Overview of financial

reporting, financial statement

analysis and valuation
FINANCIAL ANALYSIS
•is the process of
evaluating financial and
other information for
decision making.
APPROACHES
 TYPES OF FINANCIAL
STATEMENTS

1. Balance Sheet
2. Income Statement
3. Cashflow Statement
4. Statement of Retained Earnings
 EXTERNAL USERS OF
STATEMENT ANALYSIS
Trade Creditors – focus on the liquidity of the firm
Bondholders – focus on the long term cashflow of
the firm
Shareholders – focus on the profitability and long-
term health of the firm
INTERNAL USES OF STATEMENT
ANALYSIS

PLAN – focus on assessing the current

financial position and evaluating potential
firm opportunities
CONTROL – focus on return on investment
for various assets and asset efficiency
UNDERSTAND – focus on understanding how
suppliers of funds analyze the firm
BUILDING BLOCKS FOR FINANCIAL
STATEMENT ANALYSIS
 Three-Legged Stool
1. Identifying the Economic characteristics of the
industries in which a firm participates and the relation of
those economic characteristics to various financial
statement ratios
2. Describing the Strategies that a firm pursues to
differentiate itself from competitors as a basis for
evaluating a firm’s competitive advantages, the
sustainability of a firm’s earnings, and its risks
3. Evaluating the Financial Statements, including the
accounting concepts and methods that underlie them and
the quality of the information they provide
METHODS OF FINANCIAL
STATEMENT ANALYSIS

Horizontal Analysis
Vertical Analysis
Common Size Statement
Ratio Analysis
 1. HORIZONTAL ANALYSIS
using comparative financial statements to calculate
percentages changes in a financial statement item
from one period to the next
Example:
Calculating Change as a Percentage
Percentage = Current Year - Based Year x 100%
Base Year Figure
%
1. HORIZONTAL ANALYSIS
1. HORIZONTAL ANALYSIS
1. HORIZONTAL ANALYSIS
 2. VERTICAL ANALYSIS
For a single financial statement, each item is
expressed as a percentage of a significant total
Example
All Income Statement items are expressed
as a Percentage of Sales
2. VERTICAL ANALYSIS
 3. COMMON SIZE STATEMENTS

Financial statements that show only

percentages and no absolute dollar amount
3. COMMON SIZE STATEMENTS
 4. RATIO ANALYSIS
- Expression of logical relationships between
items in a financial statement of a single period
- Percentage relationship between revenue
and net income
 FINANCIAL REPORTING
- Is the process of preparing the corporation’s financial
statement in accordance with Generally Accepted
Accounting Principles (GAAP).
- The Statement prepared includes: an Income
Statement, Balance Sheet and a Statement of Cash
Flows
Real Estate Dictionaries
 ANNUAL REPORT FOR A
COMPANY

- For legal and necessity reasons,

companies publish a formal report at
the end of each financial year.
 Three broad sections
• Directors Reports - the first section of the annual report is a narrative, often
on the form of a letter from the company’s chairman to its shareholders
giving important pieces of information
• Financial Statements - will help business owners and other interested
people to analyze the data in financial statements to provide them with
better information about such key factors for decision making and ultimate
business survival.
• Audit Report - This report is given by the external s after they have
examined the accounting records, supporting evidence and financial
statements prepared on the basis of such records at the end of the year
 TYPES OF AUDIT REPORT
1. Unqualified Report
- If the external auditor is fully satisfied with the state of affairs, he gives a clean or unqualified report
which indicate that the financial statements are by and large very much in order.
2. Qualified Report
- If the external auditors find some minor irregularities in the accounts or the financial statements which
do not materially affect the year’s profit or financial position at the year end, he may give a qualified
report, indicating areas about which he is dissatisfied.
3. Adverse Report
- If the external auditors find too many errors and misstatements in the accounts, or if the accounts have
not been properly kept, and the financial statements give materially incorrect profit and financial
statements are not reliable.
4. Disclaimer
- If the external Auditors finds the book of accounts or supporting documents are inadequate for the
purpose of preparing meaningful financial statements, he may give a disclaimer., which indicates that he
was not able to form any opinion on the accounting records and/or financial statements due to
inadequate records and evidence.
 SOURCES OF INFORMATION
1. Company Reports
• Directors Report
• Financial Statement
• Schedules and notes to the Financial Statements
• Auditors Report
2. Stock Exchanges
3. Business Periodicals
4. Information Services
 ACCRUAL CONCEPT

