I. Overview of Financial Statement Analysis

OVERVIEW OF FINANCIAL STATEMENT ANALYSIS
COURSE OUTCOMES:
 Discuss the purpose of financial analysis and reporting to assess business performance and financial
health of an organization in order to forecast future business activities and value of a firm.
 Apply financial statement analysis tools and techniques to generate financial data.
 analyze and interpret financial data and relevant information taken from financial statements
necessary to make important business decisions.
Business Analysis
is the evaluation of a company’s prospects and risks for the purpose of making business
decisions based on financial statements.
These business decisions extend to equity and debt valuation, credit risk assessment,
earnings predictions, audit testing, compensation negotiations, and countless other decisions.
Aids in making informed decisions by helping structure the decision task through an
evaluation of a company’s business environment, its strategies, and its financial position and
performance.
Colgate’s strengths are the popularity of its brands and the highly diversified nature of its
operations. These strengths, together with the static nature of demand for consumer products,
give rise to Colgate’s financial stability, thereby reducing risk for its equity and debt investors.
For example, Colgate’s stock price weathered the bear market of 2008–2009, when the S&P
500 shed half its value (see Exhibit 1.2). The static nature of demand in the consumer products
markets, however, is a double-edged sword: while reducing sales volatility, it also fosters
fierce competition for market share. Colgate has been able to thrive in this competitive
environment by following a carefully defined business strategy that develops and increases
market leadership positions in certain key product categories and markets that are consistent
with the company’s core strengths and competencies and through relentless innovation.
For example, equity investors desire answers to the following types of questions before deciding to buy, hold,
or sell Colgate stock:
 What are Colgate’s future business prospects? Are Colgate’s markets expected to grow? What are Colgate’s
competitive strengths and weaknesses? What strategic initiatives has Colgate taken, or does it plan to take,
in response to business opportunities and threats?
 What is Colgate’s earnings potential? What is its recent earnings performance? How sustainable are current
earnings? What are the “drivers” of Colgate’s profitability? What estimates can be made about earnings
growth?
 What is Colgate’s current financial condition? What risks and rewards does Colgate’s financing structure
portray? Are Colgate’s earnings vulnerable to variability? Does Colgate possess the financial strength to
overcome a period of poor profitability?
 How does Colgate compare with its competitors, both domestically and globally?
 What is a reasonable price for Colgate’s stock?
Creditors and lenders also desire answers to important questions before entering into lending
agreements with Colgate. Their questions include the following:
 What are Colgate’s business plans and prospects? What are Colgate’s needs for future
financing?
 What are Colgate’s likely sources for payment of interest and principal? How much cushion
does Colgate have in its earnings and cash flows to pay interest and principal?
 What is the likelihood Colgate will be unable to meet its financial obligations? How volatile
are Colgate’s earnings and cash flows? Does Colgate have the finan-cial strength to pay its
commitments in a period of poor profitability?
Answers to these and other questions about company prospects and risks require
analysis of both qualitative information about a company’s business plans and
quantitative information about its financial position and performance. Proper
analysis and interpretation of information is crucial to good business analysis.
This is the role of financial statement analysis. Through it, an analyst will better
understand and interpret both qualitative and quantitative financial information so
that reliable inferences are drawn about company prospects and risks.
Types of Business Analysis

