Far - Chapter I
Far - Chapter I
Far - Chapter I
OVERVIEW
Financial statement analysis is an integral and important part of the broader
field of business analysis. Business analysis is the process of evaluating a
company’s economic prospects and risks. This includes analyzing a company’s
business environment, its strategies, and its financial position and performance.
Business analysis is useful in a wide range of business decisions such as whether to
invest in equity or in debt securities, whether to extend credit through short- or long-
term loans, how to value a business in an initial public offering (IPO), and how to
evaluate restructurings including mergers, acquisitions, and divestitures.
a. Credit Analysis
Creditors lend funds to a company in return for a promise of
repayment with interest. This type of financing is temporary since creditors
expect repayment of their funds with interest. Creditors lend funds in many
forms and for a variety of purposes.
Trade (or operating) creditors deliver goods or services to a company
and expect payment within a reasonable period, often determined by
industry norms. Most trade credit is short term, ranging from 30 to 60
days, with cash discounts often granted for early payment.
Nontrade creditors (or debtholders) provide financing to a company in
return for a promise, usually in writing, of repayment with interest on
specific future dates. This type of financing can be either short or long
term and arises in a variety of transactions.
In pure credit financing, an important element is the fixed nature of
benefits to creditors. That is, should a company prosper, creditors’ benefits
are limited to the debt contract’s rate of interest or to the profit margins on
goods or services delivered.
However, creditors bear the risk of default. This means a creditor’s
interest and principal are jeopardized when a borrower encounters financial
difficulties. This asymmetric relation of a creditor’s risk and return has a major
impact on the creditor’s perspective, including the manner and objectives of
credit analysis.
Credit analysis is the evaluation of the creditworthiness of a company.
Creditworthiness is the ability of a company to pay its obligations.
Accordingly, the main focus of credit analysis is on risk, not
profitability. Variability in profits, especially the sensitivity of profits to
downturns in business, is more important than profit levels. Profit levels
are important only to the extent they reflect the margin of safety for a
company in meeting its obligations. Credit analysis focuses on
downside risk instead of upside potential. This includes analysis of both
liquidity and solvency.
Liquidity is a company’s ability to raise cash in the short term to meet
its obligations. Liquidity depends on a company’s cash flows and the
makeup of its current assets and current liabilities.
Solvency is a company’s long run viability and ability to pay long-term
obligations. It depends on both a company’s long-term profitability and
its capital (financing) structure.
b. Equity Analysis
Equity investors provide funds to a company in return for the risks
and rewards of ownership. Equity investors are major providers of
company financing. Equity financing, also called equity or share
capital, offers a cushion or safeguard for all other forms of financing
that are senior to it. This means equity investors are entitled to the
distributions of a company’s assets only after the claims of all other
senior claimants are met, including interest and preferred dividends. As
a result, equity investors are said to hold a residual interest. This
implies equity investors are the first to absorb losses when a
company liquidates, although their losses are usually limited to the
amount invested. However, when a company prospers, equity
investors share in the gains with unlimited upside potential. Because
equity investors are affected by all aspects of a company’s financial
condition and performance, their analysis needs are among the most
demanding and comprehensive of all users.
Individuals who apply active investment strategies primarily use
technical analysis, fundamental analysis, or a combination. Technical
analysis, or charting, searches for patterns in the price or volume
history of a stock to predict future price movements.
Fundamental analysis, which is more widely accepted and applied, is
the process of determining the value of a company by analyzing and
interpreting key factors for the economy, the industry, and the
company. A main part of fundamental analysis is evaluation of a
company’s financial position and performance. A major goal of
fundamental analysis is to determine intrinsic value, also called
fundamental value. Intrinsic value is the value of a company (or its
stock) determined through fundamental analysis without reference to
its market value (or stock price).
An investor’s strategy with fundamental analysis is straightforward: buy
when a stock’s intrinsic value exceeds its market value, sell when a
stock’s market value exceeds its intrinsic value, and hold when a
stock’s intrinsic value approximates its market value.
b. Accounting Analysis
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.
Financial statements are the primary source of information for financial
analysis. This means the quality of financial analysis depends on the
reliability of financial statements that in turn depends on the quality of
accounting analysis. Accounting analysis is especially important for
comparative analysis.
Comparability problems arise when different companies adopt
different accounting for similar transactions or events. Comparability
problems also arise when a company changes its accounting across
time, leading to difficulties with temporal comparability. Second,
discretion and imprecision in accounting can distort financial statement
information.
