Intro to Financial Statement Analysis PDF

The financial statement analysis framework sets out a generic set of steps for analysts to apply to a multitude of objectives when analyzing debt issues, equity securities, and corporate actions. The framework consists of six steps: Step 1: State the objective and context. Determine what questions...

The financial statement analysis framework sets out a generic set of steps for analysts to apply to a multitude of objectives when analyzing debt issues, equity securities, and corporate actions. The framework consists of six steps: Step 1: State the objective and context. Determine what questions the analysis seeks to answer, the form in which this information needs to be presented, and what resources and how much time are available to perform the analysis. Step 2: Gather data. Acquire the company's financial statements and other relevant data on its industry and the economy. Ask questions of the company's management, suppliers, and customers, and visit company sites. Step 3: Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios and perform statistical analysis. Prepare exhibits such as graphs and common-size balance sheets. Step 4: Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports. Step 5: Report the conclusions or recommendations. Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations.The role of financial statement analysis is to use the information in a company's financial statements, along with other relevant information, to make economic decisions. Examples of such decisions include whether to invest in the company's securities or recommend them to investors, whether to extend trade or bank credit to the company, and assigning credit ratings to a company's debt. Analysts use financial statement data to evaluate a company's past performance and current financial position to form opinions about the company's ability to earn profits and generate cash flow in the future. As part of this process, analysts will identify risk factors that affect the company's future profitability and position. Standard-setting bodies are professional organizations of accountants and auditors that establish financial reporting standards. Regulatory authorities are government agencies that have the legal authority to enforce compliance with financial reporting standards. The two primary standard-setting bodies are the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). In the United States, the FASB sets forth the U.S. Generally Accepted Accounting Principles (U.S. GAAP). Outside the United States, the IASB establishes the International Financial Reporting Standards (IFRS). Other national standard-setting bodies exist as well. Some of the older IASB standards are referred to as the International Accounting Standards (IAS). Regulatory authorities, such as the Securities and Exchange Commission (SEC) in the United States and the Financial Conduct Authority in the United Kingdom, are established by national governments. Most national authorities belong to the International Organization of Securities Commissions (IOSCO). Together, the members of IOSCO regulate more than 95% of the world's financial markets. IOSCO is not a regulatory body, but its members work together to improve cross-border cooperation and make national regulations and enforcement more uniform around the world. The IOSCO Objectives and Principles of Securities Regulation are based on three main objectives: 1\. Protecting investors 2\. Ensuring markets are fair, efficient, and transparent 3\. Reducing systemic risk Step 6: Update the analysis. Repeat these steps periodically, and change the conclusions or recommendations when necessary.Financial reporting refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements. IOSCO requires issuers to provide full, accurate, and timely disclosure of financialresults, risk, and other information used in the decision-making process. It alsorequires accounting standards that are used to prepare financial statements to be ofa high standard and internationally accepted. The SEC's requirements for financial reporting by U.S. companies are shown in Figure 29.1 as an example of reporting requirements. The SEC has the responsibility of enforcing the Sarbanes-Oxley Act of 2002. The act prohibits a company's external auditor from providing certain additional paid services to the company, to avoid theconflict of interest involved, and to promote auditor independence. The act requiresa company's executive management to certify that the financial statements are presented fairly and to include a statement about the effectiveness of the company's internal controls of financial reporting. Additionally, the external auditor must provide a statement confirming the effectiveness of the company's internal controls. Proxy statements are issued to shareholders when there are matters that require ashareholder vote. These statements, which are also filed with the SEC, are a goodsource of information about the election of (and qualifications of) board members, compensation, management qualifications, and the issuance of stock options. In the European Union (EU), each member state has its own securities regulations, but all countries in the EU are required to report using IFRS. The European Commission also has established the European Securities Commission, which advises the European Commission on securities regulation issues, and the European Securities and Market Authority (ESMA), which coordinates regulation within the EU. Financial statement notes (footnotes) include disclosures that provide further details about the information summarized in the financial statements. Footnotes allow users to improve their assessments of the amount, timing, and uncertainty of the estimates reported in the financial statements. Footnotes do the following: They discuss the basis of presentation such as the fiscal period covered by the statements, whether IFRS or U.S. GAAP is adhered to, and the inclusion of