Please read: A personal appeal from Wikipedia founder Jimmy Wales

Read now

Financial statement analysis

From Wikipedia, the free encyclopedia Jump to: navigation, search

Accountancy
Key concepts Accountant Accounting period Bookkeeping Cash and accrual basis Cash flow management Chart of accounts Journal Special journals Constant Item Purchasing Power Accounting Cost of goods sold Credit terms Debits and credits Double-entry system Mark-to-market accounting FIFO & LIFO GAAP / IFRS General ledger Goodwill Historical cost Matching principle Revenue recognition Trial balance Fields of accounting Cost Financial Forensic Fund Management Tax Financial statements

Statement of financial position Statement of cash flows Statement of changes in equity Statement of comprehensive income Notes MD&A XBRL Auditing Auditor's report Financial audit GAAS / ISA Internal audit SarbanesOxley Act Accounting qualifications CA CPA CCA CGA CMA CAT CFA CIIA ACCA CIA CTP ICAEW CIMA IPA ICAN This box: view talk edit

Financial statement analysis (or financial analysis) is the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports. Financial statement analysis consists of 1) reformulating reported financial statements, 2) analysis and adjustments of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted financial statements. The two first steps are often dropped in practice, meaning that financial ratios are just calculated on the basis of the reported numbers, perhaps with some adjustments. Financial statement analysis is the foundation for evaluating and pricing credit risk and for doing fundamental company valuation. 1) Financial statement analysis typically starts with reformulating the reported financial information. In relation to the income statement, one common reformulation is to divide reported items into recurring or normal items and non-recurring or special items. In this way, earnings could be separated in to normal or core earnings and transitory earnings. The idea is that normal earrings are more permanent and hence more relevant for prediction and valuation. Normal earnings are also separated into net operational profit after taxes (NOPAT) and net financial costs. The balance sheet is grouped, for example, in net operating assets (NOA), net financial debt and equity. 2) Analysis and adjustment of measurement errors question the quality of the reported accounting numbers. The reported numbers can for example be a bad or noisy representation of invested capital, for example in terms of NOA, which means that the return on net operating assets (RNOA) will be a noisy measure of the underlying profitability (the internal rate of return, IRR). Expensing of R&D is an example when such investment expenditures are expected to yield future economic benefits, suggesting that R&D creates assets which should have been capitalized in the balance sheet. An example of an adjustment for measurement errors is when

the analyst removes the R&D expenses from the income statement and put them in the balance sheet. The R&D expenditures are then replaced by amortization of the R&D capital in the balance sheet. Another example is to adjust the reported numbers when the analyst suspects earnings management. 3) Financial ratio analysis should be based on regrouped and adjusted financial statements. Two types of ratio analyses are performed: 3.1) Analysis of risk and 3.2) analysis of profitability: 3.1) Analysis of risk typically aims at detecting the underlying credit risk of the firm. Risk analysis consists of liquidity and solvency analysis. Liquidity analysis aims at analyzing whether the firm has enough liquidity to meet its obligations when they should be paid. A usual technique to analyze illiquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also useful. Solvency analysis aims at analyzing whether the firm is financed so that it is able to recover from a losses or a period of losses. A usual technique to analyze insolvency risk is to focus on ratios such as the equity in percentage of total capital and other ratios of capital structure. Based on the risk analysis the analyzed firm could be rated, i.e. given a grade on the riskiness, a process called synthetic rating. Ratios of risk such as the current ratio, the interest coverage and the equity percentage have no theoretical benchmarks. It is therefore common to compare them with the industry average over time. If a firm has a higher equity ratio than the industry, this is considered less risky than if it is above the average. Similarly, if the equity ratio increases over time, it is a good sign in relation to insolvency risk. 3.2) Analysis of profitability refers to the analysis of return on capital, for example return on equity, ROE, defined as earnings divided by average equity. Return on equity, ROE, could be decomposed: ROE = RNOA + (RNOA - NFIR) * NFD/E, where RNOA is return on net operating assets, NFIR is the net financial interest rate, NFD is net financial debt and E is equity. In this way, the sources of ROE could be clarified. Unlike other ratios, return on capital has a theoretical benchmark, the cost of capital - also called the required return on capital. For example, the return on equity, ROE, could be compared with the required return on equity, kE, as estimated, for example, by the capital asset pricing model. If ROE < kE (or RNOA > WACC, where WACC is the weighted average cost of capital), then the firm is economically profitable at any given time over the period of ratio analysis. The firm creates values for its owners. Insights from financial statement analysis could be used to make forecasts and to evaluate credit risk and value the firm's equity. For example, if financial statement analysis detects increasing superior performance ROE - kE > 0 over the period of financial statement analysis, then this trend could be extrapolated into the future. But as economic theory suggests, sooner or later the competitive forces will work - and ROE will be driven toward kE. Only if the firm has a sustainable competitive advantage, ROE - kE > 0 in "steady state".

