Reading 21 - Financial Statement Analysis - An Introduction

Question 1

Role of financial statement reporting:

Answer 1

To provide information about a company’s financial performance, financial position, and changes in financial position.

Question 2

Role of financial statement analysis:

Answer 2

To assess a company’s past performance and evaluate its future prospects using financial reports along with other relevant company information. Assessments are performed prior to making an investing decision, offering any credit facilities, or making other economic decisions related to the company.

Question 3

How can a company’s performance be examined?

Answer 3

A company’s performance can be examined through profitability (ability to generate profits from core business activities) and cash flow (ability to generate cash receipts in excess
of cash payments) measures. A forecast of the expected amount of future cash flows is important in determining the company’s ability to meet its obligations.

Question 4

Liquidity

Answer 4

Liquidity refers to a company’s ability to meet its short-term obligations. 


Question 5

Solvency

Answer 5

Solvency refers to a company’s ability to meet its long-term obligations. 


Question 6

Role of financial statements

Answer 6

Companies prepare financial statements to report their operating performance to investors and creditors. 


Question 7

Statement of Comprehensive Income (or Income Statement plus Statement of Other Comprehensive Income) 


Answer 7

The income statement is also known as the statement of operations or profit and loss statement. It provides operating information relating to a company’s business activities over a period of time (the accounting period). The income statement presents revenues earned by a company and corresponding costs. The difference between a company’s total revenue and total costs equals net income. 


Net income = Revenue − Expenses



Question 8

Why are income statements useful?

Answer 8

Income statements are useful in evaluating a company’s profitability and therefore are an 
important source of information for financial statement analysis. 


Question 9

Balance sheet

Answer 9

Balance sheets, also known as statements of financial position, present a company’s assets, liabilities, and equity at a point in time. The interrelationships between these three components of the balance sheet is presented in the basic accounting equation:

Assets = Liabilities + Owners’ equity

Question 10

Assets

Answer 10

Assets are the productive resources that a company owns.

Question 11

Liabilities

Answer 11

Liabilities are amounts that the company owes other entities.

Question 12

Owners’ equity

Answer 12

Owners’ equity represents shareholders’ residual claim on the company’s assets after deducting liabilities.

Owners’ equity = Assets − Liabilities

Question 13

Cash Flow Statement

Answer 13

A cash flow statement reports the various sources of cash receipts and cash payments. The statement classifies the sources and uses of cash into operating, investing, and financing activities.

Question 14

Cash Flow Statement: Operating activities

Answer 14

Operating activities refer to the day‐to‐day core business activities of a company. 


Question 15

Cash Flow Statement: Investing activities

Answer 15

Investing activities relate to the acquisition or disposal of long‐term assets. 


Question 16

Cash Flow Statement: Financing activities

Answer 16

Financing activities relate to the injection or repayment of capital. 


Question 17

Cash Flow Statements: What is a desirable quality?

Answer 17

Cash flow statements reflect a company’s ability to generate cash from its core business activities. It is desirable that a company generates most of its cash from operating activities, as opposed to investing and financing activities.

Question 18

Cash Flow Statements: How can it give insights?

Answer 18

A company’s sources and uses of cash provide valuable insight into its liquidity and solvency levels and its financial flexibility (ability to react and adapt to financial adversities and investment opportunities).

Question 19

Statement of changes in owners’ equity

Answer 19

This statement reports any changes in owners’ investment in the business. It is useful in understanding changes in the financial position of a company. 


Question 20

Financial notes and supplementary information

Answer 20

Financial notes are an important part of financial statements because they provide detailed explanatory information about the following:

• Accounting policies, methods, and estimates 

• Business acquisitions and disposals 

• Commitments and contingencies 

• Legal proceedings 

• Subsequent events 

• Related‐party transactions 

• Business and geographic segments 

• Financial instruments and risks arising from them 


Question 21

Footnotes

Answer 21

Footnotes contain important details about the accounting methods, estimates, and assumptions that have been used by the company in preparing its financial statements.
For example, information about the choice of revenue recognition method used and assumptions made to calculate depreciation expense are typically found in the footnotes. The availability of such information facilitates comparisons between companies that prepare their financial statements in accordance with different accounting standards (IFRS vs. U.S. GAAP). Note that financial statement footnotes are also audited. 


