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From Financial Statementto Business Analysis

Step 1: Business strategy analysis

Step 2: Accounting analysis

Step 3: Financial analysis

Step 4: Prospective analysis

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Financial & Accounting Analysis

Financial Statement

Financial AnalysisAccounting Analysis

Recasting Financial Statement: firms could adopt different classifications

Unbiased Accounting

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Accrual Accounting

Fundamental features of corporate financial reports

On the basis of expected cash receipt and payments

Recording of economic transactions

Not necessarily actual

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Income statement

ExpensesRevenues

realizationprinciple

economic resources

earned during used up in

a time period

economic resources

matching and conservatismprinciple

Profit = revenues - expenses

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Balance sheet

LiabilitiesAssets

economic resources owned by a firm economic obbligations arising from past benefit

Equity = assets - liabilities

future economic benefit

measurable with reasonable certainty

met with reasonable certainty

time reasonably well defined

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Delegation of reporting to management

Corporate managers

Benefits

intimate knowledge of firm’s businesses

management manipulation of accounting numbers

accounting discretion

Costs

preserved reduced

Accounting rules and auditing

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Accounting analysis

Evaluate the quality of disclosure

(4)

Identify key accounting policies

(1)

Assessaccounting flexibility

(2)

Evaluateaccounting strategy

(3)

Six steps to evaluatea firm’s accounting

quality

Identify potential red flags(5)

Undo accounting distortions

(6)

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Accounting analysis

How well the success factors and risks are being managed by the firm

•Bank: interest and credit risk management•Retail: inventory management•Pharmaceuticals: research and development•…

Identify key accounting policies

(1)

Business strategy analysis

Accounting measures

Business events

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Accounting analysis

•Expense or capitalize costs•Estimate expected defaults on loans•Estimate long-terms projects•Depreciation policy (straight.line or accelerated methods)•Inventory accounting policy (LIFO, FIFO, or average cost)•…

Assessaccounting flexibility

(2)

Trade Off

More flexibility

Less flexibility

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Accounting analysis

•How do the firm’s accounting policies compare to the norms in the industry?•Do managers face strong incentives to use accounting discretion to manage earnings? (tax policy)•What is the impact of the changes in policies? (warranty expenses)•Does the firm structure any significant business transactions so that it can achieve certain accounting objectives? (leasing firms)•…

Evaluateaccounting strategy

(3)

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Accounting analysis

•Does the company provide adequate disclosure to assess the firm’s business strategy and its economic consequences? (industry condition, competitive position, plans for the future)•Does the firm adequately explain its current performance? (financial notes)•Does the firm provide adequate additional disclosure to help outsiders understand how key success factors are being managed? (decrasing in profit)•If a firm is in multiple business segments, what is the quality of segment disclosure?•How forthcoming is the management with respect to bad news?•How good is the firm’s investor program?•…

Evaluate the quality of disclosure

(4)

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Accounting analysis

Certain items must be examined more closely•Unexplained changes in accounting, especially when performance is poor•Unexplained transaction that boost profits•Unusual increases in trade receivables in relation to sales increases•Unusual increases in inventories in relation to sales increases•An increasing gap between a firm’s reported profit and its cash flow from operations•An increasing gap between a firm’s reported profit anche its tax profit•Unexpected large asset write-offs•Large year-end adjustments•Qualified audit opinions or changes in independent auditors that are not well justified•Poor internal governance mechanisms•…

Identify potential red flags(5)

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Accounting analysis

•Restate numbers to reduce the distortion to the extent possible•Impossibility to perfectly undo the distortion using outside information alone•Use the cash flow statement and the notes to the financial statements•Use the tax notes•…

Undo accounting distortions

(6)

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Accounting analysis pitfalls

Potential pitfalls and common misconceptions

Conservative accountingis not the same as“good” accounting

Not all unusual accounting

is questionable

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Accounting analysis

The Airline Industry

Most airlines have frequent flyer programs that promise customers free flightsonce they have accumulated 25,000 miles of travel with the same airline.

How should these programs be reflected in the airlines’financial statements?

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Accounting analysis

Liabilities

economic obbligation arising from past benefit

met with reasonable certainty

time reasonably well defined

Promises that require future expenditure

ticket sales in the past

for example: 1.2 milion free trips

within 3 to 5 years after the revenue ticket sales are made

Balance sheet

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Accounting analysis

Expenses

cost associated

with benefit that are comsumed in this time period

matching concept

Free-trip tickets in the future

increase in revenue ticket sales

Income statement

Administrative cost Costs related to the flight Opportunity cost

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Implement accounting analysis

Accounting Analysis

Analyst

Undo distortions

Adjustments to the financial statement

Balance Sheet

Income Statement(revenue/expenses)

Process

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Implement accounting analysis

RECASTING FINANCIALSTATEMENT

DIFFERENCES

Nomenclature Classifications Formats

New Template Time-series & cross sectional comparison

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Implement accounting analysisDifferent format

IFRS: format for operating expenses

By nature By function

- Cost of materials

- Cost of personnel

- Cost of non currentassets

- Cost of sold

-SG&A (selling, General & Administrative)

Cause Purpose

Recast using Financial Notes