[edit] See also

Business valuation Fundamental analysis

Financial analysis is the selection, evaluation, and interpretation of financial data, along with other pertinent information, to assist in investment and financial decision-making. Financial analysis may be used internally to evaluate issues such as employee performance, the efficiency of operations, and credit policies, and externally to evaluate potential investments and the creditworthiness of borrowers, among other things. The analyst draws the financial data needed in financial analysis from many sources. The primary source is the data provided by the company itself in its annual report and required disclosures. The annual report comprises the income statement, the balance sheet, and the statement of cash flows, as well as footnotes to these statements. Certain businesses are required by securities laws to disclose additional information. Besides information that companies are required to disclose through financial statements, other information is readily available for financial analysis. For example, information such as the market prices of securities of publicly-traded corporations can be found in the financial press and the electronic media daily. Similarly, information on stock price indices for industries and for the market as a whole is available in the financial press. Another source of information is economic data, such as the Gross Domestic Product and Consumer Price Index, which may be useful in assessing the recent performance or future prospects of a company or industry. Suppose you are evaluating a company that owns a chain of retail outlets. What information do you need to judge the company's performance and financial condition? You need financial data, but it doesn't tell the whole story. You also need information on consumer Financial ratios spending, producer prices, consumer prices, and the competition. This is economic data that is readily available from government and private sources. Besides financial statement data, market data, and economic data, in financial analysis you also need to examine events that may help explain the company's present condition and may have a bearing on its future prospects. For example, did the company recently incur some extraordinary losses? Is the company developing a new product? Or acquiring another company? Is the company regulated? Current events can provide information that may be incorporated in financial analysis. The financial analyst must select the pertinent information, analyze it, and interpret the analysis, enabling judgments on the current and future financial condition and operating performance of the company. In this reading, we introduce you to financial ratios -- the tool of financial analysis. In financial ratio analysis we select the relevant information -- primarily the financial statement data -- and evaluate it. We show how to incorporate market data and economic data in the analysis and interpretation of financial ratios. And we show how to interpret financial ratio analysis, warning you of the pitfalls that occur when it's not used properly. We use Microsoft Corporation's 2004 financial statements for illustration purposes throughout this reading. You can obtain the 2004 and any other year's statements directly from Microsoft. Be sure to save these statements for future reference.

[edit] Notes

[edit] External links

[1] SFAF - the French Society of Financial Analysts [2] ACIIA - Association of Certified International Investment Analysts [3] EFFAS - European Federation of Financial Analysts Societies

Retrieved from "http://en.wikipedia.org/w/index.php?title=Financial_statement_analysis&oldid=455579893" View page ratings Rate this page What's this? Trustworthy

Objective

Complete

Well-written

I am highly knowledgeable about this topic (optional) I have a relevant college/university degree It is part of my profession It is a deep personal passion The source of my knowledge is not listed here I would like to help improve Wikipedia, send me an e-mail (optional) We will send you a confirmation e-mail. We will not share your e-mail address with outside parties as per our feedback privacy statement. Submit ratings