consolidated entities. They provide information about accounting methods, assumptions, and estimates used by management. They provide additional information on information included in the primary financial statements and items such as business acquisitions or disposals, legal actions, employee benefit plans, contingencies and commitments, significantcustomers, related party transactions, position and performance of segments ofthe firm, and significant post balance sheet events.They are audited along with the primary financial statements. Both U.S. GAAP and IFRS require companies to report segment data, but the requireddisclosure items are only a subset of the required disclosures for the company as awhole. Nonetheless, an analyst can prepare a more detailed analysis and forecast by examining the performance of business or geographic segments separately. Segment profit margins, asset utilization (turnover), and return on assets can be very useful in gaining a clear picture of a firm's overall operations. For forecasting, growth rates of segment revenues and profits can be used to estimate future sales and profits and to determine the changes in company characteristics over time. A business segment (operating segment) is a portion of a larger company that accounts for more than 10% of the company's revenues, assets, or income. Anoperating segment should be distinguishable from the company's other lines ofbusiness in terms of the risk and return characteristics of the segment. Segmentsreported should account for a minimum of 75% of the firm's external sales. The following must be disclosed for each segment within the financial statement notes: Revenue (external and between segments) A measure of profit or loss A measure of assets and liabilities Interest (revenue and expense) Acquisitions of PP&E and intangibles Depreciation and amortization Other noncash expenses Income tax expense Share of equity-accounted investments results Geographic segments are also identified when they meet the size criterion given previously and the geographic unit has a business environment that is different from that of other segments or the remainder of the company's business. For example, in its 2016 annual report, Boeing described its business segments as follows: We are organized based on the products and services we offer. We operate in five principal segments: -- Commercial Airplanes -- Our Defense, Space & Security (BDS) business comprises three segments: Boeing Military Aircraft (BMA) Network & Space Systems (N&SS) Global Services & Support (GS&S) -- Boeing Capital (BCC) Management commentary (also known as management report, operating and financial review, or management discussion and analysis \[MD&A\]) is one of the most useful sections of an annual report. IFRS guidance recommends that management commentary address the nature of the business, management's objectives, the company's past performance, the performance measures used, and the company's key relationships, resources, and risks. Analysts must be aware that some parts of management commentary may be unaudited. For publicly held firms in the United States, the SEC requires management commentary to discuss trends and identify significant events and uncertainties that affect the firm's liquidity, capital resources, and results of operations. Management must also discuss the following: Effects of inflation and changing prices, if material Impact of off-balance-sheet obligations and contractual obligations, such as purchase commitments Accounting policies that require significant judgment by management Forward-looking expenditures and divestitures An audit is an independent review of an entity's financial statements. Public accountants conduct audits and examine the financial reports and supporting records. The objective of an audit is to enable the auditor to provide an opinion on the fairness and reliability of the financial statements. The independent certified public accounting firm employed by the board of directors is responsible for seeing that the financial statements conform to the applicable accounting standards. The auditor examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to determine that there are no material errors in the financial statements. The auditor's report is an important source of information. The standard auditor's opinion contains three parts and states the following: 1\. Whereas the financial statements are prepared by management and are its responsibility, the auditor has performed an independent review. 2\. Generally accepted auditing standards were followed, thus providing reasonable assurance that the financial statements contain no material errors. 3\. The auditor is satisfied that the statements were prepared in accordance with accepted accounting principles and that the principles chosen and estimates made are reasonable. The auditor's report must also contain additional explanation when accounting methods have not been used consistently between periods. An unqualified opinion (also known as an unmodified opinion or clean opinion) indicates that the auditor believes the statements are free from material omissions and errors. If the statements make any exceptions to the accounting principles, the auditor may issue a qualified opinion and explain these exceptions in the audit report. The auditor can issue an adverse opinion if the statements are not presented fairly or are materially nonconforming with accounting standards. If the auditor is unable to express an opinion (e.g., in the case of a scope limitation), a disclaimer of opinion is issued. Any opinion other than unqualified is sometimes referred to as a modified opinion. The auditor's opinion will also contain an explanatory paragraph when a material loss is probable, but the amount cannot be reasonably estimated. These uncertainties may relate to the going concern assumption (the assumption that the firm will continue to operate for the foreseeable future), to the valuation