetary or Non-Monetary depending on circumstances. • Prepayments or advance payments can either be monetary or non-monetary, based on a contract with a third party (the party to which payment was made). If as per the contract, the pre-paid amount is non-refundable (which it usually is) or if there is no contract and the probability of geng the amount back is very low, then it should be treated as a nonmonetary asset. • Investments in preference shares shall be treated as monetary assets if there is a clause in the contract, by virtue of which, the redempon of preference shares has to be undertaken by the issuing enty aer a certain me in the future. Otherwise, investments in preference shares will be treated as assets that are non-monetary. 2- Accounts receivable and allowance for bad debts – Accounts receivable are the amounts owed to a company by customers as a result of delivering goods or services and extending credit in the ordinary course of business and they are also known as trade receivables or simply receivables. They are valued at their net realizable value (what is used to value accounts receivable is the value for the sale that have not been collected yet, so revenues that have not been collected yet). – Uncollecble accounts (bad debts) are receivables determined to be uncollecble because debtors are unable or unwilling to pay their debts. They need to be deducted from accounts receivable gross. There are two basic ways to record uncollecble: • Specic write-o method : the receivables not paid are wrien o when they are recognized as uncollecble (example, in case of bankruptcy) → The specic write-o method assumes that all sales are fully collecble unl proved otherwise (gross value equals the net realizable value of accounts receivable) • Allowance method: it esmates the poron of accounts receivable that are expected not to be collected → When an account is idened as uncollecble, that account is removed from the books and an expense is recorded and this method, which is used by companies that rarely experience bad debts, is called allowance method → The allowance method esmates the amount of uncollecble accounts to be matched to the related revenues and it allows to recognize bad debts during the proper period, before specic uncollecble accounts are idened in a subsequent period, thus improving the matching of revenues and expenses → The allowance method has two basic elements: An esmate of the amounts that will ulmately be uncollecble 6 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi A contra account, Allowance for Uncollecble Accounts, which contains the esmate and is deducted from Accounts Receivable → The allowance method is based on historical experience and the assumpon that the current year is similar to prior years → The allowance is quaned directly as percentage of ending account receivable (somemes dierenated based on the age of the overdue) or indirectly as a percentage of credit sales 3- Inventory evaluaon and cost of goods sold – Inventories are measured at the lower of cost and net realisable value, which is the esmated selling price in the ordinary course of business less the esmated costs of compleon and the esmated costs necessary to make the sale – The cost of inventories includes all costs of purchase, costs of conversion (direct labour and producon overhead) and other costs incurred in bringing the inventories to their present locaon and condion – Under the IFRS the cost of inventories is assigned by: • Specic idencaon of cost for items of inventory that are not ordinarily interchangeable • The rst-in, rst-out or weighted average cost formula for items that are ordinarily interchangeable (generally large quanes of individually insignicant items) – When inventories are sold, the carrying amount of those inventories is recognised as an expense in the period in which the related revenue is recognised – The amount of any write-down of inventories to net realisable value and all losses of inventories are recognised as an expense in the period the write-down or loss occurs 4- Fixed assets (tangible and intangible), depreciaon and amorzaon – There are two main categories of xed assets: • Tangible xed assets, including PPE (property, plants and equipment), land, etc. – everything that is long lived, which means that ... and that it will generate cash ow beyond the current accounng period • Intangible assets, which have no physical form (like trademarks, patents, copyrights, ….) – According to the cost principle, acquired xed assets should be recorded at their actual cost, also called historical cost – Remember that the cost of any asset, including xed assets, is the sum of all the costs incurred to bring the asset to its intended use – For xed assets, therefore, the typical items included in the cost are: • Purchase price • Applicable taxes • Purchase commission • Legal fees • Transportaon charges • Insurance while the asset is in transit • Installaon costs • Cost for tesng the asset before it is used, etc. – At the end of the accounng period, rm record an expense related to the fact that during the same period they have used xed assets, so they contributed to the revenue earned. – Depreciaon is the process of allocang the cost of a xed asset over the years of its useful life, that is over the years