Financial Statements Analysis

The Basics

William F. Messier, Jr.

SDA BOCCONI
MBA 29
 Learning Objectives
After studying this chapter, you should be
able to:
◆ Locate and use the many sources of information
about company performance.
◆ Analyze the components of a company using
trend analysis and other techniques.
 Sources of Information
About Companies
◆ Financial statement analysis - using financial
statements to assess a company’s performance
◆ Information about publicly traded companies
comes in many forms and may be found in many
places.
• Annual reports
• SEC filings and databases
• Company press releases
• Articles that appear in the financial press
 Sources of Information
About Companies
◆ The annual report is important to investors
because of its completeness and its reliability due
to the audit performed by an independent auditor.
• The annual report includes:
– Financial statements
– Footnotes to the financial statements
– A summary of accounting principles used
– Management’s discussion and analysis of the financial results
– The auditor’s report
– Comparative financial data for a series of years
– Narrative information about the company
 Sources of Information
About Companies
◆ Publicly traded companies must also prepare
reports for the government agencies (e.g.,
Securities and Exchange Commission - SEC).
• Form 10-K - presents financial statement data in
greater detail than the financial statements in annual
reports
• Form 10-Q - includes quarterly financial statements
that provide more timely but less complete
information than annual reports
 Sources of Information
About Companies
◆ Company press releases provide the basis for
articles in the financial press such as The Wall
Street Journal (Europe/Asia), Financial Times,
and other business magazines.
◆ Services such as Value Line, Moody’s Investors
Services, Standard and Poor’s Industrial Surveys,
and Dun & Bradstreet provide useful information
to investors.
 Sources of Information
About Companies
◆ The Internet is changing the way that people
make investments.
• Many investors now buy and sell securities without
the help of a broker.
• Much of the market information is available
electronically, usually for free from various sources.
• Visit the web sites of Pirelli, Recordati, or Luxottica
and note how much information is shown in various
places – investor relations.
 Financial Statement Analysis

Applying analytical techniques to financial

statements and other relevant data to produce
information useful for decision making.
 Some Features Of
Financial Statement Analysis
◆ Not simply a probing for more detail
◆ More appropriately described as a process of

• Synthesis
• Summarization
• Study of relationships
• Comparative analyses
 Objectives of Financial
Statement Analysis
◆ Although different investors demand different
returns, they all use financial statement analysis
for common reasons.
• To predict their expected returns
• To assess the risks associated with those returns

◆ Financial statement analysis focuses on past

performance to predict future performance.
 Objectives of Financial
Statement Analysis
◆ Creditors want to know about short-term liquidity
and long-term solvency.
• Short-term liquidity - an organization’s ability to meet
current payments as they become due
• Long-term solvency - an organization’s ability to
generate enough cash to repay long-term debts as they
mature
 Objectives of Financial
Statement Analysis
◆ Equity investors are more concerned with returns
in the form of dividends and increased market
price of the stock.
• These investors are naturally more interested in
profitability.
• Profits spur both dividends and increased stock prices.
 Evaluating Trends and
Components of the Business
◆ Evaluating trends and components of a business
are two ways of looking at financial information.
• Trend analysis involves comparing financial trends
from one year to another.
• Evaluating components of a business can be done in
more than one way.
– Relationships among elements of the financial statements
may be examined.
– Components may also be thought of as separate business
units or segments. These components may be examined.
 Trend Analysis
◆ Trends are predictable patterns that have been
observed in the past and are expected to continue
into the future.
• A pattern must be identified, and expectations of
whether the trend will continue must be formed.
• Trends can be shown as changes in amounts from year
to year or as percentage changes from year to year.
 Trend Analysis
◆ The euro amount of the change is simply the
current year minus the previous year.
◆ The percentage change is computed as follows:

Amount of change
% Change = ×100
Prior year amount
 Trend Analysis
STELLAR CORPORATION
Income Statements
for the Years Ended December 31, 2002 and 2001

Increase % Increase
2002 2001 (Decrease) (Decrease)