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. Trade creditors do not usually receive (explicit)
interest for an extension of credit. Instead, trade creditors earn a return from the profit margins on the business
transacted.
 Nontrade creditors (or debtholders) provide financing to a company in return for a promise, usually in
writing, of repayment with interest (explicit or implicit) on specific future dates. This type of financing can be
either short or long term and arises in a variety of transactions.
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.
 Equity analysis is symmetric in that it must assess both downside risks and 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.
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).
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.
Other Uses of Business Analysis. Business analysis and financial statement analysis are important in a
number of other contexts.
 Managers. Analysis of financial statements can provide managers with clues to strategic changes in
operating, investing, and financing activities. Managers also analyze the businesses and financial
statements of competing companies to evaluate a competitor’s profitability and risk. Such analysis
allows for interfirm comparisons, both to evaluate relative strengths and weaknesses and to benchmark
performance.
 Mergers, acquisitions, and divestitures. Business analysis is performed when-ever a company
restructures its operations, through mergers, acquisitions, divestitures, and spin-offs. Investment bankers
need to identify potential targets and determine their values, and security analysts need to determine
whether and how much additional value is created by the merger for both the acquiring and the target
companies.
 Financial management. Managers must evaluate the impact of financing decisions and dividend policy
on company value. Business analysis helps assess the impact of financing decisions on both future
Other Uses of Business Analysis. Business analysis and financial statement analysis are important in
a number of other contexts.
 Directors. As elected representatives of the shareholders, directors are responsi-ble for protecting
the shareholders’ interests by vigilantly overseeing the company’s activities. Both business
analysis and financial statement analysis aid directors in fulfilling their oversight responsibilities.
 Regulators. The Internal Revenue Service applies tools of financial statement analysis to audit tax
returns and check the reasonableness of reported amounts.
 Labor unions. Techniques of financial statement analysis are useful to labor unions in collective
bargaining negotiations.
 Customers. Analysis techniques are used to determine the profitability (or staying power) of
suppliers along with estimating the suppliers’ profits from their mutual transactions.
Business analysis encompasses several interrelated processes. Exhibit 1.4 identifies these
processes in the context of estimating company value—one of the many important ap-
plications of business analysis. Company value, or intrinsic value, is estimated using a
valuation model.
 Inputs to the valuation model include estimates of future payoffs (prospective cash flows or
earnings) and the cost of capital.
 The process of forecasting future payoffs is called prospective analysis. To accurately
forecast future payoffs, it is important to evaluate both the company’s business prospects
and its financial statements.
 Evaluation of business prospects is a major goal of business environment and strategy
analysis.
A company’s financial status is assessed from its financial statements using financial analysis.
In turn, the quality of financial analysis depends on the reliability and economic content of the
financial statements. This requires accounting analysis of financial statements. Financial
statement analysis involves all of these component processes—
 Accounting analysis,
 Financial analysis, and
 Prospective analysis.
Business Environment and Strategy Analysis
 Analysis of a company’s future prospects is one of the most important aims of business
analysis.
 It also is a subjective and complex task.
 To effectively accomplish this task we must adopt an interdisciplinary perspective. This
includes attention to analysis of the business environment and strategy.
 Analysis of the business environment seeks to identify and assess a company’s economic
and industry circumstances. This includes analysis of its product, labor, and capital
markets within its economic and regulatory setting. Analysis of business strategy seeks to
identify and assess a company’s competitive strengths and weaknesses along with its
opportunities and threats.
Consists of two parts—industry analysis and strategy analysis.
 Industry analysis is the usual first step since the prospects and structure of its
industry largely drive a company’s profitability. Industry analysis is often done
using the framework proposed by Porter (1980, 1985) or value chain analysis.
Under this framework, an industry is viewed as a collection of competitors that
jockey for bargaining power with consumers and suppliers and that actively
compete among themselves and face threats from new entrants and substitute
products. Industry analysis must assess both the industry prospects and the
degree of actual and potential competition facing a company.

Consists of two parts—industry analysis and strategy analysis.
 Strategy analysis is the evaluation of both a company’s business decisions and
its success at establishing a competitive advantage. This includes assessing a
company’s expected strategic responses to its business environment and the
impact of these responses on its future success and growth. Strategy analysis
requires scrutiny of a company’s competitive strategy for its product mix and
cost structure.
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.
ACCOUNTING ANALYSIS
These accounting limitations affect the usefulness of financial statements and can
yield at least two problems in analysis.
First, lack of uniformity in accounting leads to comparability problems.
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.
ACCOUNTING ANALYSIS
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.
 (1) Managerial estimates can be subject to honest errors or omissions. This estimation
error is a major cause of accounting distortions.
 (2) Managers might use their discretion in accounting to manipulate or window-dress
financial statements. This earnings management can cause accounting distortions.
 (3) Accounting standards can give rise to accounting distortions from a failure to
capture economic reality.
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. One set of questions is future
oriented. For example,
 Does a company have the resources to succeed and grow?
 Does it have resources to in-vest in new projects?
 What are its sources of profitability?
 What is the company’s future earning power?
FINANCIAL ANALYSIS
A second set involves questions that assess a company’s track record and its
ability to deliver on expected financial performance. For example,
 How strong is the company’s financial position?
 How profitable is the company?
 Did earnings meet analyst forecasts? This includes an analysis of why a
company might have fallen short of (or exceeded) expectations.
FINANCIAL ANALYSIS
Financial analysis consists of three broad areas—
 Profitability analysis,
 Risk analysis, and
 Analysis of sources and uses of funds.
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).
 it focuses on reasons for changes in profitability and the sustainability of earnings.
FINANCIAL ANALYSIS
Risk analysis is the evaluation of a company’s ability to meet its commitments.
 involves assessing the solvency and liquidity of a company along with its earnings variability.
Because risk is of foremost concern to creditors in the context of credit 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.
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.
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.
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.
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.
Financial Statement- Basis of Analysis

