2 1 Introduction to financial statement analysis This note is summarized by Hui Wang Learning outcomes The candidate should be able to

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2 1 Introduction to financial statement analysis This note is summarized by Hui Wang Learning outcomes The candidate should be able to Powered By Docstoc
					         2.1 Introduction to financial statement analysis

                                            ** This note is summarized by Hui Wang.

Learning outcomes
The candidate should be able to:
   a. Discuss the roles of financial reporting and financial statement analysis;
   b. Discuss the role of key financial statements (income statement, balance sheet,
       cash flow statement and statement of changes in owners’ equity) in evaluating a
       company’s performance and financial position;
   c. Discuss the importance of financial statement notes and supplementary
       information (including disclosures of accounting methods, estimates and
       assumptions) and management’s discussion and analysis;
   d. Discuss the objective of audits of financial statements, the types of audit reports,
       and the importance of effective internal controls;
   e. Identify and explain information sources other than annual financial statements
       and supplementary information that analysts use in financial statement analysis;
   f. Describe the steps in the financial statement analysis framework.

Liquidity & solvency

Liquidity describes the ability of an asset to be converted into cash quickly and without
any price discount. In financial statement analysis, it measures the extent to which a firm
has cash to meet immediate and short-term obligations. Solvency measures the ability of
a firm to meet its long-term obligations.

Financial statements and supplementary information

The four key financial statements are income statement, balance sheet, statement of cash
flows, and statement of changes in owner’s equity.
Supplementary information can be found from:
    a. Footnotes and supplementary schedules;
    b. Management’s discussion and analysis (MD&A);
    c. The external auditor’s reports.

Income statement

Income statement is a financial statement that measures a company’s financial
performance over a specific accounting period. It gives a summary of how the business
incurs its revenues and expenses through both operating and non-operating activities. It
also shows the net profit or loss incurred over a specific accounting period, typically over
a fiscal quarter or year. Income statement is also known as a statement of operations or
profit and loss (R&L) statement.

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Income statements are reported on a consolidated basis-the revenues and expenses of
affiliated companies under the control of the reporting company are incorporated into its
income statement. The basic equation underlying the income statement is,
                           Revenue – Expenses = Net income

Balance sheet

Balance sheet is a financial statement that summarizes a company’s assets, liabilities and
shareholders’ equity at a specific point in time. These three balance sheet segments give
investors an idea as to what the company owns and owes, as well as the amount invested
by the shareholders. Balance sheet is also known as the statement of financial position or
statement of financial condition. The basic equation underlying the balance sheet is,
                           Assets = Liabilities + Owners’ equity

Cash flow statement

The cash flow statement reports the cash generated and used during the time interval
specified in its heading. The cash flow statement organizes and reports the cash generated
and used in the following categories:
Operating activities                          Involve transactions that enter into the
                                              determination of net income and are
                                              primarily activities that comprise the daily
                                              business functions of a company
Investing activities                          Report the purchase and sale of long-term
                                              investments and property, plant and
Financing activities                          Report the issuance and repurchase of the
                                              company’s own bonds and stock and the
                                              payment of dividends

Financial flexibility

Financial flexibility refers to a company’s ability to take advantage of unforeseen
opportunities or its ability to deal with unexpected events depending on the company’s
financial policies and financial structure.

Statement of changes in owners’ equity

The statement of changes in owners’ equity identifies the changes in equity by
reconciling the beginning and ending equity (shown in the balance sheets.) This change is
determined by comparing such items as retained earnings, contributed capital and the
valuation of assets. The change in equity occurs as a result of business earnings, a change
in asset valuation, or the actions of owners who contribute more capital or withdraw
capital from the business. The statement of changes in owners’ equity is also called
statement of shareholders’ equity, or statement of retained earnings.