Sales €98,600 €89,500 €9,100 10.2%

Expenses:
Wages expense 45,800 42,900 2,900 6.8
Rent expense 12,000 12,000 0 0.0
Utilities expense 6,500 6,450 50 0.8
Depreciation expense 5,000 5,900 (900) (15.3)
Total expenses 69,300 67,250 2,050 3.0
Net Income €29,300 €22,250 €7,050 31.7
============= ============= ===========
 Trend Analysis
◆ Changes in euro amounts and percentage terms
help to expose patterns.
• Understanding these patterns is most important.
• The answers to why items changed tell a lot about
how a company is run, how it will perform in the
future, and whether or not it would be a good
investment.

◆ Analysts generally look at several years’ worth of

financial information to discover trends.
 Common-Size Statements
◆ Common-size statements - financial statements
expressed in component percentages
• The income statement is expressed as a percentage of
sales.
– This makes it easy to compare percentages to those of other
companies because percentages are a common index.
• The balance sheet is expressed as a percentage of total
assets.
– This is often referred to as component percentages because
they measure each component as a percentage of the total.
 Common-Size Statements
◆ For the income statement, sales is set at 100%
and each other element is expressed as a
percentage of the sales figure.
◆ For the balance sheet, the total assets amount is
set at 100%, and each other element is expressed
as a percentage of the total assets figure.
 Common-Size Statements
STELLAR CORPORATION
Income Statements
for the Years Ended December 31, 2002 and 2001

2002 2001
Sales € 98,600 100% € 89,500 100%
Expenses
Wages expense 45,800 46% 42,900 48%
Rent expense 12,000 12% 12,000 13%
Utilities expense 6,500 7% 6,450 7%
Depreciation expense 5,000 5% 5,900 7%
Total expenses 69,300 70% 67,250 75%
Net income € 29,300 30% € 22,250 25%
 Management’s Discussion
and Analysis
◆ Management’s discussion and analysis - a
required section of the annual report that
concentrates on explaining the major changes in
the income statement, liquidity, and capital
resources
• Management’s discussion often
includes a discussion of trends and
analysis of components.
 Segment Reporting
◆ Many large companies are involved in more than
one type of business activity or market.
• Each individual type of business activity or market
may be considered a segment.

◆ The FASB requires information on a business

segment to be reported based on the way it is
reported to management.
• The information is reported consistent with the way
the company manages the business.
 Segment Reporting
◆ When analyzing segment data, two things should
be considered.
• Evaluating segment data forces us to ask important
questions that help us to truly understand the business.
• Truly understanding the business means not only
understanding what is sold and how much is made but
also interpreting how financial reports summarize
dynamic changes in the business.
 Prominence of
Earnings Per Share
◆ Earnings per share is a basic reporting element in
the financial statements.
◆ Some issues tend to complicate the calculation of
earnings per share.
• Use of a weighted-average number of shares of
common stock
• Outstanding shares of nonconvertible preferred stock
• Changes in capitalization structure such as stock splits
and stock dividends
 Weighted-Average Shares and
Preferred Stock
◆ If all shares outstanding are common shares, the
biggest complication is the use of a weighted-
average number of shares of common stock.
◆ The following formula is used in this case.

Earning per share = Net income

of common stock Weighted - average number of shares
 Weighted-Average Shares
and Preferred Stock
◆ Earnings per share is calculated as net income
divided by weighted-average number of shares
outstanding during the period.
• The weighted-average number of shares is based on
the number of months that the shares were
outstanding during the year.
 Weighted-Average Shares
and Preferred Stock
Online, Inc., has 750,000 shares of common
stock outstanding at the beginning of the calendar
year, and 200,000 additional shares were issued
on October 1. What is the weighted-average
number of shares outstanding during the year?
 Weighted-Average Shares
and Preferred Stock
The weighted-average number of shares is
computed as follows:
750,000 x weighting of 12/12 = 750,000
200,000 x weighting of 3/12 = 50,000
800,000
=================

OR
750,000 x 9/12 = 562,500
950,000 x 3/12 = 237,500
800,000
=================
 Weighted-Average Shares
and Preferred Stock
◆ Another complication arises if there are shares of
nonconvertible preferred stock outstanding.
• The dividends on preferred stock for the current
period, whether or not paid, should be deducted in
calculating EPS because those dividends are not
available to be paid to common shareholders.

