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AcF100 - Financial Statement Analysis > Week 21 - Introduction to Financial Statement Analysis > Flashcards

Week 21 - Introduction to Financial Statement Analysis Flashcards

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1
Q

What is the purpose of Accounting?

A

To record, organise, and report a company’s economic transactions by following GAAP, and to create financial statements.

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2
Q

What rules must accountants follow?

A

GAAP — Generally Accepted Accounting Principles.

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3
Q

What are the main financial statements created in Accounting?

A

Income Statement

Balance Sheet

Cash Flow Statement

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4
Q

What is the purpose of Finance?

A

To analyse information and make decisions about investing, borrowing, and managing money.

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5
Q

How does Finance decide if something (e.g., stock, bond) is a good investment?

A

Gather data (financial statements, market info, economy).

Analyse risk vs. return.

Use tools like NPV, IRR, ratios, and valuation models.

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6
Q

What types of data are needed in Finance?

A

Financial statements, market information, and broader economic data.

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7
Q

Who does financial statement analysis?

A

Financial Analysts

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8
Q

What is the analyst’s main task?

A

To “unpack” financial reports and recreate the underlying economic reality as accurately as possible.

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9
Q

What do financial statements represent?

A

A summary of a company’s underlying economic reality.

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10
Q

Why is an analyst’s work challenging?

A

Because financial reports imperfectly reflect economic reality — analysts must interpret and adjust for noise or distortions.

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11
Q

How do analysts deal with imperfect financial reports?

A

By carefully analysing, adjusting, and interpreting financial statements to better approximate the true economic condition of the company.

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12
Q

What are business fundamentals?

A

The company’s actual economic activities and conditions.

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13
Q

What influences the way financial reports are prepared?

A

GAAP (Accounting rules)

Management discretion (choices in accounting methods, estimates, transaction structure, and timing)

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14
Q

What aspects of management discretion affect financial reporting?

A

Choice of accounting methods

Use of accounting estimates

Structuring and timing of transactions

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15
Q

Why might financial reports differ from business fundamentals?

A

Because GAAP rules and management discretion can cause financial reports to imperfectly represent the underlying economic reality.

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16
Q

Is company performance only determined by management competence?

A

No. Other factors like the economic environment, government policy, accounting rules, and corporate law also affect performance.

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17
Q

What external factors influence company performance besides management?

A

Economic environment

Government policy

Accounting rules and regulation

Corporate law

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18
Q

Why is understanding context important in evaluating a company?

A

Because external factors beyond management control also impact company performance.

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19
Q

What context areas are we focusing on?

A

Industry and strategy.

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20
Q

Where can we find a company’s financial statements?

A

In the company’s annual report.

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21
Q

What documents are included in a company’s annual report?

A

Financial statements

Independent Auditor’s Report

Strategic Report (including the Chief Executive’s Letter)

Directors’ Report

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22
Q

What is found in the Strategic Report section of an annual report?

A

The Chief Executive’s Letter and other information about the company’s strategy and performance.

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23
Q

What is included in the Directors’ Report?

A

Corporate Governance Report

Directors’ Remuneration Report

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24
Q

What does the Independent Auditor’s Report provide?

A

An external opinion on whether the financial statements present a true and fair view of the company’s financial position.