A company pursues a number of activities in a desire to provide a salable product or service
and to yield a satisfactory return on investment. Its financial statements and related disclosures
inform us about the four major activities of the company:
 planning,
 financing,
 investing, and
 operating.
Planning Activities
A company exists to implement specific goals and objectives. For example, Colgate aspires to remain a
powerful force in oral, personal, and home care products. A company’s goals and objectives are captured
in a business plan that describes the company’s purpose, strategy, and tactics for its activities.
A business plan assists managers in focusing their efforts and identifying expected opportunities and
obstacles. Insight into the business plan considerably aids our analysis of a company’s current and future
prospects and is part of the analysis of business environment and strategy. We look for information on
company objectives and tactics, market demands, competitive analysis, sales strategies (pricing,
promotion, distribution), management performance, and financial projections. Information of this type, in
varying forms, is often revealed in financial statements. It is also available through less formal means
such as press releases, industry publications, analysts’ newsletters, and the financial press.
Financing Activities
A company requires financing to carry out its business plan. Colgate needs
financing for purchasing raw materials for production, paying its employees,
implementing marketing campaigns, and research and development.
Financing activities refer to methods that companies use to raise the money to
pay for these needs. Because of their magnitude and their potential for
determining the success or failure of a venture, companies take care in acquiring
and managing financial resources.
Financing Activities
There are two main sources of external financing—
 equity investors (also called owners or shareholders) and
 creditors (lenders).
Decisions concerning the composition of financing activities depend on
conditions existing in financial markets. Financial markets are potential sources
of financing. In looking to financial markets, a company considers several issues,
including the amount of financing necessary, sources of financing of financing
agreements.
Investing Activities
Investing activities refer to a company’s acquisition and maintenance of
investments for purposes of selling products and providing services, and for the
purpose of investing excess cash. Investments in land, buildings, equipment, legal
rights (patents, licenses, copyrights), inventories, human capital (managers and
employees), information systems, and similar assets are for the purpose of
conducting the company’s business operations. Such assets are called operating
assets.
Investing Activities
Also, companies often temporarily or permanently invest excess cash in securities such as other
companies’ equity stock, corporate and government bonds, and money market funds. Such
assets are called financial assets.
Operating Activities
Operating activities represent the “carrying out” of the business plan given its financing and
investing activities. Operating activities involve at least five possible components: research and
development, procurement, production, marketing, and administration. Operating activities are
a company’s primary source of earnings. Earnings reflect a company’s success in buying from
input markets and selling in output markets.
Financial Statements Reflect Business Activities

