Part 1: Introduction to Financial Statement Analysis

Question 1

Financial Reporting

Answer 1

The way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements.

Question 2

Financial statement analysis

Answer 2

To use the information in a company financial statements, along with other relevant information to make economic decisions.

e.g. whether to invest in company’s securities or recommend them to investors, whether to extend trade or bank credit to the company.

Use:

• To evaluate company’s past performance and current financial position, to form company opinions about company’s ability to earn profits and generate future cashflow.

Question 3

Balance sheet

Answer 3

This reports the firms financial position at a point in time.

This consists of 3 elements:

1. Assets are resources controlled by the firm.
2. Liabilities are amounts owed to lenders and other creditors.
3. Owner’s equity (shareholder’s equity, shareholder funds, net assets) - the residual interest in net assets of an entity that remains after deducting its liabilities from assets.

Question 4

Accounting Equation:

Answer 4

assets = liabilities + owners’ equity

Question 5

Company’s capital structure

Answer 5

The proportions of liabilities and equity used to finance a company.

Question 6

Statement of comprehensive income

Answer 6

This reports all changes in equity except for shareholder transactions (e.g. issuing stock, repurchasing stock, paying dividends).

Question 7

Income statement

Answer 7

The reports on the financial performance of the firm over a period of time.

The three elements:

1. Revenues - the inflows from delivering/producing goods, rendering services or other activities that constitute the entity’s ongoing major or central operations.
2. Expenses - the outflows from delivering/producing g/s that constitute the entity’s ongoing major or central operations.
3. Other income - this includes gains that may/may not arise in the ordinary course of business.

Question 8

Statement of changes in equity

Answer 8

This reports the amounts and sources of changes in equity investors investment in firm over a period of time.

Question 9

Statement of cash flows

Answer 9

This reports the company’s cash receipts and payments, these are classified as follows:

1. Operating cashflows - the cash effects of transactions that involve normal business of the firm.
2. Investing cashflows - those resulting from acquisition or sale of property, plant, and equipment or a subsidiary or segment of securities and investments in other firms.
3. Financing cashflows - those resulting from issuance or retirement of firms debt and equity securities, including dividends paid to stockholders.

Question 10

Financial statement notes

Answer 10

This includes disclosures that provide further details about the information summarised in financial statements, allowing users to improve their assessments of amount, timing, and uncertainty of estimates reported in financial statements.

They:

• Discuss the basis of presentation such as fiscal period covered by statements and inclusion of consolidated entities.
• Provide info about accounting methods, assumptions and estimates used by management.
• Provide add. info on items such as business acquisitions or disposals, legal actions, employee benefit plans, contingencies, and commitments, significant customers, sales to related parties and segments of firm.

Question 11

Management commentary (MD&A)

Answer 11

This addresses the nature of the business, management objectives, the company’s past performance, the performance measures used, the company’s key relationships, resources, and risks.

Question 12

Discussions by MD&A:

Answer 12

• Effects of inflation and changing prices if material.
• Impact of off-balance-sheet and contractual obligations such as purchase commitments.
• Accounting policies require significant judgement by management.
• Forward looking expenditures and divestures.

Question 13

Audit

Answer 13

The independent review of an entity’s financial statements, to enables the auditor to provide an opinion on the fairness and reliability of financial statements.

e.g. analysis of Board of Directors accounting statements, company’s accounting and control systems, confirms assets and liabilities, determine no material errors in financial statements.

Question 14

Standard auditors opinion

Answer 14

3 parts:

1. Perform an independent review of financial statements prepared by management.
2. If accepted auditing standards were followed, this provides reasonable assurance financial statements contain no material errors.
3. Auditor satisfaction statements were prepared in accordance with accepted accounting principles, and are chosen with estimates being reasonable.

Question 15

Unqualified opinion

Answer 15

The auditor believes statements are free from material omissions and errors.

Question 16

Qualified opinion

Answer 16

If statements make any exceptions to accounting principles, explained in audit report.

Question 17

Adverse opinion

Answer 17

If the statements are not presented fairly or materially nonconforming with accounting standards.

Question 18

Disclaimer of opinion

Answer 18

If auditor is unable to express an opinion; such as scope limitation.

Question 19

Modified opinion

Answer 19

Any opinion other than unqualified.

Question 20

Going concern assumption

Answer 20

The material loss is probable, the amount cannot be easily estimated, concerning valuation/realization of asset values, or litigation.

This is of serious concern, and may call for close examination.

Question 21

Internal controls

Answer 21

The process by which the company ensures that it presents accurate financial statements is the responsibility of management.

e.g. US publically traded companies - Key/Critical Audit Matters, quarterly and semi-annual reports, Form 8-K; companies must file to report events such as acquisitions and disposals of major assets, or changes in management or corporate governance.

Question 22

Proxy statements

Answer 22

Issued to shareholders when there are matters that require a shareholder vote, filed within SEC.

A good source of information about the election of board members, compensation, management qualifications, and issuance of stock options.

Question 22

Proxy statements

Answer 22

Issued to shareholders when there are matters that require a shareholder vote, filed within SEC.

A good source of information about the election of board members, compensation, management qualifications, and issuance of stock options.

Question 23

Corporate reports/press release

Answer 23

These are written by management, viewed as public relations or sales materials.

I.e. earnings guidance before financial statements release.

Trade journals, statistical reporting services, government agencies provide information on economic conditions, company industry, and competitor comparisons.

Question 24

Financial Statement Analysis Framework

Answer 24

1. State objective and context
2. Gather data
3. Process the data
4. Analyse and interpret data
5. Report conclusions and recommendations
6. Update analysis