Essentials of Financial Statement Analysis

Topics: Balance sheet, Generally Accepted Accounting Principles, Financial ratios Pages: 25 (3390 words) Published: August 20, 2012
Chapter 5: Essentials of Financial Statement Analysis Evaluating accounting “quality”  

How do we define financial reporting quality? Qualitative characteristics of accounting Information:      

Understandability Decision usefulness Reliability Relevance Consistency Comparability 1

Attributes of High Quality Financial Reporting

Financial reporting (earnings) quality has been considered positively associated with the following:  High persistence of earnings and cash flows  High predictive ability of earnings and cash flows  High earnings response coefficient  Low level of earnings management  More voluntarily disclosure  Strong corporate governance 2

Manipulating Income and Earnings Management

Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance. “Most managers prefer to report earnings that follow a

smooth, regular, upward path.”2

1. Arthur

Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.

What should the users be aware of ?

Statement users must:  Understand current financial reporting settings and standards.  Recognize that management may manipulate the financial information.  Distinguish between reliable financial statement information and poor quality information. 4

Financial statement analysis and accounting quality
Financial analysis tools: Commonsize statements, trend statements and financial ratios.  But they can be no better than the data from which they are constructed (i.e., the comparative financial statements). 


Financial statement analysis and accounting quality

The accounting distortions need to be watched when using these tools. Examples include: 1. Nonrecurring gains and losses 2. Differences in accounting methods. 3. Differences in accounting estimates. 4. GAAP implementation differences. 5. Historical cost convention. 6

Learning Objective:

Essentials of Financial Statement Analysis


Analysis, Forecast and Vulation Procedures

Reviewing the Financial Statements:  Review comparative financial statements and audit opinion. Adjusting and forecasting accounting numbers: 

Adjusting Accounting Numbers to remove nonrecurring items, the different choice in capital structures, distortions from earnings management, and significant subsequent events from reported net income. 8


Assessing Profitability and Creditworthiness:

Common size statements.  Trend statements  Financial ratio analysis: Use ratios to assess liquidity, profitability and solvency.  Credit analysis: Use ratios and cash flow statement to determine the short term and long term risk of default. 


Forecast and Valuation
 Comprehensive

Financial statement forecasts (see Appendix B
of Chapter 6 )

 Valuing

Equity Securities (see

Appendix A of Chapter 6):

a. Free cash-flow model  b. Abnormal earnings model (residual income model). 10

Essentials of Financial Statement Analysis

Step 1: To be informed that financial statement analysis is a careful evaluation of the quality of a company’s reported accounting numbers. Step 2: Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices.

Only then you can truly “ get behind the numbers” and see what’s really going on the Company.


Financial analysis tools




Comparative Financial statements: Statements are compared across years. Common-size statements: Recast each statement item as a percentage of a certain item. Trend statements: Recast each statement item in percentage of a base year number. Financial ratios. 12

Basic Approaches...
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