At the end of a period—typically a quarter or a year—financial statements are prepared to
report on financing and investing activities at that point in time, and to summarize operating
activities for the preceding period. This is the role of financial statements and the object of
analysis. It is important to recognize that financial statements report on financing and investing
activities at a point in time, whereas they report on operating activities for a period of time.
Balance Sheet
The accounting equation (also called the balance sheet identity) is the basis of the accounting system:
Assets, Liabilities, and Equity. The left-hand side of this equation relates to the resources controlled by
a company, or assets. While the right-hand side of the equation relates to the sources of resources
controlled by a company (assets).
Assets are resources invested that are expected to generate future earnings through operating activities.
Liabilities are funding from creditors and represent obligations of a company or, alternatively, claims
of creditors on assets.
Equity (or shareholders’ equity) is the total of (1) funding invested or contributed by owners
(contributed capital) and (2) accumulated earnings in excess of distributions to owners (retained
earnings) since inception of the company.
Balance Sheet
Income Statement
An income statement measures a company’s financial performance over a period of time,
typically a year or a quarter. It is a financial representation of the operating activities of a
company during the period. Typically, the bottom line is net income, which purports to
measure the amount that the company earned during the period. The line items of the income
statement provide details of revenues, expenses, gains, and losses in a bid to explain how a
company earned its net income.
In addition to signaling earning power, income is also supposed to measure the net change in
shareholder’s equity during a period from nonowner sources—that is, before considering
distributions to and contributions from equity holders.
Income Statement
The measure of income that serves this role is called comprehensive income and is reported by
most companies in its statement of shareholders’ equity. Income statements often include
several other interim measures of income.
Income from continuing operations represents earnings from continuing operations before the
provision for income tax.
Operating earnings does not have a fixed definition, but refers to the difference between sales
revenues and all operating expenses.
Gross profit (or gross margin) is the difference between sales and cost of goods sold, and
measures the ability of a company to cover its product costs.
Income Statement
Statement of Changes in Shareholders’ Equity

The statements of retained earnings, comprehensive income, and changes in capital accounts
are often called the statements of changes in shareholders’ equity. This statement is useful in
identifying reasons for changes in equity holders’ claims on the assets of a company.
Statement of Cash Flows

Earnings do not typically equal net cash flows, except over the life of a company. Because
accrual accounting yields numbers different from cash flow accounting, and we know that cash
flows are important in business decisions, there is a need for reporting on cash inflows and
outflows.
Statement of Cash Flows
FINANCIAL STATEMENT ANALYSIS

Analysis Tools. Five important sets of tools for financial analysis:
1. Comparative financial statement analysis
2. Common-size financial statement analysis
3. Ratio analysis
4. Cash flow analysis
5. Valuation
Comparative Financial Statement Analysis

Individuals conduct comparative financial statement analysis by reviewing
consecutive balance sheets, income statements, or statements of cash flows from
period to period. This usually involves a review of changes in individual account
balances on a year-to-year or multiyear basis. The most important information
often revealed from comparative financial statement analysis is trend.
Comparative Financial Statement Analysis

Common-Size Financial Statement Analysis
Financial statement analysis can benefit from knowing what proportion of a group or
subgroup is made up of a particular account. Specifically, in analyzing a balance sheet, it
is common to express total assets (or liabilities plus equity) as 100%. Then, accounts
within these groupings are expressed as a percentage of their respective total. In
analyzing an income statement, sales are often set at 100% with the remaining income
statement accounts expressed as a percentage of sales. Because the sum of individual
accounts within groups is 100%, this analysis is said to yield common-size financial
statements. This procedure also is called vertical analysis given the up-down (or down-
up) evaluation of accounts in common-size statements. Common-size financial statement
analysis is useful in understanding the internal makeup of financial statements.

