OVERVIEW OF

FINANCIAL
STATEMENT ANALYSIS

LECTURE 1
LEARNING OBJECTIVES
• Explain business analysis and its relation
to financial statement analysis.
• Identify & discuss different types of
business analysis.
• Explain business activities and their
relation to financial statement analysis.
• Describe the purpose of each financial
statement and linkages between them.

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CHAPTER OUTLINE
• Definition
• Types of Business Analysis
• Uses of Business Analysis
• Components of Business Analysis
• Business Activities

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COMPONENTS OF BUSINESS ANALYSIS

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 DEFINITION
• Financial statement- richest source of information about
a company:- Balance Sheet, Income Statement.
• Financial Statement Analysis
– Is the application of analytical tools & techniques to
general- purpose financial statements & related data to
derive estimates & inferences useful in business analysis.
– Purpose: To provide a reliable source of financial
information necessary for business analysis.
– FS reveals how a company obtains its resources
(financing), where & how those resources are deployed
(investing), & how effectively those resources are
deployed (operating profitability)
– Help produce useful information for decision making.
– Objective of FSA: is to use the information provided in
the statements to produce quantified information to
support the ultimate equity, credit, or other decision of
interest to the analyst. 5
Business Analysis
• Business Analysis: Defination:
– Is the process of evaluating a company’s economics
prospect and risks for the purpose of making decision.
– Business environment, financial position and
performance

– Useful in business decisions:

• (whether to invest in equity or in debt securities, ST or LT,)
• Credit risk assessment
• Earnings prediction
• Audit
• Compensation negotiation

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TYPES OF BUSINESS ANALYSIS

• (1) Credit Analysis

– Creditors
• Trade Creditors vs Non Trade Creditors
– Liquidity & Solvency

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 Credit Analysis
Credit analysis supports the lending decision.
Credit analysis is the evaluation of the ability of a company to
honor its financial obligations (i.e., pay all of its debts). Current and
potential creditors and debt investors perform credit analysis.
Credit worthiness: Ability to honor credit obligations
(downside risk)

Liquidity Solvency
Ability to meet short-term Ability to meet long-term
obligations
Focus: obligations Focus:
• Current Financial • Long-term financial
conditions conditions
• Current cash flows • Long-term cash flows
• Liquidity of assets • Extended profitability
 Credit Analysis
Creditors

Trade Creditors Non-trade Creditors

• Provide goods or • Provide major
services financing
• Most short-term • Most long-term
• Usually implicit
interest • Usually explicit
interest
• Bear risk of
default • Bear risk of default
TYPES OF BUSINESS ANALYSIS
• (2) Equity Analysis
• Equity Investors
• Technical Analysis
• Fundamental Analysis

– Equity Investors
• Provide funds to a company in return for the risks and
rewards of ownership.
• Major providers of company financing
• Entitled to the distribution of a company assets only after
the claim of all other senior claimants.

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 Equity Analysis
Equity analysis supports equity investment decisions.
Equity investment decisions involve buying, holding, or selling the
stock of a company. Current and potential investors perform equity
analysis.

Assessment of downside risk and upside

potential
Technical Analysis
Charting:
searches for the patterns in
the price or volume history
of a stock to predict future
price movements.
Fundamental Analysis
• Is the process of determining the value
of the company by analyzing &
interpreting the key factors .
• Evaluation of co’s financial position &
performance
• Analyze and interpret
– Economy, Industry, Company
 Intrinsic Value
Equity(or Fundamental
analysis Value) decisions.
supports equity investment
Value of Company (or stock) without reference to market value (or
stock price)
The objective of fundamental analysis is to determine the intrinsic
value of an entity. Determination of fundamental value can be used
to support stock decisions and to price acquisitions.

Intrinsic value > Market value Buy

Strategy

Intrinsic value < Market value Sell

Intrinsic value = Market value Hold
USES OF BUSINESS ANALYSIS
• Internal users:
– owners
– To managers
– Employees
– Directors
– Internal auditors

• External users: (for current & potential….)

