Financial Statement Analysis: A Comprehensive Guide for Business Decisions, Ejercicios de Análisis Farmacéutico

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Financial statements analysis

Need for financial statement analysis

• Financial statements are to be analysed

and interpreted to the users of financial

information so that they can appreciate the

figures .figures.

• The analysis will provide the users with

adequate information which can be used

to make business decisions

BUSINESS ACTIVITIES OF COMPANIES

Planning activities

• A company’s goal and objectives are captured in a business plan that describes the company’s purpose, strategy and tactics for activities.
• Knowledge or insight into a business plan considerably aids FSA of a company’s current and future prospects.
• FS analysts look for information on company objectives, tactics, market demands, competitive analysis, sales strategies (pricing, promotion, distribution), management performance and financial projections.performance and financial projections.
• Information is often revealed in financial reports and through less formal means such as press releases, industry publications and financial newspapers.
• Other important sources:
  • Shareholders’ letter
  • Management’s discussion and analysis

Financial activities

• A company requires financing to carry out its business plan. Two main sources:
• Equity investors
  • Equity investors are major supplier of finance
  • Equity investors’ return are not guaranteed and depend on the level of future earnings
  • Equity financing can be cash, assets or service rendered to a company in exchange for shares
  • Private offerings: shares sold to one or more individuals or organizations
  • Public offerings: shares sold to the public
• Creditor investors
  • Creditor financing of business often occurs through loans
  • Creditors include banks, savings and loans company
  • Creditor financing requires repayment of the loan with interest at specific dates
  • Other short term creditor financing are:
    • Employees providing services to the company without receiving pay per week
    • Utility payment in arrears
    • Supplier payment on credit basis
    • Tax payment in arrears
  • Creditors’ return are specified in loan contract

The directors’ report

• The directors report sets out the responsibilities of management in preparing a company’s financial statements
• Purposes of directors report:
  • To reinforce senior management’s responsibilities for the company’s financial and internal control system
  • To reinforce the shared roles of directors and auditors in preparing the financial statements
• It must include:
  • Review of the company’s financial condition and results of the operation (OFR)
  • Review of the year and likely future developments
  • Highlight of favourable or unfavourable trends and significant events and uncertainties (e.g. inflation and changes in prices and its effects)
  • Names of directors and details of shareholdings
  • Particulars of significant changes in fixed assets
  • Events that occurred since the end of the year, called “post balance sheet events”
  • Dividends proposed to be declared upon the consent of shareholders

7

Auditors report

• An external auditor is an independent certified public accountant hired by management to assess whether the company’s financial statements are prepared in conformity with generally accepted accounting principles (GAAP), accounting standards, companies laws, etc.
• Types of report issued by auditors:
  • Unqualified (clean) opinion : Financial statements “present fairly” (according to accepted accounting practices) a company’s financial performance and position
  • – Qualified opinionQualified opinion : This is an unqualified opinion except for the items relating to: This is an unqualified opinion except for the items relating to the qualification
  • Adverse opinion : Financial statement do not “present fairly” a company’s financial performance and position
  • Disclaimer of opinion : Audit is insufficient in scope to render an opinion
• Financial analyst must review the auditor’s report to ascertain whether the company received an unqualified opinion before conducting any analysis

Supplementary information

• Supplementary information are schedules required by accounting regulatory agencies
• Companies with publicly traded securities are required to produce:
  • Business segment data
  • Export sales
  • Marketable securities
  • – Valuation accountsValuation accounts
  • Short term borrowings
  • Quarterly financial data or half year financial data
  • Source for supplementary data for the USA [http://www.sec.gov/edgarhp.html]

Social responsibility report

• Social responsibility report recognizes the need for social responsibility
• Financial analyst must scrutinize companies social responsibility activities such as:
  • Management’s commitment to employees
  • Management integrity and devotion to human resource development
• List other social responsibility activities of their companies

What does FSA involved?

