Financial Analysis

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1/20/2013

MACC 594: LECTURE NOTES, MODULE I: INTRODUCTION TO ANALYSIS AND REVIEW OF BASIC CONCEPTS PART I. A. REVIEW OF FINANCIAL STATEMENTS ANALYZING THE BALANCE SHEET • The balance sheet lists the firm’s assets, liabilities and equity accounts and their balances at the end of the period. • What does the balance sheet reveal about a firm? • Size of the company (total assets or net assets) • Major assets owned and proportion of current vs. noncurrent assets: - Is the mix of assets consistent with norms in the industry? - Is it likely that any large assets are overstated (warn of future writedowns)? • Major liabilities and proportion of current vs. noncurrent liabilities: - Is it likely that any liabilities are understated? • Identify trends or abrupt changes in major assets, liabilities and equity during period. Attempt to explain cause of any abrupt changes.

ANALYZING THE BALANCE SHEET--CONTINUED
• How are assets financed? Compare proportions of financing from different sources: • Internal financing: earned capital / total assets • External financing from shareholders: contributed capital / total assets • External financing from suppliers and creditors: total liabilities / total assets (and total debt / total assets)

• Examine equity and identify major components and red flags: • Retained deficits (i.e., negative retained earnings) and negative stockholders equity are red flags • Has the firm spent exorbitant amounts of money repurchasing shares? Compare treasury stock to contributed capital and earned capital.

• Use balance sheet to assess liquidity and solvency. • Highly leveraged firms (high debt) with problems on the asset side (overstated assets) are likely to have problems. Some problems appear on the balance sheet before they reduce net income.

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ANALYZING THE BALANCE SHEET -- CONTINUED


Limitations (weaknesses) of the balance sheet:


For many assets and liabilities, book value is far below market value; therefore, the balance sheet understates the value of these items.  E.g., land. Some assets and liabilities are not recognized on the balance sheet.  E.g., research and development, intangible assets developed within the firm, operating leases. Classification scheme is not meaningful  Partitioning: operating vs. financing is more useful for equity analysis than current vs. noncurrent.





ANALYZING THE INCOME STATEMENT
• The “bottom line”: net income Is the firm profitable (or reporting losses)? Consider size and trends. Is growth from sustainable sources?



The “top line”: sales revenue Consider size and trends; sustainable growth in net income is from revenue growth Income from operations -- is it growing? why? Cutting costs is not a sustainable source of growth. How is the firm generating most of its income and growth in income? Source: operating activities, nonoperating activities, or earnings management? Sustainability: recurring or nonrecurring items?




• What largest expenses? What are largest sources of income? Identify trends and explain abrupt changes.

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ANALYZING THE INCOME STATEMENT--CONTINUED

• Earnings per share and diluted earnings per share • Use figures to calculate profit margins, which reveal how effectively the firm generates profit from its sales revenue.

• Link between income statement and balance sheet: net income is added to retained earnings at the end of the fiscal period.

• Limitations (weaknesses) of the income statement:  Figures (revenues, expenses, gains and losses) are easy to manipulate—the quality of some firms’ earnings is low.  For such firms, net income is not a meaningful measure of real economic profit. firm’s recurring operating profit.

 Income statement does not provide a standardized measure of a  Cannot determine portion of growth that is organic.

ANALYZING THE INCOME STATEMENT -- CONTINUED


Step One: Identify Sources of Income  Identify income statement items...
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