Accrual Concept - business transactions are

recorded when they occur and not when the
related payments are received or made. This
concept is called accrual basis of accounting and it
is fundamental to the usefulness of financial
accounting information.
 SIGNIFICANCE OF ACCRUAL
CONCEPT

1. It helps in knowing actual expenses and

actual income during a particular time
period.
2. It helps in calculating the net profit of the
business.
 ASSET AND LIABILITY
VALUATION AND INCOME
RECOGNITION
CHAPTER 2
 LEARNING OBJECTIVES
1. Understand how changes in Asset and Liability
Valuations on the Balance Sheet impact the measurement
of Net Income on the Income Statement.
2. Obtain an overview of the pervasive importance of
Income Tax effects on reported financial statements and
appreciate the use of deferred tax assets and liabilities to
reconcile financial reporting with tax reporting.
3. Apply an analytical framework for mapping the effects of
various business events and transactions on the balance
sheet and the income statement
 Asset and Liability Valuation
Valuation – is the process of estimating what
something is worth
- The valued items are usually financial assets
or liabilities
Valuation can be done on
• ASSETS – Items the organization owns that can be
cashed upon. Tangible / Intangible
• Liabilities – items with monitary value that are
liable to be paid back
 ASSET VALUATION

• Is the process of determining the Fair

Market or Present Value of assets, using
book values, absolute valuation models like
discounted cash flow analysis, option pricing
models or comparable.
 What is an Asset?
Personal Assets are things of present or future
value owned by an individual or household.

Business Assets - are things of value that

sustain production and growth. For a business,
assets can include machines, property, raw
materials, and inventory—as well as intangibles
such as patents, royalties, and other intellectual
property.
Income Recognition
types of assets on a typical Balance
Sheet
• Current and Fixed Assets
 Purpose of Valuation

• Selling Assets
• To know the position of the Organization
• Capital Budgeting
• Investment Analysis
• Property Tax Liability
• Litigation
 Accounting Formula
• Assets = Liabilities + Shareholders’ Equity
 •reflect various
combinations of historical
data, current information,
and expectations of future
outcomes
 1. HISTORICAL VALUE

• is based on the cost of an asset when a firm acquired it or the

nominal amount of a liability when a firm initially incurred it.
Current value, on the other hand, updates historical value with
information about the fair value of an asset and a liability at the
date of the current balance sheet
• Acquisition cost (assets)
• • Adjusted acquisition cost (assets)
Historical Value: Acquisition Cost
• The acquisition cost of an asset is the amount paid initially to acquire the
asset. Acquisition cost includes all costs required to prepare the asset for
its intended use, but does not include costs to operate the asset
• Example 1
• At a cost of $200,000, In-N-Out Burger acquired a tract of land for a
restaurant site. It paid attorneys $7,500 to conduct a title search and to
prepare the required legal documents for the purchase, and it paid a state
real estate transfer tax of $2,500. The acquisition cost of the land is
$210,000
• ($200,000 + $7,500 + $2,500)
 Historical Value: Adjusted
Acquisition Cost

• For some assets, the service potential is consumed gradually (like

machinery that has a limited life) or immediately (like inventory,
which provides all of its benefits when it is sold). As the service
potential of an asset is consumed, the consumed portion is
expensed (that is, the asset is reduced and an expense is
increased).
 Historical Value: Adjusted
Acquisition Cost