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25
What main components are included in a company's annual report?
Financial statements Independent Auditor’s Report Strategic Report (including Chief Executive’s Letter) Directors’ Report (including Corporate Governance Report and Directors’ Remuneration Report)
26
Who signs off and oversees the content in an annual report?
The Board of Directors (BoD).
27
What is the organisational hierarchy (triangle) related to reporting?
Top → Board of Directors (BoD) Middle → Management suite (CEO, CFO, etc.) Bottom → Managers and employees
28
Who is responsible for running the company on a daily basis?
The management suite (CEO, CFO, and other top executives).
29
Who oversees management and represents shareholder interests?
The Board of Directors (BoD).
30
What is the purpose of a company's annual report?
To provide narrative and quantitative information to interested parties (shareholders, creditors, stakeholders, etc.).
31
What types of information are included in annual reports?
Past performance Present financial condition Future strategy and forecasts
32
Who are the audiences for annual reports?
Shareholders, creditors, and other stakeholders.
33
How does an annual report balance time perspectives?
It reflects on the past and present, and forecasts the future.
34
What does the Balance Sheet (Statement of Financial Position, SOFP) show?
The company’s financial position at a point in time — assets, liabilities, and owners’ equity.
35
What does the Income Statement (Statement of Profit or Loss, SOPL) show?
Measures of performance over a period of time — mainly profits.
36
What does the Cash Flow Statement show?
Cash inflows and outflows over a period of time — actual cash performance.
37
What is the purpose of the Statement of Changes in Equity?
To reconcile the Balance Sheet and Income Statement by showing changes in owners’ equity over time.
38
What does the Balance Sheet show?
Assets, liabilities, and equity at a point in time.
39
What do Assets represent?
What the company owns.
40
What do Liabilities represent?
What the company owes.
41
What does the Income Statement show?
The changes in equity over time through income and expenses.
42
What is the first step in using accounting analysis?
To assess how well financial statements capture the economic ‘reality’.
43
What are the key steps in performing accounting analysis?
Identify key accounting policies Assess accounting flexibility Evaluate accounting strategy Evaluate quality of disclosure Identify potential red flags Synthesize risks and undo accounting distortions
44
What is the purpose of identifying key accounting policies?
To understand how the company’s choices may impact the presentation of financial statements.
45
What does assessing accounting flexibility mean?
Understanding the leeway management has in applying accounting rules, and how it might affect financial statements.
46
Why evaluate accounting strategy?
To understand management’s approach to using accounting methods to reflect financial performance, often with long-term goals in mind.
47
What’s important when evaluating the quality of disclosure?
Ensuring transparency and comprehensiveness in presenting financial information.
48
Why is it important to identify potential red flags in accounting?
To detect manipulation, risks, or discrepancies that might distort the company’s financial health.
49
What analytical tools are useful in accounting analysis?
Understanding accounting rules Understanding management incentives Comparing with peers and over time
50
Why is understanding management incentives important in accounting analysis?
Because management may have incentives to report in a way that boosts short-term financial appearances, which can distort the economic reality.
51
What’s the ultimate goal of using these analytical tools in accounting?
To synthesise risks, undo accounting distortions, and better capture the economic reality of the company.
52
What is the purpose of business strategy analysis?
To identify key profit drivers and business risks.
53
What non-numeric information is necessary for assessing a company's performance?
Industry-level analysis (e.g., Porter’s 5 Forces) Firm-level analysis (e.g., Competitive Strategy) ESG impacts (Environmental, Social, Governance)
54
What is firm-level analysis used to evaluate?
A company’s competitive strategy within its industry, focusing on how it creates value and sustains a competitive advantage.
55
What does ESG stand for, and why is it important?
ESG stands for Environmental, Social, and Governance factors. These factors impact a company’s risks and opportunities and are crucial for long-term performance.
56
What determines the profitability of an industry?
The degree of competition and bargaining power within the industry, which affects both costs and pricing power.
57
What is the purpose of Industry Analysis?
To understand the profitability and attractiveness of an industry using frameworks like Porter’s Five Forces.
58
What are the components of Porter’s Five Forces?
Rivalry among existing firms Threat of new entrants Threat of substitute products Bargaining power of buyers Bargaining power of suppliers
59
What does "Rivalry among existing firms" refer to in industry analysis?
The competition within the industry and the ability of firms to steal market share by: Entering price wars Improving service Investing in advertising
60
How can firms steal market share from competitors?
Entering price wars (reducing prices to attract customers) Improving service (offering better quality or customer experience) Advertising (increasing brand visibility and appeal)
61
Key questions to analyse rivalry:
– What is the growth potential in the industry? * Growing industry = lower competition (more room for all firms to expand) – How concentrated is the industry? * Highly concentrated = less competition (fewer players sharing the market) – Are there scale or learning economies (reduce costs over volume or experience)? * Create barriers for smaller or less efficient competitors, reducing the intensity of rivalry – Are there exit barriers (e.g., sunk costs, long-term contracts)? * High exit barriers keep firms in the industry, intensifying rivalry even in low-profit conditions
62
Rivalry among existing firms Example: J Sainsbury plc