Saved successfully Your ratings have not been submitted yet Your ratings have expired Please reevaluate this page and submit new ratings. An error has occured. Please try again later. Thanks! Your ratings have been saved. Please take a moment to complete a short survey. Start survey Maybe later Thanks! Your ratings have been saved. Do you want to create an account? An account will help you track your edits, get involved in discussions, and be a part of the community. Create an accountorLog in Maybe later Thanks! Your ratings have been saved. Did you know that you can edit this page? Edit this page Maybe later Categories:

Valuation

Personal tools

Log in / create account

Namespaces

Article Discussion

Variants Views

Read Edit

View history

Actions Search
Special:Search

Navigation

Main page Contents Featured content Current events Random article Donate to Wikipedia

Interaction

Help About Wikipedia Community portal Recent changes Contact Wikipedia

Toolbox

What links here Related changes Upload file Special pages Permanent link Cite this page Rate this page

Print/export

Create a book Download as PDF Printable version

Languages

esky

Deutsch Franais Bahasa Indonesia Italiano Portugus Suomi Svenska This page was last modified on 14 October 2011 at 19:37. Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may apply. See Terms of use for details. Wikipedia is a registered trademark of the Wikimedia Foundation, Inc., a non-profit organization. Contact us Privacy policy About Wikipedia Disclaimers Mobile view

Get PDF (610K) More content like this Find more content: Introduction

In a recent paper, Gerber and Shiu (2003) propose to model the asset X1(t) and liability X2(t) values of a firm by means of correlated geometric Brownian motions. Using martingale arguments, they are able to derive an analytical expression for the dividend pay-out needed to maintain the firm value X(t) = (X1(t),X2(t)) in the cone O := _x = (x1, x2) R2 : x1 x2 and x1 > 1x2 (1)
_ Corresponding author. Email addresses: marc.decamps@fortis.com (Marc Decamps), ann.deschepper@ua.ac.be (Ann De Schepper), marc.goovaerts@econ.kuleuven.be (Marc Goovaerts). Preprint submitted to Journal of Economic Dynamics and Control 26 September 2008

Electronic copy available at: http://ssrn.com/abstract=1279224 with > 1, imposing bankruptcy when the firm value hits the barrier e(1) := _x = (x1, x2) R2 : x1 = 1x2 for the first time. Maximizing the discounted dividend accumulated until ruin time = inf{t 0 : X(t) e(1)}, Gerber and Shiu (2003) provide an optimal value of but conjecture the optimality over all possible dividend strategies. In this paper, we prove that the results of Gerber and Shiu (2003) are optimal only if the asset value of the firm is controlled, and we generalize the results to strategies allowing to control the liability values together with the asset values. Asset-Liability Management (ALM) techniques concern the dynamic control of the balance sheet. It consists of controlling the positive and negative cash flows generated by the company activity in order to narrow the difference between assets and liabilities while maximizing the creation of value. The dynamic control of the firm value as exposed in this paper is to some extent not coherent with common standard financial theories. In asset pricing theory as pioneered by Miller and Modigliany (1958), the firm value is not affected by the dividend pay-out or by the methods of financing activities. Contrary to this, the model exposed in the present paper allows to invest the profits or to pay dividends to shareholders by modifying the dynamic of the firm asset value. Although the model is not consistent with the results of Miller and Modigliany (1958), it provides a tractable framework to study and compare the risks involved by a set of optimal assetliability management policies. The problem is classical in actuarial mathematics and finds natural applications to manage the solvency of insurance companies, isolated business lines or pension funds. A similar framework is proposed in Hojgaard and Taksar (2002). As far as we know, the literature on ALM only considers the surplus process of the assets over the liabilities. Without claiming any exhaustiveness, we refer to Asmussen and Taksar (1997), Hojgaard and Taksar (1999), Hojgaard (2002), Hubalek and Schachermayer (2004), Gerber and Shiu (2003, 2004), Rudolf and Ziemba (2004), Grandits et al. (2007), or Hoevenaers et al. (2008). It implicitly restricts the ALM committee to act on the asset value of the firm by the payment of dividend to shareholders, and to optimize these dividends. However, it is more realistic to allow the ALM committee to reinvest into new lines of business and raise liabilities when the assets grow faster than the liabilities. In this paper, the controlled firm value satisfies dXi(t) = iXi(t)dt + iXi(t)dBi(t) idC(t); X(0) = x; i = 1, 2 (2) where {B(t), t 0} is a bivariate Brownian motion with correlation 0 1 and = (1, 2) is a constant unit vector. The process X1 corresponds to the assets, and X2 to the liabilities. Throughout the paper, 2 i,j_ stands for the covariance matrix 2 i,j_ =