• It involves sorting through vast information to gain insight into a company’s current and future prospects.
• It involves evaluation of relevant and reliable information for business decisions

Relevant questions to be answered using FSA Creditors perform FSA to answer the following questions:

• What are the reasons for a company’s need for additional financing?
• What are the likely sources for payment of interest and principal?
• How has the company handled its prior short and long-term financing?

Shareholders and potential shareholders perform FSA to answer the following questions:

• What are the company’s current and long-term operating prospect?
• What is the company’s future earnings potentials?
• Are earnings vulnerable to significant variability?
• What is the current financial conditions?
• What factors most likely determine the company’s financial position?
• What is the company’s capital (financing) structure?
• What risks and rewards does the company’s capital structure present?
• How does the company performed compared to its competitors?

An example of how to analyze an item in a financial statement: Debtors

• Debtors are amounts due that arise from the sale of goods, services or loan of money
• Debtors include accrued amounts due such as rents and interest
• Debtors are analyze because of their impact on a company’s asset position and income stream
• Collection of debtors is best estimated on the basis of past experience with suitable allowance for the economy, industry and debtor conditionsallowance for the economy, industry and debtor conditions
• The risk is that, past experience might not be an adequate measure of future loss
• Management estimates the allowance for doubtful debts based on experience, customer fortunes, economy, industry expectations and collection policies

Assessing collection risk of debtors

• Are debtors collection probability assessed?
• Techniques for investigating debtors collection:
  • Determine patterns of debtors for competing companies as a percentage of sales vis-à-vis the company under analysis
  • Examine customer concentration. Risk increase when total debtors are concentrated among one or few major customersamong one or few major customers
  • Investigate the age pattern of debtors (watch out for overdue and how long)
  • Determine the proportion of debtors that are renewals of previous accounts
  • Analyze adequacy of allowances for trade discounts, returns and other credits

Stocks

• Stocks refer to goods held for sale as part of a company’s normal business operations
• Scrutinize stocks since they are a major component of operating assets and directly affect determination of income
• Stock should be valued at cost or market value

Analysis implications of stocks

• Does stock physically exist and is it fairly valued? Audit procedure should give assurance
• Board of directors and audit committee are accountable for management abuses of stock
• Cases involving manipulation of stocks continue to arise:
  • Cenco company’s scheme involves irregularity of nearly $25 million forced Cenco’s auditors to pay damages of $3.5 million
  • Saxon Industries maintained its borrowings from banks by overstating stocks by about $50 million. When management’s scheme was exposed, Saxon filed for bankruptcy
• Accounting standards require disclosure of changes in policies and impact of such changes. Analysts should be alert for changes such as from FIFO to LIFO (^17)

Comparative financial statement analysis

• It is conducted by setting consecutive balance sheets, income statements and cash flows side by side and reviewing changes in individual categories on a year-to-year or multi-year basis.
• It is also referred to as horizontal analysis
• Comparative analysis reveals trends of items or elements in the statements
• Comparative analysis also reveals direction, speed and extent of a trend.
• Comparative analysis also compares trends in related items.
  • Examples: 10% sales increase accompanied with a 20% increase in freight-out costs requires investigation and explanation.
• Two techniques of comparative analysis: (i) year-to-year change analysis (ii) index- number trend series analysis.

Year –to-year change analysis

2006 2005 Change Change ¢ ¢ ¢ % Net revenue 659,347 466,194 193,153 41. Cost of revenue 275,939 205,596 70,343 34. Gross profit 383,408 260,598 122,810 47. Operating expenses: Research and development 87,628 60,848 26,780 44. Sales and marketingSales and marketing 81,54881,548 58,73758,737 22,81122,811 38.838. General and administrative 35,784 23,229 12,555 54. Write-off of technology 52,313 0 52,313 - - Income from operation 126,135 117,784 8,351 7. Interest income 12,694 7,932 4,762 60. Interest expense (840) (1,179) (339) (28.0) Income before income taxes 137,989 124,537 13,452 10. Provision for income taxes 34,614 31,135 3,479 11. Net income 103,375 93,402 9,973 10.