Accounting distortions are deviations of accounting information from
the underlying economics. These distortions occur in at least three
forms.
o Managerial estimates can be subject to honest errors or
omissions. This estimation error is a major cause of accounting
distortions.
o Managers might use their discretion in accounting to
manipulate or window-dress financial statements. This
earnings management can cause accounting distortions.
o Accounting standards can give rise to accounting distortions
from a failure to capture economic reality.
These three types of accounting distortions create accounting
risk in financial statement analysis.
Accounting risk is the uncertainty in financial statement analysis due
to accounting distortions. A major goal of accounting analysis is to
evaluate and reduce accounting risk and to improve the economic
content of financial statements, including their comparability.
Accounting analysis also includes evaluation of earnings
persistence, sometimes called sustainable earning power.
Accounting analysis is often the least understood, appreciated, and
effectively applied process in business analysis. Part of the reason
might be that accounting analysis requires accounting knowledge.
Analysts that lack this knowledge have a tendency to brush accounting
analysis under the rug and take financial statements as reported. This
is a dangerous practice because accounting analysis is crucial to any
successful business or financial analysis.
c. Financial Analysis
Financial analysis is the use of financial statements to analyze a
company’s financial position and performance, and to assess future
financial performance. Several questions can help focus financial
analysis.
For example:
Does a company have the resources to succeed and
grow?
Does it have resources to invest in new projects?
What are its sources of profitability?
What is the company’s future earning power?
How strong is the company’s financial position?
How profitable is the company?
Did earnings meet analyst forecasts?
Financial analysis consists of three broad areas—profitability analysis,
risk analysis, and analysis of sources and uses of funds.
1. Profitability analysis is the evaluation of a company’s return on
investment. It focuses on a company’s sources and levels of
profits and involves identifying and measuring the impact of
various profitability drivers. It also includes evaluation of the two
major sources of profitability—margins (the portion of sales not
offset by costs) and turnover (capital utilization). Profitability
analysis also focuses on reasons for changes in profitability and the
sustainability of earnings.
2. Risk analysis is the evaluation of a company’s ability to meet its
commitments. Risk analysis involves assessing the solvency and
liquidity of a company along with its earnings variability. Because
risk is of foremost concern to creditors, risk analysis is often
discussed in the context of credit analysis. Still, risk analysis is
important to equity analysis, both to evaluate the reliability and
sustainability of company performance and to estimate a company’s
cost of capital.
3. Analysis of cash flows is the evaluation of how a company is
obtaining and deploying its funds. This analysis provides insights
into a company’s future financing implications.
For example, a company that funds new projects from
internally generated cash (profits) is likely to achieve
better future performance than a company that either
borrows heavily to finance its projects or, worse, borrows
to meet current losses.
d. Prospective Analysis
Prospective analysis is the forecasting of future payoffs—typically earnings,
cash flows, or both. This analysis draws on accounting analysis, financial analysis,
and business environment and strategy analysis. The output of prospective
analysis is a set of expected future payoffs used to estimate company value.
While quantitative tools help improve forecast accuracy, prospective analysis
remains a relatively subjective process. This is why prospective analysis is
sometimes referred to as an art, not a science. Still, there are many tools we can
draw on to help enhance this analysis.
e. Valuation
Valuation is a main objective of many types of business analysis. Valuation
refers to the process of converting forecasts of future payoffs into an estimate
of company value. To determine company value, an analyst must select a valuation
model and must also estimate the company’s cost of capital. While most valuation
models require forecasts of future payoffs, there are certain ad hoc approaches that
use current financial information.
REFERENCES
Subramanyam, K.R. & Wild, J.J. (2009). Financial Statement Analysis (10th ed.).
McGraw-Hill/Irwin.
https://madnanarshad.files.wordpress.com/2014/02/fsa- by-john-j-wild-
10th-wdition.pdf
Easton, P.D., McAnally, M.L, Sommers, G.A., & Xiao, J.Z. (2018). Financial
Statement Analysis and Valuation (5th ed.). Cambridge Business
Publishers, LLC. https://www.scribd.com/document/389680583/Financial-
Statement-Analysis-and-Valuation-5th-pdf
Anastacio, M.L., Dacanay, R.C. & Aliling, L.E. (2016). Fundamentals of Financial
Management. Rex Book Store Inc.