Chapter 1

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analysis of both liquidity and solvency.

Chapter 1 1. Liquidity is a company’s ability to


Financial Statement raise cash in the short term to
meet its obligations. Liquidity
Analysis depends on a company’s cash flows
and the makeup of its current
Business Analysis assets and current liabilities.
2. Solvency is a company’s long run
 Financial statement analysis is one viability and ability to pay long-
important step in business term obligations. It depends on
analysis. Business analysis is the both a company’s long-term
process of evaluating a company’s profitability and its capital
economic prospects and risks. This (financing) structure.
includes analyzing a company’s
business environment, its Equity Analysis- Equity investors
strategies, and its financial position provide funds to a company in return for
and performance. the risks and rewards of
ownership. Individuals who apply active
Types of Business Analysis investment strategies primarily use
technical analysis, fundamental analysis,
Credit Analysis- Creditors lend funds to or a combination.
a company in return for a promise of - Technical analysis, or charting,
repayment with interest. searches for patterns in the price or
This type of financing is temporary since volume history of a stock to predict
creditors expect repayment of their funds future price movements.
with - Fundamental analysis, A main part of
interest. Creditors lend funds in many fundamental analysis is evaluation of a
forms and for a variety of purposes. company’s financial position and
1. Trade (or operating) creditors - performance. A major goal of
deliver goods or services to a fundamental analysis is to determine
company and expect payment intrinsic value, also called fundamental
within a reasonable period, often value.
determined by industry norms. *Intrinsic value is the value of a
2. Nontrade creditors (or debtholders) company (or its stock) determined
provide financing to a company in through fundamental analysis without
return for a promise, usually in reference to its market value (or stock
writing, of repayment with interest price).
(explicit or implicit) on specific
future dates. This type of financing Other Uses of Business Analysis
can be either short or long term Managers- provides a strategic change
and arises in a variety of in operating, investing, and financing
transactions. activities.
Mergers, acquisitions, and
Credit analysis focuses on downside risk divestitures- Business analysis is
instead of upside potential. This includes performed whenever a company
restructures its operations, through Accounting Analysis
mergers, acquisitions, divestitures, and -process of evaluating the extent to
spin-off. which a company’s accounting reflects
Financial management- Business economic reality.
analysis helps assess the impact of -it affects the usefulness of financial
financing decisions on both future statements and can yield at least two
profitability and risk. problems in analysis.
Directors- As elected representatives of 1. Comparability problems- arise when a
the shareholders, directors are company changes its accounting across
responsible for protecting the time
shareholders’ interests by vigilantly 2. Accounting distortions- estimation
overseeing the company’s error
Regulators- to audit tax returns and  earnings management
check the reasonableness of reported  accounting standards
amounts.
Labor unions- collective bargaining
negotiations. Financial Analysis- to analyze a
Customers- Analysis techniques are company’s financial position and
used to determine the profitability (or performance, and to assess future
staying financial performance.
power) of suppliers along with estimating Financial analysis consists of three
the suppliers’ profits from their mutual broad areas
transactions. 1. Profitability analysis is the evaluation
of a company’s return on investment.
Components of Business Analysis 2. Risk analysis is the evaluation of a
company’s ability to meet its
commitments.
3. Analysis of cash flows is the evaluation
of how a company is obtaining and
deploying
its funds.

Prospective Analysis- forecasting of


future payoffs—typically earnings, cash
flows,
or both.
- This analysis draws on accounting
analysis, financial analysis, and
business
environment and strategy analysis.

Business Activities
- The four major activities of the
company: planning, financing, investing,
and operating. It is important to
understand each of these major business
activities before we can effectively
analyze a company’s financial Financial Statement- measures a
statements. company’s financial performance over a
period of time, typically a year or a
Planning Activities- A company’s goals quarter
and objectives are captured in a business Balance Sheet
plan that describes the company’s Total Investing =
purpose, strategy, and tactics for its Total Financing= Creditor Financing
activities. + Owner Financing
Financing Activities- refer to methods
that companies use to raise the money
to pay for these needs.
Investing activities- refer to a
company’s acquisition and maintenance Income Statement
of investments Revenues – Cost of goods sold =
for purposes of selling products and Gross Profit
providing services, and for the purpose Gross profit – Operating expenses =
of investing Operating/Net Profit
excess cash.
Operating Activities- Operating Statement of Cash Flows
activities are a company’s primary source
The statement of cash flows reports cash
of earnings.
inflows and outflows separately for a
Financial Statements Reflect
company’s operating, investing, and
Business Activities
financing activities over a period of time.
Additional Information- Financial  The most important information
statements are not the sole output of a often revealed from comparative
financial reporting system. Additional financial statement analysis is
information about a company is also trend.
communicated.  can reveal the direction, speed,
and extent of a trend.
 Management’s Discussion and
Analysis (MD&A).
Common-Size Financial Statement
 Management Report.
Analysis
 Auditor Report.
 Explanatory Notes.  useful in understanding the
 Supplementary Information. internal makeup of financial
 Proxy Statements. statements.
 the distribution of financing
across current liabilities,
noncurrent liabilities, and
equity.
 useful for intercompany
comparisons because
financial statements of
different companies.

FINANCIAL STATEMENT ANALYSIS


PREVIEW
 This section gives preliminary
exposure to five important sets of
tools for financial analysis:
1. Comparative financial statement
analysis
2. Common-size financial statement
analysis

Comparative Financial Statement


Analysis
 This usually involves a review of
changes in individual account
balances on a year-to-year or
multiyear basis.
Ratio Analysis
- provide us with insights into
underlying conditions.
- They are one of the starting points
of analysis, not an end point.
Valuation Models This model is
 Valuation is an important outcome called the dividend discount model. This
of many types of business and equity valuation formula is in terms of
financial statement analysis. expected dividends rather than actual
 normally refers to estimating the dividends.
intrinsic value of a company
 The basis of valuation is present
Analysis in an Efficient Market
value theory.
The efficient market hypothesis, or EMH
Debt Valuation for short, deals with the reaction of
market prices to financial and other
information.

There are three common forms of EMH.


The weak form EMH asserts that prices
Bt is the value of the bond at time t reflect fully the information contained in
where It + n is the interest payment in historical price movements.
period t+n The semi strong form EMH asserts that
F is the principal payment (usually the prices reflect fully all publicly available
debt’s face value), and information. The strong form EMH
r is the investor’s required interest rate, asserts that prices reflect all information
or yield to maturity. including inside information.

When valuing bonds, we determine the


expected (or desired) yield based on
factors
such as current interest rates, expected
inflation, and risk of default.

Equity Valuation

Vt is the value of an equity security at


time t
where Dt +n is the dividend in period
t+n, and
k is the cost of capital.
E refers to expected dividends

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