Lahore School of Lahore School of EconomicsEconomics

BBA IIIBBA IIISummer Term II-2010Summer Term II-2010

History & Balance Sheet AnalysisHistory & Balance Sheet Analysis

History & Balance History & Balance Sheet AnalysisSheet Analysis

Chap # 1Chap # 1

Overview of Financial Overview of Financial Statement AnalysisStatement Analysis

Overview of Financial Statement Analysis

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Users of Financial StatementsBusiness ActivitiesTypes of Financial Statements Information Accompanying financial StatementsFinancial Statement Analysis PreviewCapital Market Efficiency & its implications on

Financial Statement Analysis

Users of Financial Statements

Internal Users

External Users

Users of Financial Statements

Internal UsersManagement of the Company

External UsersCreditorsEquity InvestorsMerger & Acquisition AnalystRegulatory AgenciesSuppliers

Business Activities in a Market Economy

Planning Activities

Financing Activities

Investing Activities

Operating Activities

Business Activities – Planning ActivitiesA company’s goals & objectives are captured

in a business plan or strategy that describes a company’s purpose, strategy & tactics for activities

Shareholder’s letter

MD&A

Business Activities – Financing ActivitiesFinancing activities are the means

company use to pay for various ventures undertaken to carry out its business plan.

Equity FinancingEarnings DistributionEarnings re-investment

Credit FinancingImplicit FinancingExplicit Financing

Risks for investors

Business Activities – Investing ActivitiesInvesting activities are the acquisition &

maintenance of investments by companies to sell products or provide services.

Value of Investments always equals the value of Financing obtained.

Excess Financing?

Size of Investment Vs Company Success

Business Activities – Operating ActivitiesOperating Activities represent the “carrying

out” of the business plan given necessary investing & Financing.

Basic Components (RPPML)

Financial Statements & Business Activities

Types of Financial StatementsBalance Sheet

Income Statement

Statement of Shareholder’s Equity

Statement of Cash flows

Types of Financial Statements – Balance SheetAsset = Liabilities + Shareholder’s Equity

Balance Sheet summarizes financial position of a company at a given point in time.

Working Capital

Investing Activities = Financing Activities

Investments = Creditor Financing + Shareholder Financing

Types of Financial Statements – Income StatementAn income statement measures company’s

financial performance between balance sheet dates & Hence, reflects a period of time.

Net Income shows net worth of a company, before considering distributions to & contributions from shareholders.

Accrual Basis of Accounting

Types of Financial Statements – Statement of Shareholder’s EquityThe statement of shareholder's Equity

reports changes in component accounts comprising equity.

This statement is useful in identifying reasons for changes in shareholder’s claims on the assets of a company.

Individual Equity Account Balances change due to selling stock, Repurchase of stock, issuing stock & re-investing of Net Income.

Types of Financial Statements – Statement of Cash flowsUnder Accrual Accounting, net income does

not typically equal net cash flows except over the life of the firm.

The statement of cash flows details cash inflows & outflows related to a company’s operating, investing & Financing activities over a period of time.

Information accompanying Financial StatementsManagement’s Discussion & Analysis

(MD&A)Management ReportAuditor ReportExplanatory NotesSupplementary InformationSocial Responsibility ReportsProxy Statements

Information accompanying Financial Statements – MD&AThe MD&A section reviews a company’s

financial condition & results of operationsThey must also disclose prospective

information involving material events & uncertainties regarding future operations.

Qualitative informationForward looking informationRequired by Law

Information accompanying Financial Statements – Management ReportA management Report sets out the

responsibilities of management in preparing a company’s Financial Statements.

Purpose:1)To reinforce senior management’s

responsibilities for the company’s Financial & Internal controls.

2)To reinforce the shared role of management, directors & auditors in preparing Financial statements.

Information accompanying Financial Statements – Auditor ReportAn external auditor is an independent

certified public Accountant hired by management to assess weather the company’s Financial Statements are prepared in conformity with generally accepted Accounting Principles.

Types of Auditor Opinions:1) Unqualified opinion2) Qualified Opinion3) Adverse Opinion4) Disclaimer of opinion

Information accompanying Financial Statements – Explanatory NotesExplanatory Notes are a means of

communicating additional information regarding items included & excluded from the body of the statements.

Explanatory notes include information on:1) Accounting Principles & Methods2) Detailed disclosure regarding each account3) Commitments & contingencies4) Transactions with related parties5) Legal proceedings

Information accompanying Financial Statements – Supplementary InformationCertain supplemental schedules required by

accounting regulatory agencies appear in exhibits to Annual Reports filed with SEC.

Supplemental Schedules include information on:1) Business Segment Data2) Export Sales3) Marketable Securities4) Valuation Accounts5) Quarterly Financial Data

Information accompanying Financial Statements – Proxy StatementsA proxy is a mean whereby a shareholder

authorizes another person to act for him/her at a meeting of shareholder.

A proxy statement contains information necessary for shareholders in voting on matters for which the proxy is solicited.

Preview of Financial Statement AnalysisBuilding Blocks of AnalysisComparative Financial Statement Analysis

(Horizontal Analysis)Common Size Financial Statements (Vertical

Analysis)Ratio analysis of Financial Statements

Preview of Financial Statement Analysis – Building BlocksShort Term LiquidityFunds FlowCapital Structure & Long Term solvencyReturn on InvestmentAsset utilizationOperating Performance

Preview of Financial Statement Analysis – Comparative Financial Statement AnalysisFinancial Statement users conduct

comparative Financial Statement Analysis (Horizontal Analysis)by setting consecutive balance sheets, income statement & cash flow statement side by side & reviewing changes.

