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Final Exam Preparation

Financial statement analysis is a systematic process that analyzes a company's financial statements to assess its performance and financial strength. It involves accounting analysis, which evaluates how well a company's accounting reflects its actual business performance, and financial analysis, which examines financial ratios and forecasts to estimate a company's future earnings and risk. The goal is to improve business decisions by providing a more objective understanding of a company's financials than intuition alone.

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239 views4 pages

Final Exam Preparation

Financial statement analysis is a systematic process that analyzes a company's financial statements to assess its performance and financial strength. It involves accounting analysis, which evaluates how well a company's accounting reflects its actual business performance, and financial analysis, which examines financial ratios and forecasts to estimate a company's future earnings and risk. The goal is to improve business decisions by providing a more objective understanding of a company's financials than intuition alone.

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Hiếu Nguyễn Minh Hoàng
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© © All Rights Reserved
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Final Exam Preparation

Problem 1: Chapter 1 (p.g 3)


What is the financial statement analysis?
Financial statement analysis is the application of analytical tools and techniques to general-purpose
financial statements and related data to derive estimates and inferences useful in business analysis.
Financial statement analysis reduces reliance on hunches, guesses, and intuition for business decisions. It
decreases the uncertainty of business analysis. It does not lessen the need for expert judgment but,
instead, provides a systematic and effective basis for business analysis. It includes accounting analysis,
financial analysis, prospective analysis.

Business Analysis and How Financial Statement Analysis work in Business Analysis
Business analysis is the evaluation of a company’s prospects and risks for the purpose of making
business decisions. The goal of business analysis is to improve business decisions by evaluating
available information about a company’s financial situation, its management, its plans and strategies, and
its business environment. Business analysis is applied in many forms and is an important part of the
decisions of security analysts, investment advisors, fund managers, investment bankers, credit raters,
corporate bankers, and individual investors.
Financial statement analysis is part of business analysis.
Intrinsic value (fundamental value): is the value of a company (or its stock) determined through
fundamental analysis without reference to its market value (or stock price). Intrinsic value is used in many
contexts, including equity investment and stock selection, initial public offerings, private placements of
equity, mergers and acquisitions, and the purchase/sale of companies without traded securities.
To determine intrinsic value, an analyst must forecast a company’s earnings or cash flows and
determine its risk. This is achieved through a comprehensive, in-depth analysis of a company’s business
prospects and its financial statements. Once a company’s future profitability and risk are estimated, the
analyst uses a valuation model to convert these estimates into a measure of intrinsic value.

Accounting analysis is a process of evaluating the extent to which a company’s accounting reflects
economic reality. This is done by studying a company’s transactions and events, assessing the effects of
its accounting policies on financial statements, and adjusting the statements to both better reflect the
underlying economics and make them more amenable to analysis. Accounting analysis includes
evaluation of a company’s earnings quality or, more broadly, its accounting quality. Accounting analysis
also includes evaluation of earnings persistence, sometimes called sustainable earning power.

While accounting principles are governed by standards, the complexity of business transactions and
events makes it impossible to adopt a uniform set of accounting rules for all companies and all time
periods. Moreover, most accounting standards evolve as part of a political process to satisfy the needs of
diverse individuals and their sometimes-conflicting interests. These individuals include users such as
investors, creditors, and analysts; preparers such as corporations, partnerships, and proprietorships;
regulators such as the Securities and Exchange Commission and the Financial Accounting Standards
Board; and still others such as auditors, lawyers, and educators. Accordingly, accounting standards
sometimes fail to meet the needs of specific individuals. Another factor potentially impeding the
reliability of financial statements is error from accounting estimates that can yield incomplete or
imprecise information. Comparability problems arise when different companies adopt different
accounting for similar transactions or events. Accounting distortions are deviations of accounting
information from the underlying economics.

First, accrual accounting improves upon cash accounting by reflecting business activities in a more
timely manner. But accrual accounting yields some accounting distortions that need to be identified and
adjusted so accounting information better reflects business activities. Second, financial statements are
prepared for a diverse set of users and information needs. This means accounting information usually
requires adjustments to meet the analysis objectives of a particular user.

The quality of earnings refers to the proportion of income attributable to the core operating activities of
a business. If a business reports an increase in profits due to improved sales or cost reductions, the quality
of earnings is considered to be high.
A key characteristic of high-quality earnings is that the earnings are readily repeatable over a series of
reporting periods, rather than being earnings that are only reported as the result of a one-time event. In
addition, an organization should routinely provide detailed reports regarding the sources of its earnings,
and any changes in the future trends of these sources. Another characteristic is that the reporting entity
engages in conservative accounting practices, so that all relevant expenses are appropriately recognized in
the correct period, and revenues are not artificially inflated.
Investors like to see high-quality earnings, since these results tend to be repeated in future periods and
provide more cash flows for investors. Thus, entities that have high-quality earnings are also more likely
to have high stock prices.

Conversely, an organization can have low-quality earnings if changes in its earnings relate to other
issues, such as
Aggressive use of accounting rules
Elimination of LIFO inventory layer
Inflation
Sale of assets for a gain
Increases in business risk

When determining operating earnings, practicing analysts often start off with core earnings from which
they exclude nonoperating income components such as interest expense

Permanent income (also called sustainable income or recurring income) is the stable average income that
a business is expected to earn over its life, given the current state of its business conditions. Permanent
income reflects a long-term focus.

We already noted that determining a company’s permanent income (sustainable earning power) is a major
quest in analysis. For this purpose, an analyst needs to first determine the permanent (or recurring)
component of the current period’s accounting income by identifying and appropriately excluding, or
smoothing, transitory (nonrecurring) components of accounting income. For example, an analyst may
exclude gain on sale of a major business segment when determining the permanent component of
earnings.

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