* Growth potential – Little potential for growth in traditional supermarkets, but large potential for growth in internet shopping * Industry concentration – Quite concentrated industry – fierce price competition * Scale economies – Bulk purchases from suppliers & from UK delivery network * Learning economies – Internet shopping: improve efficiency as it gains experience in online retailing
63
What does the "Threat of New Entrants" mean in industry analysis?
The likelihood that new competitors will enter the industry and intensify competition, pressuring existing companies to lower prices and reduce profits.
64
How does a high threat of new entrants affect existing companies?
It forces existing firms to lower prices or improve offerings, which can reduce profitability.
65
What are examples of barriers to entry that protect existing firms?
Economies of scale Brand loyalty High capital requirements Patents and proprietary technology Licenses or legal restrictions
66
Threat of new entrants Key Questions:
– Can new entrants benefit from economies of scale? * New entrants may struggle to compete on cost with established players who already benefit from economies of scale – Is there a first mover advantage? * Early market entrants can secure strong brand recognition, customer loyalty, and supplier relationships. – Any entry barriers? * Discourage or prevent new firms from entering the market
67
Threat of new entrants Example: J Sainsbury plc
* Economies of Scale – New entrants would not have the purchasing power (exert influence over suppliers) as large supermarkets like Sainsbury’s * First-Mover Advantage – New entrants would have to invest significant resources to build brand recognition * Distribution Networks – New entrants would need considerable time and resources to build relationships with suppliers of branded goods and establish the distribution network * Entry barriers – Few legal barriers to entry – But other entry barriers such as distribution networks
68
What is the "Threat of Substitute Products" in industry analysis?
The risk that customers switch to alternative products if they are easier or cheaper to obtain.
69
When are customers more likely to switch to substitutes?
When it is easy to switch When substitutes are cheaper than current options
70
Threat of substitute products Key Questions:
- Are there substitute products? Is it easy for customers to switch to substitutes (switching costs)? – How willing are customers to switch to substitutes (brand loyalty)? – What is the firm doing to prevent competition from substitutes?
71
Threat of substitute products Example: J Sainsbury plc
* Substitute products – Tesco, Asda, Amazon Fresh, etc. * Low switching costs – similar prices across main retailers * Customer Willingness – price-sensitive, willing to switch if substitutes offer better prices, promotions. * Customer Loyalty – Use loyalty programs (e.g., Nectar card) that provide rewards and discounts to encourage repeat customers.
72
What is the "Bargaining Power of Buyers" in industry analysis?
The ability of customers to demand lower prices, better quality, or more services when they have strong buyer power.
73
Bargaining Power of Buyers Key Questions:
– How price sensitive are our buyers? * If buyers are highly price-sensitive, they are more likely to demand lower prices or switch to alternatives, increasing their bargaining power – How much power do the buyers have? * Buyer power: influence or control the price, quality, or terms of a product. * Factors influencing buyer power include: concentration of buyers, availability of substitutes, switching costs
74
Bargaining Power of Buyers Example: J Sainsbury plc
* Sainsbury’s has ranges to meet the needs of different types of customer (Basics, Organics, Taste the difference) – Basics * budget-conscious shoppers, low switching costs, higher bargaining power – Taste the Difference or Organics * less price-sensitive, higher brand loyalty, fewer direct substitutes, less bargaining power
75
What is the "Bargaining Power of Suppliers" in industry analysis?
The ability of suppliers to charge higher prices or demand better terms if they hold strong negotiating power.
76
When do suppliers have strong bargaining power?
When they have a monopoly (few or no alternative suppliers) When they offer a highly differentiated product or service
77
How does strong supplier power affect companies?
It increases costs for companies, potentially reducing their margins and profitability.
78
Bargaining Power of Suppliers Key Questions:
– What price sensitivity is there? – How much bargaining power do suppliers have?
79
Bargaining Power of Suppliers Example: J Sainsbury plc
* Suppliers’ limited control over price – agreed selling prices with major retailers like Sainsbury's * Low supplier power – Due to Sainsbury's size and market share, suppliers have small bargaining power in relation to major supermarkets like Sainsbury's, Tesco, and Asda. – Sainsbury’s can switch between suppliers or even source private label products (own-brands), which further reduces suppliers' influence.
80
What is the purpose of Competitive Strategy Analysis?
To understand how a company creates a competitive advantage and the factors that help or hinder its success within an industry.
81
At what level is Competitive Strategy Analysis performed?
At the firm level — focusing on the individual company's goals, strategies, and challenges.
82
What are the two main types of competitive strategies?
Cost Leadership Differentiation
83
What is Cost Leadership Strategy?
Offering standardised products at a lower price to attract a high sales volume and dominate market share.
84
What is Differentiation Strategy?
Offering unique products at a premium price, building strong brand loyalty and reducing competition based on price alone.
85
Strategies for Creating Competitive Advantage: An example J Sainsbury
Cost leadership * ‘Basics brand’ with cheaper price – buy in bulk and sell in no-frills packaging * Adverts : ‘live well for less’ * Targets budget-conscious customers Product differentiation * ‘Taste the difference’, ‘SO organic’ * Reinforced through advertising – ‘try something new today’ * Target customers who are willing to pay more for quality and specialty products

AcF100 - Financial Statement Analysis (9 decks)

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