• JPMorgan Chase, a financial services firm, acquires a computer

from IBM for $5 million, expects to use the computer for five
years, and then plans to sell it for $1 million. JPMorgan Chase
depreciates $4 million over the computer’s expected five-year
useful life. At the end of the five-year useful life, the remaining $1
million of adjusted acquisition cost reflects the expected sales
proceeds, with differences between this and any actual sales
proceeds recorded as a gain or loss.
 2. CURRENT INFORMATION
Current Value: Initial Fair Value
Firms use acquisition cost valuations and adjusted acquisition cost
valuations for assets that are not characterized by fixed and
determinable amounts of future cash flows (that is, nonmonetary
assets).
For example, inventories; land; buildings; equipment; legal rights
to use another entity’s technologies, facilities, name, or
distribution channels; and goodwill are examples of nonmonetary
assets.
 Current Values: Fair Value
• Whereas historical value approaches to valuing assets and liabilities provide relevant and
reliable information, they may lose relevance as valuations become old and outdated
and do not reflect current economic conditions
• The FASB defines fair value as “the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date.” This definition explicitly characterizes fair value as a measure of
“exit price,” which is the amount for which a firm could sell an asset or pay to settle or
transfer a liability.
• The IASB defines fair values lightly differently, as “the amount for which an asset could
be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s
length transaction.” This definition allows for the use of an exit price or an entry price
(the amount for which a firm could buy an asset or incur a liability). Differences could
arise between entry and exit price approaches
 Current Values: Fair Value
• Smithfield Foods is the world’s largest producer of pork. Almost half
of Smithfield Foods’ inventories are live hogs. There is an actively
traded market in hogs and hog futures on the Chicago Mercantile
Exchange, which enables a straightforward fair valuation of the live
hog portion of inventories (assuming Smithfield intends to sell these
hogs in open markets).
Current Values: Fair Value Based
on Current
Current replacement cost is the amount a firm would have to pay
currently to acquire or produce an asset it now holds. By virtue of
the term’s reference to an external market, this is special case of
applying the fair value approach discussed previously. However,
whereas straight forward fair values generally pertain to financial
assets and commodities, current replacement cost generally applies
to nonmonetary assets.
Current Values: Fair Value Based
on Current
• Graybar Electric Company is a distributor of electrical equipment and
maintains inventory at various distribution facilities. Graybar holds a large
inventory of gas tube surge protectors for use in residential telephone lines
(1,000,000 units at a cost of $0.75 each). Due to the rise of low-cost
producers and the decreased demand due to decreasing deployment of
wired telephone lines, the cost of these protectors has fallen to $0.25 per
unit.
• Thus, Graybar unrealized holding loss for this inventory of $500,000
(1,000,000 [$0.75 $0.25]), so must reduce the value of the gas tube
protector inventory from $750,000 to $250,000
Current Values: Fair Value Based

• Current Values: Fair Value Based

• Net realizable value is the net amount a firm would receive if it sold
an asset (for example, inventory for which current value has
declined below cost). Just as with current replacement cost
valuation, net realizable value is another special case of a fair value
approach. However, it also shares features of adjusted historical cost
valuation approaches, because historical cost provides a reference
point to determine whether net realizable valuation is applicable.
 Current Values: Fair Value Based
• Google holds approximately $8 billion of investments in various short-
term securities. The net realizable value of these investments could be
computed based on the closing price of each security minus costs to sale,
such as trading commissions.
• Google’s short-term investments is based on prices quoted in actively
traded markets, this amount is both relevant and reliable.
 Income Recognition
• Recognition simply means that the accountant makes an entry to
record a transaction or an event.
• Recognized net income equals revenues and gains minus
expenses and losses.
• The income statement reports the earnings from a firm’s
operating activities for a period of time (as the difference
between revenues and expenses), but also reports gains or losses
realized from investing activities (for example, sale of marketable
securities at a gain or loss) and financing activities (for example,
retirement of debt before maturity at a gain or loss).
 Income Taxes
• In this chapter, the discussion thus far has considered the
measurement of assets, liabilities, revenues, gains, expenses,
and losses before considering any income tax effects. Everyone
is aware that taxes are a significant aspect of doing business,
but few understand how taxes impact financial statements. The
objective of the brief discussion in this section is to familiarize
you with the basic concepts underlying the treatment of
income taxes in the financial statements
 Income Taxes

• For example:
• • Smithfield Foods writes down its live hog inventory $44 million due
to a decline in the market price for live hogs. However, for tax
reporting, Smithfield Foods cannot deduct this write-down
immediately, but must wait until the loss is realized through an actual
sale of the live hogs. Should Smithfield Foods record the presumed tax
benefit that will arise from
PROFITABILITY ANALYSIS
CHAPTER 3
WEEK 6-7
LEARNING OBJECTIVES
1. Evaluate firm profitability using the primary measure of
firm performance—net income—as well as profitability
analysis techniques including
Earnings Per Share Analysis
Common-size Analysis
Percentage Change Analysis
2. Analyze and interpret levels of and changes in the
profitability of a firm using the rate of return on assets and
its components: profit margin and total assets turnover.
 PROFITABILITY ANALYSIS

- is an analysis of the profitability of an

organization's output.
- Output of an organization can be grouped
into products, customers, locations,
channels and/or transactions.
 EARNINGS PER SHARE (EPS)
• is calculated as a company's profit divided by
the outstanding shares of its common stock.
The resulting number serves as an indicator of a
company's profitability.
• is a company's net profit divided by the number
of common shares it has outstanding.
 FORMULA AND CALCULATION
FOR EPS
•is calculated as net profit divided by available
shares.
•the balance sheet and income statement are used
to find the period-end number of common
shares, dividends paid on preferred stock (if any),
and the net income or earnings.
 Simple Capital Structure: Basic
EPS
Basic EPS = Net Income – Preferred Stock Dividends
(Simple Capital Structure) Weighted Average Number
 EXAMPLE 2 – CALCULATING EPS