Question 22

Management’s discussion and analysis (MD&A)

Answer 22

The management discussion and analysis section (required under U.S. GAAP) highlights important trends and events that affect a company’s liquidity, capital resources, and operations. Management also discusses prospects for the upcoming year with respect to inflation, future goals, material events, and uncertainties. The section must also discuss critical accounting policies that require management to make subjective judgments 
and have a material impact on the financial statements. Although it contains important information, analysts should bear in mind that the MD&A section is not audited. 


Question 23

IFRS is in the process of finalizing a framework to provide guidance relating to items that should be discussed in management commentary. These items include: 


Answer 23

• The nature of the business 

• Management objectives and strategies 

• The company’s significant resources, risks, and relationships 

• Results of operations 

• Critical performance measures 


Question 24

Auditing

Answer 24

The financial statements presented in a company’s annual report must be audited. They must be examined by an independent accounting firm (or audit practitioner) which
then states its opinion on the financial statements. Audits are required by contractual arrangement, law, or regulation.

Question 25

Objective of audits:

Answer 25

Under International Standards for Auditing, objectives of an auditor are:

• To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting frame‐work; and 

• To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings.

Question 26

Types of Audit Opinions

Answer 26

An unqualified opinion

A qualified opinion

An adverse opinion

A disclaimer of opinion

Question 27

Types of Audit Opinions: An unqualified opinion

Answer 27

An unqualified opinion states that the financial statements have been presented fairly in accordance with applicable accounting standards. 


Question 28

Types of Audit Opinions: A qualified opinion

Answer 28

A qualified opinion states that the financial statements have been presented fairly, but do contain exception(s) to the accounting standards. The audit report provides further details and explanations relating to the exception(s). 


Question 29

Types of Audit Opinions: An adverse opinion

Answer 29

An adverse opinion states that the financial statements have not been presented fairly and significantly deviate from acceptable accounting standards. 


Question 30

Types of Audit Opinions: A disclaimer of opinion

Answer 30

A disclaimer of opinion is issued when the auditor, for whatever reason, is not able to issue an opinion on the financial statements. 


Question 31

Internal controls

Answer 31

Internal controls: The internal control system of a company seeks to ensure the reliability 
of processes used by the company in preparing its financial statements. In the United States, management is responsible for the effectiveness of internal control, to evaluate the effectiveness of internal control, to support the evaluation, and to provide a report on internal control. 


Question 32

Identify information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information. 


Answer 32

Interim reports

Proxy statements

Press releases

External sources

Question 33

Interim reports

Answer 33

Interim reports are prepared either semiannually or quarterly. They contain the four financial statements and footnotes, but are not audited.

Question 34

Proxy statements

Answer 34

Proxy statements are distributed to shareholders when there are matters that require a shareholder vote. They provide information about management and director compensation, company stock performance, and potential conflicts of interest between management, the board of directors, and shareholders. 


Question 35

Press releases

Answer 35

Press releases, in addition to a company’s website and conference calls, provide current information about the company. 


Question 36

External sources

Answer 36

External sources provide information about the economy, the industry that the company operates in, and the company’s competitors. Such information is useful as it allows the analyst to place the company’s performance in perspective. Examples of external sources include trade journals and government agencies. 


Question 37

List the steps in the financial statement analysis framework:

Answer 37

Define the purpose and context of the analysis

Collect data

Process data

Analyze/interpret the processed data

Develop and communicate conclusions

Follow up

Question 38

A generic framework for financial statement analysis involves the following steps: 
Define the purpose and context of the analysis

Answer 38

In cases where the task is well‐defined, the purpose is governed by institutional norms. However, there are also analytical tasks that require the analyst’s discretion in defining the purpose. The definition of the purpose determines the approach, tools, data sources, and the format used to present results. In this preliminary stage, the analyst is also required to define the context of the analysis, which requires understanding the audience, the time frame, and the resources available for completion of the task. 


Question 39

A generic framework for financial statement analysis involves the following steps: Collect data

Answer 39

The analyst acquires the necessary information to answer the questions that were defined in the previous stage. For instance, a task with the purpose of analyzing the historical performance of a company could be carried out by understanding the financial statements alone. However, a more thorough analysis that requires understanding a company’s financial performance and position relative to the industry would require collecting industry data as well. 


Question 40

A generic framework for financial statement analysis involves the following steps: Process data

Answer 40

The financial information collected is converted into ratios, growth rates, common‐ size financial statements, charts, and regressions. 


Question 41

A generic framework for financial statement analysis involves the following steps: Analyze/interpret the processed data

Answer 41

The data is interpreted and a recommendation is reached. 