2 1 12 12 2
2

. In general, a control process is a stochastic process {C(t), t 0}, which is progressively measurable. In this paper, we use a more strict definition, and we also assume that the 2 control process {C(t), t 0} is a non-negative non-decreasing adapted process started at 0 right continuous with left limit and admits the following cumulative representation C(t) = Z t
0

a(s)ds, where the process {a(t), t 0} can be unbounded. Remark that the assumptions on C(.) do not imply the continuity of the control with respect to t, and thus C(.) can have discontinuities _C(t) = C(t) C(t). The ALMcommittee modifies both the assets and the liabilities in a given ratio 1/2 (a change of _X1(t) in the assets implies a change _X2(t) = 1
2

_X1(t) in the liabilities). It is clear that 1 is positive (e.g. through the payment of dividend to shareholders) and 2 is negative (e.g. through investment in new lines of business), or equivalently = (,p1 2) for some [0, 1]. In this paper, we establish that the proposed framework includes the model of Gerber and Shiu (2003) as a particular case. Note that our approach differs from Leland (1994), where the author also proposes to model the asset value of a firm by means of a diffusion process and where he examines the optimal capital structure and corporate debts as contingent claims on the firm asset value. The results of Leland (1994) rely on the assumption that the firm asset value is traded (or can be replicated) and extends the results of Black and Cox (1976) to incorporate bankruptcy costs and taxes. The framework exposed in Leland (1994) or Black and Cox (1976) is not applicable to the present situation as the controlled asset firm obeys a stochastic differential equation with a degenerated drift proportional to the local time of the firm on an optimal edge e(), and as we can no longer rely on the existence of an equivalent risk-neutral measure to price contingent claims on the controlled firm asset value. The default event is the first hitting time of the firm value X on the edge e(1), = inf{t 0 : X(t) e(1)}, with inf = +, and the total (discounted) cash flow until ruin time is Jx(C(.)) = Z
0

ers
2

Xi=1 |i| dC(s). The constant r is the exogenously given valuation force of interest. It can be for instance the return on a portfolio of long dated (or nowadays even perpetual) fixed income instruments. The force of interest can include a premium for various risks including long term credit, liquidity and reinvestment risk. Hence r can be significantly higher than the money-market spot rate of the Black-Scholes risk-neutral world. The cash flow variable Jx(C(.)) is the total value creation achieved by the ALM strategy as a growth of the liabilities or as dividend pay-out to the shareholders. The ALM strategy is fully determined

by the choice of {, 1}. Provided a unit vector R2, the objective of the ALM committee is the dynamic optimization of the average total discounted creation of value V (x) = sup
C(.)

E [Jx(C(.))] = E [Jx(C(.))] 3 over all admissible control functions C(.). Note that a control function C(.) is called admissible, if for every deterministic initial condition, equation (2) has a unique solution which is also weakly unique. In the sequel, we assume that r > 1 > 2, in order to ensure the boundedness of the quantity V (x), but we will also comment on the case where this assumption is not satisfied. Note that although the assumption r > 1 > 2 is only realistic for predictable business lines, it includes some of the most traditional insurance activities as for instance retail life insurance. In this paper, we derive a two-dimensional Hamilton-Jacobi-Bellman (HJB) optimality equation for V (x) using singular stochastic control. We show that the optimal control is proportional to the local time of the firm value on the edge e() for some constant > 1. The optimal controlled firm value satisfies X(t) = X(t ) where X is a twodimensional geometric Brownian motion -reflected on the edge e(). More precisely, the process behaves like a geometric Brownian motion in the half-plane below e(), but at the edge e() it is reflected in the specified reflection direction of the vector . Under the optimal ALM policy, for the particular case = (1, 0) or = (0,1), we provide a series expansion for the term structure of survival probabilities Px(t) := Px( > t) as well as for the optimal value creation until time t V (x, t) = Ex "Z t
0