Earning per share Net income - Preferred dividends

=
of common stock Weighted - average number of shares
 Basic and Diluted EPS
◆ When a company has convertible securities, stock
options outstanding, or other financial
instruments that can be converted to common
shares, the calculation of EPS becomes even
more complicated.
• When convertible securities exist, EPS is calculated
using the assumption that any and all convertible
shares are turned into common stock at the beginning
of the period.
 Basic and Diluted EPS
◆ The presence of convertible securities increases
the number of common shares to the highest
possible number considering the convertible
securities and stock options outstanding.
• If the number or shares outstanding is increased,
earnings per share is decreased.
• These convertible securities are said to dilute (reduce)
earnings per share.
 Disclosure of
Nonrecurring Items
◆ Financial statement analysis focuses on normal
recurring items of the financial statements, not
nonrecurring items.
◆ Four major categories of nonrecurring items:
• Special items
• Extraordinary items
• Discontinued operations
• Accounting changes
 Special Items
◆ Special items - expenses that are large enough
and unusual enough to warrant separate
disclosure
• Companies generally have flexibility in deciding
when to treat something as a special item.
• Special items appear as separate line items among
operating expenses on the income statement.
• Any necessary discussion must be included in the
footnotes to the financial statements.
 Extraordinary Items
◆ Extraordinary items - items that are unusual in
nature and infrequent in occurrence that are
shown separately, net of tax, in the income
statement
• Unusual in nature means that an item is different from
the typical or normal operating activities of a
business.
• Infrequent in occurrence means that an event should
not be expected to recur often.
 Discontinued Operations
◆ Discontinued operations - the termination
(closing or sale) of a business segment reported
separately, net of tax, in the income statement
• Any gain or loss from the actual disposal of the
segment must be disclosed along with the results of
operations (income or loss) for that segment during
the period before the disposal.
 Accounting Changes
◆ Accounting changes occur when the standard
setters require a new way of accounting for a
particular item.
• For example, when the IASB changes its rules, it
often requires a major one-time recognition (revenue
or expense).
• Accounting changes are shown separately and are
shown net of tax.
 Income Statement Presentation
◆ The presentation of nonrecurring items on the
income statement is as follows:
Income from continuing operations before income taxes
Deduct income taxes
Income from continuing operations
Discontinued operations, net of tax
Income before extraordinary items
Extraordinary items, net of tax
Income before cumulative effect of an accounting change
Cumulative effect of an accounting change, net of tax
Net income
 International Considerations
◆ Financial statement analysis may be complicated
by several factors when companies carry on
operations in different countries.
• Differences in accounting methods
• Language in which the results are reported
• Currency in which results are reported
• Different securities markets, tax structures, and local
customs
 Price-Earnings Ratios
and Growth
◆ The P-E ratio is helpful for relating the price of a
stock to the earnings it is generating.
• Value investors look for stocks with low P-E ratios
because they feel these stocks are undervalued.
• Growth investors feel that stocks with high P-E ratios
are likely to be high growth stocks.
– The price is high because investors see strong growth
ahead.
 Price-Earnings Ratios
and Growth
◆ One way to relate P-E ratios to growth is the
price-earnings growth (PEG) ratio.
• It is a tool to help focus attention on certain stocks
and to help moderate knee-jerk reactions to other
ratios.

Price-earnings P-E ratio

=
growth ratio Earnings growth rate
 Always Remember When
Reading Financial Statements
◆ The statements are one possible interpretation of
the financial situation of the company
◆ That interpretation was decided by management
◆ Always consider how reasonable you believe the
given interpretation to be
◆ Remember the notion of Conservative vs.
Favorable Accounting
Financial Statements Analysis
The Basics

ANY QUESTIONS?