Question 42

A generic framework for financial statement analysis involves the following steps: Develop and communicate conclusions

Answer 42

An appropriate format for the presentation of analysis is determined. The presentation format is sometimes determined by regulatory authorities or professional standards. 


Question 43

A generic framework for financial statement analysis involves the following steps: Follow up

Answer 43

Financial statement analysis does not end with the preparation of a recommendation report. When equity analysis is performed or a credit rating is assigned, periodic reviews are required to determine whether previously drawn conclusions remain valid. 


Question 44

Financial Statement Analysis Framework: 1) Define the purpose and context of the analysis – Sources of information and output

Answer 44

Sources of information

The nature of the analyst’s function, such as evaluating an equity or debt investment or issuing a credit rating

Communication with client or supervisor on needs and concerns

Institutional guidelines related to developing specific work product

Output

Statement of the purpose or objective of analysis

A list (written or unwritten) of specific questions to be answered by the analyst

Nature and content of report to be provided

Timetable and budgeted resources for completion

Question 45

Financial Statement Analysis Framework: 2) Collect data – Sources of information and output

Answer 45

Sources of information

Financial statements, other financial data, questionnaires, and industry/economic data

Discussions with management, suppliers, customers, and competitors

Company site visits (e.g., to production facilities or retail stores)

Output

Organized financial statements Financial data tables


Completed questionnaires, if applicable

Question 46

Financial Statement Analysis Framework: 3) Process data – Sources of information and output

Answer 46

Sources of information

Data from the previous phase

Output

Adjusted financial statements

Common‐size statements


Ratios and graphs


Forecasts

Question 47

Financial Statement Analysis Framework: 4) Analyze/interpret the processed data – Sources of information and output

Answer 47

Sources of information

Input data as well as processed data

Output

Analytical results


Question 48

Financial Statement Analysis Framework: 5) Develop and communicate conclusions – Sources of information and output

Answer 48

Sources of information

Analytical results and previous reports

Institutional guidelines for published reports

Output

Analytical report answering questions posed in phase

Recommendation regarding the purpose of the analysis, such as whether to make an investment or grant credit

Question 49

Financial Statement Analysis Framework: 6) Follow up – Sources of information and output

Answer 49

Sources of information

Information gathered by periodically repeating above steps as necessary to determine whether changes to holdings or recommendations are necessary

Output

Updated reports and recommendations

Question 50

Balance Sheet

Answer 50

The financial statement that presents an entity’s current financial position by disclosing resources the entity controls (its assets) and the claims on those resources (its liabilities and equity claims), as of a particular point in time (the date of the balance sheet). Also called statement of financial position or statement of financial condition.

Question 51

Statement of financial position

Answer 51

The financial statement that presents an entity’s current financial position by disclosing resources the entity controls (its assets) and the claims on those resources (its liabilities and equity claims), as of a particular point in time (the date of the balance sheet).

Question 52

Statement of financial condition

Answer 52

The financial statement that presents an entity’s current financial position by disclosing resources the entity controls (its assets) and the claims on those resources (its liabilities and equity claims), as of a particular point in time (the date of the balance sheet)

Question 53

Owner’s equity

Answer 53

The excess of assets over liabilities; the residual interest of shareholders in the assets of an entity after deducting the entity’s liabilities. Also called shareholders’ equity.

Question 54

Current vs. non-current assets

Answer 54

Current assets are defined, in general, as those that are cash or cash equivalents; are held for trading; or are expected to be converted to cash (realized), sold, or consumed within 12 months or the company’s normal operating cycle. All other assets are classified as non-current.

Question 55

Current vs. non-current assets

Other definition:

Answer 55

Current liabilities are defined, in general, as those that are expected to be settled within 12 months or the company’s normal operating cycle. All other liabilities are classified as non-current.

Question 56

Revenue

Answer 56

The amount charged for the delivery of goods or services in the ordinary activities of a business over a stated period; the inflows of economic resources to a company over a stated period.

Question 57

Expenses

Answer 57

Outflows of economic resources or increases in liabilities that result in decreases in equity (other than decreases because of distributions to owners); reductions in net assets associated with the creation of revenues.

Question 58

Statement of operations/profit and loss (P&L) Statement

Answer 58

A financial statement that provides information about a company’s profitability over a stated period of time.

The basic equation underlying the income statement is Revenue + Other income – Expenses = Income – Expenses = Net income.

Question 59

Diluted shares

Answer 59

The number of shares that would be outstanding if all potentially dilutive claims on common shares (e.g., convertible debt, convertible preferred stock, and employee stock options) were exercised.