Ratio Analysis
Ratio analysis is among the most popular and widely used tools of financial analysis. Yet its
role is often misunderstood and, consequently, its importance often overrated. A ratio expresses
a mathematical relation between two quantities. A ratio of 200 to 100 is expressed as 2:1, or
simply 2.
While computation of a ratio is a simple arithmetic operation, its interpretation is more
complex. To be meaningful, a ratio must refer to an economically important relation. For
example, there is a direct and crucial relation between an item’s sales price and its cost.
Accordingly, the ratio of cost of goods sold to sales is important. In contrast, there is no
obvious relation between freight costs and the balance of marketable securities. The example
in Illustration 1.14 highlights this point.
Ratio Analysis
Illustration of Ratio Analysis. We can compute numerous ratios using a company’s financial statements. Some
ratios have general application in financial analysis, while others are unique to specific circumstances or
industries. This section presents ratio analysis as applied to three important areas of financial statement
analysis:
1. Credit (Risk) Analysis
a. Liquidity. To evaluate the ability to meet short-term obligations.
b. Capital structure and solvency. To assess the ability to meet long-term obligations.
2. Profitability Analysis
a . Return on investment. To assess financial rewards to the suppliers of equity and debt financing.
b. Operating performance. To evaluate profit margins from operating activities.
c. Asset utilization. To assess effectiveness and intensity of assets in generating sales, also called turnover.
3. Valuation
a. To estimate the intrinsic value of a company (stock).
Credit Analysis. First, we focus on liquidity. Liquidity refers to the ability of an enterprise to meet its short-
term financial obligations. An important liquidity ratio is the current ratio, which measures current assets available
to satisfy current liabilities. Colgate’s current ratio of 1.18 implies that there are 118 cents of current assets
available to meet each $1 of currently maturing obligations. A more stringent test of short-term liquidity, based on
the acid-test ratio, uses only the most liquid current assets: cash, short-term investments, and accounts receivable.
Colgate has 69 cents of such liquid assets to cover each $1 of current liabilities. The acid-test ratio suggests that
Colgate’s liquidity situation is cause for concern. Still, we need more information to draw definite conclusions
about liquidity. The length of time needed for conversion of receivables and inventories to cash also provides
useful information regarding liquidity. Colgate’s collection period for receivables is approximately 35 days, and its
days to sell inventory is 64. Neither of these indicates any liquidity problems. However, these measures are more
useful when compared over time (i.e., changes in these measures are more informative about liquidity problems
than levels). Overall, our brief analysis of liquidity suggests that while Colgate’s composition of current assets and
current liabilities indicate only moderate liquidity, its receivables and inventory peri-ods coupled with its excellent
cash flow from operations (see later discussion) indicate that there is not much cause for concern.
Analysis of Solvency. Solvency refers to the ability of an enterprise to meet its long-term financial
obligations. To assess Colgate’s long-term financing structure and credit risk, we examine its capital
structure and solvency. Its total debt-to-equity ratio of 4.01 indicates that for each $1 of equity
financing, $4.01 of financing is provided by creditors. Its long-term debt-to-equity ratio is 2.55,
revealing $2.55 of long-term debt financing to each $1 of equity. Both these ratios are extremely high
for a manufacturing company; such high ratios are more typical for a financial institution! On their
own, they do raise concerns about Colgate’s ability to service its debt and remain solvent in the long
run. However, these ratios do not consider Colgate’s excellent profitability. Another ratio that also
considers profitability in addition to capital structure is the times interest earned ratio (or interest
coverage ratio), which is the ratio of a company’s earnings before interest to its interest payment.
Colgate’s 2011 earnings are 73.87 times its fixed (interest) commitments. This ratio indicates that
Colgate will have no problem meeting its fixed-charge commitments. In sum, given Colgate’s high
(and stable) profitability, its solvency risk is low.
Profitability Analysis. We begin by assessing different aspects of return on investment.
Colgate’s return on assets of 20.63% implies that a $1 asset investment generates 20.63 cents
of annual earnings prior to subtracting after-tax interest. Equity holders are especially
interested in management’s performance based on equity financing, so we also look at the
return on equity. Colgate’s return on common equity (or more commonly termed as return on
equity) of 45.37% suggests it earns 45.73 cents annually for each $1 of equity investment.
Both of these ratios are significantly higher than the average for publicly traded companies of
approximately 7% and 12%, respectively. Colgate’s return on equity, in particular, is probably
one of the highest among U.S. companies.
Another part of profitability analysis is evaluation of operating performance. This is done by
examining ratios that typically link income statement line items to sales. These ratios are often
referred to as profit margins, for example, gross profit margin (or more concisely gross
margin). These ratios are comparable to results from common-size income statement analysis.
The operating performance ratios for Colgate in Exhibit 1.14 reflect a remarkable operating
performance in the face of a highly competitive environ-ment and recent economic downturn.