• Suppose the fiscal year 2017 net income for Bank

of America. Its net income was 18.232 Billion. Its
preferred stock dividends were 1.614 Billion. Its
average outstanding common shares stood at
110.196 Billion.
EXAMPLE 2 - COMPUTATION
 COMMON-SIZE ANALYSIS

• also referred as vertical analysis, is a tool that financial

managers use to analyze financial statements.
• It evaluates financial statements by expressing each line
item as a percentage of the base amount for that period.
The analysis helps to understand the impact of each item
in the financial statement and its contribution to the
resulting figure.
 COMMON-SIZE ANALYSIS
• A simple way of creating greater comparability
across firms and for the same firm through time
is common-size analysis.
• Common-size analysis is most frequently
utilized in the analysis of profitability (the
income statement), but it also can be used in
the analysis of financial position (the balance
sheet).
COMMON-SIZE ANALYSIS
COMMON-SIZE ANALYSIS
FORMULA
 TYPES OF COMMON SIZE
ANALYSIS
Vertical Analysis - refers to the analysis of specific line items in relation
to a base item within the same financial period. For example, in the
balance sheet, we can assess the proportion of inventory by dividing the
inventory line using total assets as the base item.

Horizontal Analysis - refers to the analysis of specific line items and

comparing them to a similar line item in the previous or subsequent
financial period. Although common size analysis is not as detailed as
trend analysis using ratios, it does provide a simple way for financial
managers to analyze financial statements.
 BALANCE SHEET COMMON SIZE
ANALYSIS
• The balance sheet common size analysis mostly
uses the total assets value as the base value.
• On the balance sheet, the total assets value
equals the value of total liabilities and
shareholders’ equity.
BALANCE SHEET COMMON SIZE
ANALYSIS
BALANCE SHEET COMMON SIZE
ANALYSIS
INCOME STATEMENT COMMON SIZE
ANALYSIS
• The base item in the income statement is usually the total sales or
total revenues.
• Common size analysis is used to calculate net profit margin, as well as
gross and operating margins. The ratios tell investors and finance
managers how the company is doing in terms of revenues, and they
can make predictions of future revenues
INCOME STATEMENT COMMON SIZE
ANALYSIS
INCOME STATEMENT COMMON SIZE
ANALYSIS
PERCENTAGE CHANGE ANALYSIS
• shows how two items changed as a percentage from one period
to another period.
• Used on a balance sheet, a percent change analysis shows how
a balance sheet account changes from year to year, or quarter to
quarter.
• The balance sheet accounts are assets, liabilities and
stockholders' equity.
PERCENTAGE CHANGE ANALYSIS
 EXAMPLE PERCENTAGE CHANGE
ANALYSIS

Last year ABC COMPANY "Cash" account had $400 and this
year "Cash" account had $700.

$700 - $400 = $300 X 100 = 75%

$400
 ALTERNATIVE DEFINITIONS OF
PROFITS
• When the analyst assesses the profitability of a firm in the recent past,
the concern is with all revenues, expenses, gains, and losses that
affected the economic value of the firm. However, when the analyst
uses measures of past profitability to forecast the firm’s future
profitability, the emphasis is on those revenues, expenses, gains, and
losses that are expected to persist
 COMPREHENSIVE INCOME

Most financial statement users analyze net income as a summary

bottom-line measure of performance. However, both U.S. GAAP
and IFRS require presentation of comprehensive income, which is
defined as “The change in equity (net assets) of a business entity
during a period from transactions and other events and
circumstances from nonowner sources
 OPERATING INCOME

Another factor driving the analysis of different aggregations of

income statement line items is that firms have different
organizational and capital structures. As a consequence, it is
sometimes helpful to examine profitability prior to considering a
variety of expenses that vary depending on different
organizational or capital structures
 SEGMENT PROFITABILITY
Many firms consist of more than one operating
segment. Both U.S. GAAP and IFRS require that
companies provide measures of profitability and certain
additional information for each segment. The definition
of segments follows the “management approach,”
which leaves the identification of operating segments
up to managers based on how they manage the
operations of the company
RATE OF RETURN ON ASSETS
(ROA)
ANALYZING THE PROFIT MARGIN
FOR ROA
• Profit margin for ROA captures the overall
profitability of a firm’s operations and is measured
as the amount of after-tax profit generated (before
financing costs) as a percentage of sales. Thus,
the analysis of profit margin focuses on all
expenses (other than interest expense) that reduce
sales to after-tax profit
SUMMARY OF PROFIT MARGIN
ANALYSIS