Question 60

Financial flexibility

Answer 60

The ability to react and adapt to financial adversities and opportunities.

Question 61

Operating activities

Answer 61

Activities that are part of the day-to-day business functioning of an entity, such as selling inventory and providing services.

Question 62

Investing activities

Answer 62

Activities which are associated with the acquisition and disposal of property, plant, and equipment; intangible assets; other long-term assets; and both long-term and short-term investments in the equity and debt (bonds and loans) issued by other companies.

Question 63

Financing activities

Answer 63

Activities related to obtaining or repaying capital to be used in the business (e.g., equity and long-term debt).

Question 64

Depreciation

Answer 64

The process of systematically allocating the cost of long-lived (tangible) assets to the periods during which the assets are expected to provide economic benefits.

Question 65

What is the primary purpose of financial reports?

Answer 65

The primary purpose of financial reports is to provide information and data about a company’s financial position and performance, including profitability and cash flows. The information presented in financial reports—including the financial statements and notes—and other reports—including management’s commentary or management’s discussion and analysis—allows the financial analyst to assess a company’s financial position and performance and trends in that performance.

Question 66

Name and describe the basic financial statements

Answer 66

The basic financial statements are the statement of financial position (i.e., the balance sheet), the statement of comprehensive income (i.e., a single statement of comprehensive income or two statements consisting of an income statement and a statement of comprehensive income), the statement of changes in equity, and the statement of cash flows.

Question 67

Describe the balance sheet and its three parts.

Answer 67

The balance sheet discloses what resources a company controls (assets) and what it owes (liabilities) at a specific point in time. Owners’ equity represents the net assets of the company; it is the owners’ residual interest in or residual claim on the company’s assets after deducting its liabilities. The relationship among the three parts of the balance sheet (assets, liabilities, and owners’ equity) may be shown in equation form as follows: Assets = Liabilities + Owners’ equity.

Question 68

Describe the income statement

Answer 68

The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue and other income the company generated during a period and what expenses, including losses, it incurred in connection with generating that revenue and other income. The basic equation underlying the income statement is Revenue + Other income – Expenses = Net income.

Question 69

Describe the statement of comprehensive income.

Answer 69

The statement of comprehensive income includes all items that change owners’ equity except transactions with owners. Some of these items are included as part of net income, and some are reported as other comprehensive income (OCI).

Question 70

What does the statement of changes in equity provide?

Answer 70

The statement of changes in equity provides information about increases or decreases in the various components of owners’ equity.

Question 71

What is the purpose of reporting cash and cash flow.

Answer 71

Although the income statement and balance sheet provide measures of a company’s success, cash and cash flow are also vital to a company’s long-term success. Disclosing the sources and uses of cash helps creditors, investors, and other statement users evaluate the company’s liquidity, solvency, and financial flexibility.

Question 72

What is the purpose of note (footnotes)?

Answer 72

The notes (also referred to as footnotes) that accompany the financial statements are an integral part of those statements and provide information that is essential to understanding the statements. Analysts should evaluate note disclosures regarding the use of alternative accounting methods, estimates, and assumptions.

Question 73

In addition to the financial statements, a company provides other sources of information that are useful to the financial analyst. What else should the analyst read?

Answer 73

In addition to the financial statements, a company provides other sources of information that are useful to the financial analyst. As part of his or her analysis, the financial analyst should read and assess this additional information, particularly that presented in the management commentary (also called management report[ing], operating and financial review, and management’s discussion and analysis [MD&A]).

Question 74

Describe the purpose of an independent audit.

Answer 74

A publicly traded company must have an independent audit performed on its annual financial statements. The auditor’s report expresses an opinion on the financial statements and provides some assurance about whether the financial statements fairly present a company’s financial position, performance, and cash flows. In addition, for US publicly traded companies, auditors must also express an opinion on the company’s internal control systems.

Question 75

What information is crucial to an analyst’s effectiveness?

Answer 75

Information on the economy, industry, and peer companies is useful in putting the company’s financial performance and position in perspective and in assessing the company’s future. In most cases, information from sources apart from the company are crucial to an analyst’s effectiveness.

Question 76

The financial statement analysis framework provides steps that can be followed in any financial statement analysis project. These steps are:

Answer 76

articulate the purpose and context of the analysis;

collect input data;

process data;

analyze/interpret the processed data;

develop and communicate conclusions and recommendations; and

follow up.