or realization of asset values, or to litigation. This type of disclosure may be a signal of serious problems and may call for close examination by the analyst. Internal controls are the processes by which the company ensures that it presents accurate financial statements. Internal controls are the responsibility of management. For publicly traded firms in the United States, the auditor must express an opinion on the firm's internal controls. The auditor can provide this opinion separately, or as the fourth element of the standard opinion. An audit report must also contain a section communicating key audit matters (international reports) or critical audit matters (U.S.), which highlights accounting choices that are of greatest significance to users of financial statements. These would include accounting choices that require significant management judgments and estimates, how significant transactions during a period were accounted for, or choices that the auditor finds especially challenging or subjective---and which, therefore, have a significant likelihood of being misstated. LOS 29.d: Describe implications for financial analysis of alternative financial reporting systems and the importance of monitoring developments in financial reporting standards. While the IASB and FASB work together to harmonize changes to accounting standards, some significant differences between IFRS and U.S. GAAP still exist. Some major differences are outlined in Figure 29.2, but additional differences will be encountered in subsequent modules. The existence of differences between the two sets of standards require the analyst to exercise caution when making comparisons between firms operating in different jurisdictions. guidance before they release their financial statements. After an earnings announcement, senior management may hold a conference call to answer questions and provide information to complement their regulatory filings. -- Ad hoc presentations and events that are similar in format to an earnings call -- Press releases focusing on major events relevant to the company -- Communications with management, investor relations, and company personnel Analysts should note that these additional sources of information provided by issuers are unlikely to have been audited. Public third-party sources: -- Free industry reports, whitepapers, and trade journals -- Government agency-produced economic and industry statistics -- Generalized and industry-specific media sources -- Social media Proprietary third-party sources: -- Analyst reports -- Reports from data platforms such as Bloomberg, Wind, and FactSet -- Reports from industry-specific agencies and consultancies Proprietary primary research: -- Studies commissioned by the analyst -- Hands-on experience with the company's products or services -- Data and advice of technical specialists employed by the analyst An analyst should also review pertinent information on economic conditions and the company's industry and compare the company to its competitors. The necessary information can be acquired from trade journals, statistical reporting services, and government agencies. As financial reporting standards continue to evolve, analysts need to monitor how these developments will affect the financial statements they use. An analyst should be aware of new products and innovations in the financial markets that generate new types of transactions. These might not fall neatly into the existing financial reporting standards. Analysts can use the financial reporting framework as a guide for evaluating what effect new products or transactions might have on financial statements. To keep up to date on the evolving standards, an analyst can monitor professional journals and other sources, such as the IASB (www.ifrs.org) and FASB (www.fasb.org) websites. CFA Institute produces position papers on financial reporting issues through the CFA Institute Centre for Financial Market Integrity. Finally, analysts must monitor company disclosures for significant accounting standards and estimates. LOS 29.e: Describe information sources that analysts use in financial statement analysis besides annual and interim financial reports. As well as regulated information provided by issuers in filings and financial statements, an analyst can also use additional information sources: Issuer sources: -- Earnings calls. Targeted at investors, analysts, and members of the media, earnings calls include presentations by the company's management and the opportunity for question-and-answer sessions. Firms often provide earnings guidance before they release their financial statements. After an earnings announcement, senior management may hold a conference call to answer questions and provide information to complement their regulatory filings. -- Ad hoc presentations and events that are similar in format to an earnings call -- Press releases focusing on major events relevant to the company -- Communications with management, investor relations, and company personnel Analysts should note that these additional sources of information provided by issuers are unlikely to have been audited. Public third-party sources: -- Free industry reports, whitepapers, and trade journals -- Government agency-produced economic and industry statistics -- Generalized and industry-specific media sources -- Social media Proprietary third-party sources: -- Analyst reports -- Reports from data platforms such as Bloomberg, Wind, and FactSet -- Reports from industry-specific agencies and consultancies Proprietary primary research: -- Studies commissioned by the analyst -- Hands-on experience with the company's products or services -- Data and advice of technical specialists employed by the analyst An analyst should also review pertinent information on economic conditions and the company's industry and compare the company to its competitors. The necessary information can be acquired from trade journals, statistical reporting services, and government agencies.