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Financial notes and supplementary schedules

The financial notes and supplementary schedules provide explanatory information about
the following:
    a. The methods and assumptions used to prepare the financial statements
    b. Business acquisitions and disposals
    c. Commitments and contingencies
    d. Legal proceedings
    e. Stock option and other employee benefit plans
    f. Related-party transactions
    g. Significant customers
    h. Subsequent events
    i. Business and geographic segments
    j. Quarterly financial data

Management’s discussion and analysis

The management’s discussion and analysis (MD&A) seeks to force a company’s
management to take responsibility for their actions and those of the company. In MD&A,
a company’s management offer details about issues such as revenues, past and future
plans for the company, uncertainty within the company, sources of liquidity, cash flow
problems, liabilities, raising funds, and materiality. The MD&A is intended to assist
investors in the understanding and assessment of significant changes and trends, as well
as risks and uncertainties, related to the results of operations and the financial condition
of the companies. It also disclose the critical accounting policies that require management
to make subjective judgments and that have a significant impact on reported financial

Auditor’s reports

The independent audit report provides reasonable assurance that the financial statements
are fairly presented-it is highly possible that the audited financial statements are free from
material error, fraud, or illegal acts that have a direct effect on the financial statements.
Note that independent auditors cannot express an opinion that provides absolute
assurance about the accuracy or precision of the financial statements.

Unqualified audit opinion (or a clean           The financial statements are presented
opinion)                                        fairly in conformity with GAAP (U.S) or
                                                give a “truce and fair view” (international)
Qualified audit opinion                         Is issued when there is: (1) scope
                                                limitation, or (2) departure from accounting
Adverse audit opinion                           Is issued when the financial statements do
                                                not present the company’s financial
                                                position in conformity with accounting
                                                standards and are not fairly presented

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Disclaimer of opinion                           Issued when the auditor is unable to form
                                                an opinion on an entity’s financial
                                                statements. A disclaimer may be issued in
                                                cases when: (1) the auditor is not
                                                independent with respect to the entity
                                                under audit; (2) a material scope limitation
                                                exists; (3) a significant uncertainty exists
In the U.S., the auditors are required to express an opinion on companies’ internal control
systems under the Sarbanes-Oxley Act.

Proxy statement

Proxy statement is a document intended to provide shareholders with information
necessary to voted in an informed manner on matters to be brought up at stockholders’
meeting. It lists the items to be voted on including nominees for directorships, the
auditing firm recommended by directors, the salaries of top officers and directors, and
resolutions submitted by management and stockholders and discloses any potential
conflicts of interest that my exist between management, the board, and shareholders.

Interim reports

Interim reports, also known as interim statement is short, unaudited financial statement
issued monthly, quarterly, or half-yearly by a firm and generally shows pretax profit,
estimated tax liabilities, earnings available for the interim divided, and other such

Financial statement analysis framework

      Phase                    Sources of information       Output
   1. Articulate the               The nature of the           Statement of the
      purpose and context             analyst’s function,          purpose or objective
      of the analysis                 such as evaluating           of analysis.
                                      an equity or debt         A list (written or
                                      investment or                unwritten) of
                                      issuing a credit             specific questions to
                                      rating.                      be answered by the
                                   Communication                  analysis.
                                      with client or            Nature and contend
                                      supervisor on needs          of report to be
                                      and concerns.                provided.
                                   Institutional               Timetable and
                                      guidelines related to        budgeted resources
                                      developing specific          for completion.
                                      work product.

   2. Collect data                  Financial                     Organized financial

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                                statements, other         statements.
                                financial data,          Financial data tables.
                                questionnaires, and      Completed
                                industry/economic         questionnaires, if
                                data.                     applicable.
                               Discussions with
                                customers, and
                               Company site visits
                                (e.g., to production
                                facilities or retail
   3. Process data             Data from the            Adjusted financial
                                previous phase.           statements.
                                                         Common-size
                                                         Ratios and graphs.
                                                         Forecasts.
   4. Analyze/interpret the    Input data as well       Analytical results.
      processed data            as processed data.
   5. Develop and              Analytical results       Analytical report
      communicate               and previous              answering questions
      conclusions and           reports.                  posed in Phase 1.
      recommendations          Institutional            Recommendation
      (e.g., with an            guidelines for            regarding the
      analysis report)          published reports.        purpose of the
                                                          analysis, such as
                                                          whether to make an
                                                          investment or grant
   6. Follow up                Information              Updated reports and
                                gathered by               recommendations.
                                repeating above
                                steps as necessary
                                to determine
                                whether changes to
                                holdings or
                                are necessary.
                                                (from CFA® Program Curriculum)

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Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)








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Description: Financial Analysis of Financial Statements document sample