– Debt & equity investors
– Financial Management
– Suppliers
– Mergers, acquisitions, & divestiture
– Regulators/ government agencies
– Labor Unions
– Customers

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*COMPONENTS
OF BUSINESS Business
Environment &
ANALYSIS Strategy Analysis

Industry Strategy
Analysis Analysis

Financial
Analysis

Analysis
Accounting of Sources Prospective
Analysis &Uses of Risk Analysis
Profitability
Funds Analysis
Analysis

Cost of Capital Estimate Intrinsic Value

COMPONENTS OF BUSINESS ANALYSIS

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 (1) Business Environment & Strategy
Analysis

• Identify and access a company’s economic

and industry circumstances
– Labor, product
• Industry Analysis
– Industry is viewed as collection of competitors
that jockey for bargaining power-compete
among themselves & face threats from new
entrants & substitute product.
– Must access both; the industry prospects and
the degree of actual & potential competition
facing a company
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• Strategy Analysis
– Is the evaluation of both a company’s
business decisions & its success at
establishing a competitive advantages.
– Accessing company’s expected strategic
response to it business environment & the
impact for future growth and success

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 (2) Accounting Analysis
• Is the process of evaluating the extent to which a
company’s accounting reflects economic reality.
• Goal: to evaluate and reduce accounting risk & to
improve the economic content of financial statement.
• Study a company’s transaction & events.
• Accounting Limitations
– Comparability problem
• Arises when different companies adopt different accounting for
similar transaction or events.
– Accounting Distortions
• Are deviations of accounting information from the underlying
economics.
– Accounting Risks
• Is the uncertainty in financial statement analysis due to accounting
distortion

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 (3) Financial Analysis

• Financial Analysis
– Is the use of FS to analyze a company’s
financial position and performance & to
access future financial performance

• Consists of 3 broad areas:-

– Profitability Analysis
– Risks Analysis
– Analysis of sources & uses of funds
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– Profitability Analysis
• The evaluation of company’s ROI
• Focuses on company’s sources & level of profits
– Risks Analysis
• Is the evaluation of a company’s ability to meet its
commitment
• Accessing liquidity & solvency
– Analysis of sources & uses of funds
• How a company is obtaining & deploying its funds.

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 (4) Prospective Analysis
• Is the forecasting of future payoff-
typically earnings, CF or both.
• Apart from doing historical analysis, we
need to analyze future well being of a
company- PROSPECT:
– Prospective gearing position
– Prospective liquidity or cash flow position
– Prospective profitability position

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 Business Activities
Planning

Investing Activities Financial

Activities Activities

Operating Activities
Revenues and expenses from providing
goods and services
BUSINESS ACTIVITIES
• A business pursues 4 major activities in a desire to provide a
saleable product and/or service and to yield a satisfactory return
on investment. These activities are:

• (1) Planning Activities

– Business plan- describe the company’s purpose , strategy &
tactics for its activities
• (2) Financing Activities
– Refers to method that companies use to raise the money to
pay for their needs (raw material, technologies, R&D)
– 2 main sources of external financing:-
• Equity investors (owners or shareholder).
• Creditors (lenders)
– Return
– Earning Distributions
– Dividend Payout
– Earning Reinvestment
– Earning Retention ratio
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BUSINESS ACTIVITIES
• (3) Investing Activities
– Refers to the company’s acquisition and
maintenance of investments for purpose of selling
products & providing services.
– Operating asset (for the purpose of conducting
business)
• Land, building, equipments, inventories, human capital
– Financial asset (invest cash in securities)
• Stock, corporate & government bonds
• (4) Operating Activities
– Represent the “carrying out” of the business plan
given its financing & investing activities
– Primary source of earning.

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 Financial Statements Reflect Business Activities

Planning
Investing Financing
Current: Operating Current:
Cash
•
Notes Payable
•
• Sales
• Accounts Payable
• Accounts Receivable • Cost of Goods Sold
• Salaries Payable
• Inventories
• Selling Expense
Marketable Securities • Income Tax Payable
• • Administrative Expense

Noncurrent: • Interest Expense

Noncurrent:
• Land, Buildings, & • Income Tax Expense
• Bonds Payable
• Common Stock
Equipment
• Patents
Net Income • Retained Earnings
• Investments
Liabilities & Equity
Income statement
Assets Cash Flow Balance Sheet

Balance Sheet Statement of Statement of

Cash Flows Shareholders’ Equity