that the asset was used • Depreciaon is an expense and a decrease in the asset value 7 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi • If, at the end of a given accounng period, the net book value of a xed asset is higher than the recoverable value of the asset, rms are required to “impair” the asset, which means to record for an extraordinary loss of value (expense) • Remember that the cost is always the highest value at which an asset can be evaluated. This means that we cannot record a value higher than the cost we paid to acquire the asset (unless the revaluaon model is used) – Amorzaon: intangible assets are rights or claims to expected benets that tend to be contractual in nature rather than physical in nature. Examples are patents, copyrights, and franchises. The accounng for intangibles is much like that of tangible assets • Acquision costs of intangibles may be: the cost of purchase, the fair value in a contribuon in kind, the capitalized cost in case of capitalizaon of operang expenses • Intangibles are amorzed using the straight-line method • Firms measure the depreciaon based on: → Depreciable cost → Esmated useful life • Depreciable cost in most cases corresponds to the total cost of the asset (see before). When it is expected that some money from the sale of the asset at the end of its useful life will be gained, the depreciable cost equals the historical cost - (minus) the residual value • The esmated useful life is an esmate of how long the assets will be useful: this can be expressed in years, units of output or other measures • There are dierent methods to allocate the depreciable value to the periods of the asset’s useful life. The most common in pracce are: → Straight-line method → Units-of-producon method → Declining balance method (accelerated depreciaon) 5- Take home – Non-monetary and monetary assets have dierent evaluaon criteria: cost based and fair value based – Accounts receivables are valued at their net realizable value – Inventories are evaluated at the lower of cost (FIFO; LIFO; weighted average, specic idencaon) or market price – Fixed assets (tangible and intangible) are evaluated, respecvely, at their depreciated or amorzed cost INTRODUCTION TO CONSOLIDATION 1- Intercorporate investment and consolidaon – When an investor has control over an investee company (over 50% ownership), it must prepare consolidated nancial statements – The investor company is called the parent (buying company) – The investee company is called the subsidiary (target company) – Although both companies remain separate legal enes, the nancial posion and earnings reports of the parent are combined with those of the subsidiary, but since the parent company controls the subsidiary, it is required to produce consolidated statements 2- Acquision – Assume two separate companies: • Company A: Assets of $650 million and Liabilies of $200 million 8 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – – • Company B: Assets of $400 million and Liabilies of $187 million This means that the book value of Equity of company A of $450 million and the book value of Equity of company B of $213 million Company A purchases all of the outstanding stock of company B (B gives shares and A pays money to the shareholder of B) for $213 million in cash The journal entry on the books of A (in millions) will report an increase in Investment in B and a decrease in Cash for the same amount of 213, so the acquision is reported as an investment (payment in cash) of company A in company B However, when we look at the consolidated account, we have to combine the assets and the liabilies of B into A: aer the acquision B will stay as a legal enty as it is, because B is sll exisng, but A will have a reducon in cash ($213 millions are gone to the shareholders of B) and there will be an investment in B 3- Consolidated nancial statements Now the company has to prepare consolidated nancial statements because now there is just one shareholder, that is all the shareholders of A, who want to know the whole “story”, so A + B, that means we have to combine the nancial statements into a consolidated one. How do we combine A + B? In combining the amounts on the balance sheet, A must eliminate its investment account and the stockholders’ equity of B, which eliminates double-counng of the investment in B: Aer the acquision A connues to use the equity method during the period and to prepare consolidated statements, P must eliminate: • Its investment account and the Shareholder’s Equity of the subsidiary on the consolidated balance sheet • Intercompany revenues and expenses on the income statement • Other intercompany transacons 4- Price not equal to book value Let’s now assume that all the acquired assets and liabilies are shown at their fair market value, so if the purchase price is more than the fair market value of the net asset, goodwill must be shown on the consolidated statement – When the acquiring company pays more than the book value of the acquired company’s net assets, consolidaon requires a two-step adjustment: 1. All acquired assets and liabilies are shown at their fair market value (FMV) 2. If the purchase price > FMV of the net assets, goodwill must be shown on the consolidated balance sheet 9 Downloaded by Chiara Davoli ([email protected])