Two techniques:1) Year to year change analysis2) Index number trend series analysis

Comparative Financial Statement Analysis – Year to year change Analysis - Example

XYZ Company’s Income statement

Year 1 Year 2

Revenues 1000 1500

Cost of Revenues

450 650

Gross Profit

550 850

Operating Expense

300 300

Interest Expense

100 150

EBT 150 400

Taxes 52 140

Net Income

98 260

Comparative Financial Statement Analysis – Year to year change Analysis - Example

XYZ Company’s Income statement

Year 1 Year 2 Change ($) Change (%)

Revenues 1000 1500 500 50%

Cost of Revenues

450 650 200 44.44%

Gross Profit

550 850 300 54.54%

Operating Expense

300 300 0 0%

Interest Expense

100 150 50 50%

EBT 150 400 250 167%

Taxes 52 140 88 169%

Net Income

98 260 162 165%

Comparative Financial Statement Analysis – Year to year change Analysis - Example

XYZ Company’s Balance Sheet

Year 1 Year 2

Cash 2500 3000

Marketable Sec.

750 1000

A/R 450 850

Property 3500 3500

Total Assets 7200 8350

A/P 200 350

Short Term Loan

2400 2750

Common Stock

4000 4000

Retained Earnings

600 1250

TL & Equity 7200 8350

Comparative Financial Statement Analysis – Year to year change Analysis - Example

XYZ Company’s Balance Sheet

Year 1 Year 2 Change ($) Change (%)

Cash 2500 3000 500 20%

MKT Sec 750 1000 250 33.33%

A/R 450 850 400 88.89%

Property 3500 3500 Zero Zero

Total Assets

7200 8350 1150 15.97%

A/P 200 350 150 75%

S. Term Loan

2400 2750 350 14.58%

C.S 4000 4000 Zero Zero

RE 600 1250 650 108%

TL & Equity

7200 8350 1150 15.97%

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example

Year 1 Year 2 Year 3

Revenues 1000 1500 1700

Cost of Revenues

450 650 750

Gross Profit 550 850 950

Operating Expense

300 300 350

Interest Expense

100 150 175

EBT 150 400 425

Taxes 52 140 148.75

Net Income 98 260 276.25

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example

Year 1 Year 2 Year 3

Revenues 100 150 170

Cost of Revenues

100 144 167

Gross Profit 100 154.54 172

Operating Expense

100 100 116

Interest Expense

100 150 175

EBT 100 267 283

Taxes 100 269 286

Net Income 100 265 281

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example

Year 1 Year 2 Year 3

Cash 2500 3000 3250

Marketable Sec.

750 1000 1100

A/R 450 850 900

Property 3500 3500 4000

Total Assets 7200 8350 9250

A/P 200 350 400

Short Term Loan

2400 2750 3000

Common Stock

4000 4000 4500

Retained Earnings

600 1250 1350

TL & Equity 7200 8350 9250

Comparative Financial Statement Analysis – Index Number Trend Series Analysis - Example

Year 1 Year 2 Year 3

Cash 100 120 130

Marketable Sec.

100 133.33 146.67

A/R 100 188.89 200

Property 100 Zero 114.28

Total Assets 100 115.97 128.47

A/P 100 175 200

Short Term Loan

100 114.58 125

Common Stock

100 Zero 112.5

Retained Earnings

100 208 225

TL & Equity 100 115.97 128.47

Common Size Financial Statement AnalysisCommon Size Financial Statement Analysis (Vertical Analysis)

is an inquiry into the internal structure of Financial statements.

Comparison of company’s common size statements with competitors or over the years, alerts our attention to differences in account structures or distributions.

Common Size Financial Statement Analysis - Example

Year 1 Year 2

Revenues 1000 1500

Cost of Revenues 450 650

Gross Profit 550 850

Operating Expense 300 300

Interest Expense 100 150

EBT 150 400

Taxes 52 140

Net Income 98 260

Common Size Financial Statement Analysis - Example

Year 1 Year 2

Revenues 100 100

Cost of Revenues 45% 43.3%

Gross Profit 55% 56.67%

Operating Expense 30% 20%

Interest Expense 10% 10%

EBT 15% 26.67%

Taxes 5.2% 9.3%

Net Income 9.8% 17.3%

Common Size Financial Statement Analysis - Example

Year 1 Year 2

Cash 34.72% 35.93#

Marketable Sec. 10.41% 11.97%

A/R 6.25% 10.17%

Property 48.61% 41.92%

Total Assets 100% 100%

A/P 2.78% 4.2%

Short Term Loan 33.33% 32.93%

Common Stock 55.55% 47.90%

Retained Earnings 8.3% 14.97%

TL & Equity 100% 100%

Ratio Analysis of Financial StatementsFinancial Ratios are tools providing us with

clues & symptoms of underlying conditions. Ratios, properly interpreted identify areas requiring further investigation.

Factors affecting RatiosRatio Interpretation

Financial Statement Analysis in an efficient Capital Market

Pricing Efficiency refers to a market where prices at all times fully reflect all available information that is relevant to the valuation of securities.

Forms1. Weak form Efficient2. Semi Strong form Efficient3. Strong Form Efficient

Financial Statement Analysis in an efficient Capital MarketWeak Form Efficient

Weak Efficiency means that the price of a security reflects past price & trading history of a security.

Semi Strong Form EfficientSemi Strong Efficiency means that the price of the security fully reflects all public information.

Strong Form EfficientStrong Efficiency exists in a market where prices of security reflects all information, weather or not it is publicly available.

Overview of Financial Statement Analysis

Chapter Preview

Users of Financial StatementsBusiness ActivitiesTypes of Financial Statements Information Accompanying financial StatementsFinancial Statement Analysis PreviewCapital Market Efficiency & its implications on

Financial Statement Analysis