Colgate’s gross profit margin of 57.31% reflects its inherent ability to sell well above its cost
of production, despite the intensely competitive consumer products’ markets. Its pre-tax
operating profit margin of 22.95% and net profit margin of 14.53% are well above average for
U.S. companies. In sum, Colgate’s pricing power and superior control of production costs
make it a very profitable company.
Asset utilization analysis is closely linked with profitability analysis. Asset utilization ratios,
which relate sales to different asset categories, are important determinants of return on
investment. These ratios for Colgate indicate above average performance. For example,
Colgate’s total asset turnover of 1.40 is higher than the average for all publicly traded
companies in the United States. Also Colgate’s working capital turnover is very large at 48.65,
because Colgate maintains a small investment in working capital relative to its sales. This
indicates that Colgate has not invested substantial amounts in working capital.
Cash Flow Analysis
Cash flow analysis is primarily used as a tool to evaluate the sources and uses of funds. Cash flow
analysis provides insights into how a company is obtaining its financing and deploying its resources. It
also is used in cash flow forecasting and as part of liquidity analysis.
Colgate’s statement of cash flows reproduced in Exhibit 1.8 is a useful starting point for cash flow
analysis. Colgate generated $2.896 billion from operating activities. It then used $1.213 billion for
investing activities, primarily for capital expenditure and payment for acquisitions. Colgate also paid
$4.429 billion for debt retirement, which it financed by issuing fresh debt to the tune of $5.843 billion.
The remaining cash flow was primarily re-turned to its shareholders, in the form of common dividends
($1.203 billion) and repurchase of common stock ($1.806 billion). Overall, Colgate’s financing
activities resulted in a net cash outflow to the tune of $1.242 billion. After accounting for foreign
currency ex-change rate fluctuations, Colgate’s cash position increased by $388 million during 2011.
Valuation Models
Valuation is an important outcome of many types of business and financial statement analysis. Valuation normally
refers to estimating the intrinsic value of a company or its stock. The basis of valuation is present value theory.
This theory states the value of a debt or equity security (or for that matter, any asset) is equal to the sum of all
expected future payoffs from the security that are discounted to the present at an appropriate discount rate.
Present value theory uses the concept of time value of money—it simply states an entity prefers present
consumption more than future consumption. Accordingly, to value a security an investor needs two pieces of
information: (1) expected future payoffs over the life of the security and (2) a discount rate.
For example, future payoffs from bonds are principal and interest payments. Future payoffs from stocks are
dividends and capital appreciation. The discount rate in the case of a bond is the prevailing interest rate (or more
precisely, the yield to maturity), while in the case of a stock it is the risk-adjusted cost of capital (also called the
expected rate of return).
Debt Valuation
The value of a security is equal to the present value of its future payoffs discounted at an
appropriate rate. The future payoffs from a debt security are its interest and principal
payments. A bond contract precisely specifies its future payoffs along with the investment
horizon. The value of a bond at time t, or Bt , is computed using the following formula:
where It n is the interest payment in period t n, F is the principal payment (usually the debt’s
face value), and r is the investor’s required interest rate, or yield to maturity. 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
Basis of Equity Valuation. The basis of equity valuation, like debt valuation, is the present
value of future payoffs discounted at an appropriate rate. Equity valuation, however, is more
complex than debt valuation. This is because, with a bond, the future payoffs are specified.
With equity, the investor has no claim on predetermined payoffs. Instead, the equity investor
looks for two main (uncertain) payoffs—dividend payments and capital appreciation. Capital
appreciation denotes change in equity value, which in turn is determined by future dividends,
so we can simplify this task to state that the value of an equity security at time t, or Vt , equals
the sum of the present values of all future expected dividends:
where Dt n is the dividend in period t n, and k is the cost of capital. This model is
called the dividend discount model. This equity valuation formula is in terms of
expected dividends rather than actual dividends. We use expectations instead of
actual dividends because, unlike interest and principal repayments in the case of a
bond, future dividends are neither specified nor determinable with certainty. This
means our analysis must use forecasts of future dividends to get an estimate of
value.
END OF OVERVIEW OF
FINANCIAL
STATEMENT ANALYSIS

I. Overview of Financial Statement Analysis

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OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

Types of Business Analysis

Credit analysis focuses on downside risk instead of upside potential. This

Investment strategies primarily use technical analysis, fundamental analysis, or a

Business Environment and Strategy Analysis

Financial Statement- Basis of Analysis

Financial Statements Reflect Business Activities

Statement of Changes in Shareholders’ Equity

Statement of Cash Flows

FINANCIAL STATEMENT ANALYSIS

Comparative Financial Statement Analysis

Comparative Financial Statement Analysis

Common-Size Financial Statement Analysis

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