ers
2

Xi=1 |i| dC(s)#. The assumption r > 1 > 2 is only needed to ensure the existence of an optimal value of . The expression for the total value creation and the series expansions proposed in the paper remain valid for sub-optimal value in the case 1 > r > 2 as in the original paper of Gerber and Shiu (2003). The rest of the paper is organized as follows. We start by deriving the HJB equation for V (x) and we represent the solution in terms of local time. In section 3, we provide an analytical expression to the HJB equation. The result is numerically illustrated and interpreted. In section 4, we study the convergence of V (x, t) to V (x) and we provide series expansions for the probabilities of default using spectral decomposition in the particular cases = (1, 0) (the ALM committee acts on the assets) and = (0,1) (the ALM committee acts on the liabilities). All the proofs are contained in the Appendix. 2. Hamilton-Jacobi-Bellman equation for V (x) In order to show the optimality of the results in Gerber and Shiu (2003), we use similar arguments as in Harrison and Taksar (1983), Asmussen and Taksar (1997) or Hojgaard and Taksar (1999). As for the one-dimensional case, the Hamilton-JacobiBellman dynamic principle leads to an optimality equation for the expected maximal cash flow V (x). For a rigorous and complete account on (multi-dimensional) singular stochastic control, we refer to Section VIII in Fleming and Soner (1993). However, similarly to 4

Asmussen and Taksar (1997), we give

like this article Find more content written by: MICHAEL C. WALKER JOHN D. STOWE SHANE MORIARITY All Authors
ABOUT US HELP CONTACT US AGENTS ADVERTISERS MEDIA PRIVACY TERMS & CONDITIONS SITE MAP

Copyright 19992011 John Wiley & Sons, Inc. All Rights Reserved.

paper concerns optimal asset-liability management when the assets and the liabilities are modeled by means of correlated geometric Brownian motions as suggested in Gerber and Shiu [2003. Geometric Brownian motion models for assets and liabilities: from pension funding to optimal dividends. North American Actuarial Journal 7(3), 37-51]. In a first part, we apply singular stochastic control techniques to derive a free boundary equation for the optimal value creation as a growth of liabilities or as dividend payment to shareholders. We provide analytical solutions to the Hamilton-Jacobi-Bellman (HJB) optimality equation in a rather general context. In a second part, we study the convergence of the cash flows to the optimal value creation using spectral methods. For particular cases, we also provide a series expansion for tJSTOR
Skip to Main Content

JSTOR Home Search Browse MyJSTOR Skip to Main Content

Login Help Contact Us About

You are not currently logged in through a participating institution or individual account. See the login page for more information.
RIGHTS AND PERMISSIONS

More Rights Options JSTOR Terms And Conditions

Search

for

Financial Management >

Vol. 2, No. 1, Spring, 1973 >

Decomposition Measur...

You are viewing the first page/citation. Full-text access may be available if you are affiliated with a participating library or publisher. Check access options orlogin if you have an account. + Show full citation

Financial Management 1973 Financial Management Association International

Abstract
Financial statements present allocations of assets, capital, liabilities, revenues, and expenses. Changes over time in such allocations that result from either policy or environment are of obvious interest. The measures presented here are designed to identify efficiently these changes and direct the search for causes. Applications are illustrated in analysis of financial statements from outside the firm as well as in the view of internal management.

JSTOR Home About Search Browse Terms and Conditions Privacy Policy Accessibility Help Contact us
JSTOR is part of ITHAKA, a not-for-profit organization helping the academic community use digital technologies to preserve the scholarly record and to advance research and teaching in sustainable ways. 2000-2011 ITHAKA. All Rights Reserved. JSTOR, the JSTOR logo, and ITHAKA are registered trademarks of ITHAKA.

he probabilities of bankruptcy in finite tim