Appunti Financial Statement Analysis

Financial Statement Analysis and Managerial Accounting UCSC

Martina Marazzi

Financial statement analysis

Fundamentals of accounting: A users’ perspective

The annual report is a fundamental document. An annual report is a financial document to report on a company's activities throughout the past year, which is bigger than the financial statements and can go up to 600 pages or more – usually the more complex the company is, the more pages the annual report is composed of.

If the company is listed, the company has to publish the annual report, since there might be people who want to know everything about the company or want to join the company; on the other hand, if the company is a family-owned business, there is no need to publish the annual report.

Annual reports are intended to give shareholders (that are the owners of the company) and other interested people information about the company's activities and financial performance. Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry.

The minimum content of the financial report depends on the legal status of the company, and it’s disciplined by the regulations in place where the legal entity is located. The voluntary disclosure of financial information in listed companies mainly is determined by financial communication choices or tactics.

For listed companies, the annual report includes specification of:

• Financial result highlight
• Governance and ownership structure
• Discussion and analysis of recent economic events
• Financial Statements (Consolidated and separate entity parent company)
  • Balance sheet (or Statement of Financial Position) – shows the financial position on a given day
  • Income statement – shows the economic performance over a given period
  • Statement of cash flows – shows the financial performance over a given period
• Footnotes to explain elements of financial statements
• The report of independent auditors
• Statement of management responsibility for preparation of financial statements

The main items of the annual report are:

• Management report to the board of directors (addresses the board of directors to know what the business is about)
• Financial statements (numbers)
• Notes to the consolidated financial statements (the notes are important to know where the financial statements, that is the numbers, come from)
• Other disclosures
• Independent auditor’s report

The notes to the consolidated financial statements are actually given because the numbers that come from the financial statements cannot be created out of the blue, but there are institutional frameworks that need to be followed.

The role of accounting standards

The OIC (Organismo Italiano di Contabilità) is the accountancy body that is composed of professionals who work in the world of accounting and sets rules, which means that they formulate the accounting principles that apply, and especially set standards in Italy for small national businesses. Standards are accounting principles that apply, and they are needed in order to compare one company to another, otherwise, the comparison would not be possible.

But in order to compare companies at an international level, there is another institution of setting, which is called IASB (International Accounting Standards Board), and is an independent, private-sector body that develops and approves IFRSs (so the accounting principle that it issues in order to assure comparability is called IFRS (International Financial Reporting Standard)).

Another item of the annual report is the auditor’s report: the independent auditors are individuals who inspect and verify the accuracy of a company's financial records, so the auditor’s report is a compliance report, and it’s important to note that the company is in charge of paying for the auditor’s report. Public companies are required to use a public accounting firm for the conduct of an audit of their financial statements. At the end of the auditing process, the auditing firm (or the independent auditor) issues an auditing report and an opinion on the quality of financial measurement.

The three main financial statements and their links

Balance sheet

The main components of the Balance Sheet are:

• Assets - economic resources of the firm that can be turned into cash
• Liabilities - economic obligations of the firm which will use cash
• Owners’ equity - the residual interest in, or remaining claims against, the firm’s assets after deducting liabilities (rights of the owners). Generally, it reflects the amount of capital the owners invested plus any profit that the company generates that is subsequently reinvested in the company

So, Assets and Liabilities are the elements that we record and recognize, while the equity is the difference between them. Owner’s equity is composed of Share Capital and Retained Earnings and is the result of their sum.

Income statement

The main components of the Income Statement are:

• Revenues - gross increases in Equity
• Expenses - gross decreases in Equity
• Net Income = Revenues – Expenses or net increase or decrease in the Equity
  • If Net Income > 0 there is a Profit
  • If Net Income < 0 there is a Loss

Statement of cash flow

The main components of the Statement of Cash Flow are:

• Cash inflows - correspond to cash receipts (+)
• Cash outflows - correspond to cash payments (-)

The story told by financial statements

These are the three most important financial statements, and they are telling a story to the users of these financial statements. They describe the financial performance of a company, so they describe its:

• Profitability: a company is profitable when its revenues are higher than expenses, but it is also a way to broaden its Equity (if the company is profitable, it can feed its Retained Earnings and consequently its Equity)
• Credibility: the higher the difference between the assets and the liabilities, the more solid the company is and there is a strong link between profitability and credibility because the more profitable the company is, the more solid it can become, and being solid for a company means that it is able to meet long-term obligations.

The liquidity production of a company tells whether the company has enough cash (not assets) to be able to meet the long-term obligations (liquidity is about “pure cash”) and it is associated with profitability because revenues sooner or later will become cash inflows and expenses will become cash outflows, and we say “sooner or later” because of the accrual principle, which is an accounting concept that requires transactions to be recorded in the time period in which they occur, regardless of when the actual cash flows for the transaction are received. So, according to the accrual system, revenues are recognized only when the services or the goods are delivered.

Frameworks and formats

The statements are not always forced into a framework, but actually, there are frameworks, formats that especially for listed companies are recurring. So, the framework, that is to say, how we present assets and liabilities (etc.), the revenues and the expenses, the cash inflows and the cash outflows are more or less informative.

The balance sheet presentation

Before investing in any company, an investor can use the balance sheet to examine the following:

• Can the firm meet its financial obligations?
• How much money has already been invested in this company?
• Is the company overly indebted?
• What kind of assets has the company purchased with its financing?

Typically, the balance sheet is represented in 2 sections, even though in the UK the Balance Sheet is typically organized into 1 section, so there is a list of assets and liabilities that combines. However, we will see a balance sheet represented in 2 sections and there are 2 criteria to classify assets and liabilities: the first criterion is liquidity, that is to say, how fast the assets can be liquidated and when the liability is due, while the second one is the activity-related criterion.

Liquidity criterion

The criterion is related to the fact that there are assets and liabilities that can be liquidated within the year and others that cannot, therefore they are divided into:

• Short Term or Current: assets that can be liquidated (=converted into cash) in the short term (in operating cycle), typically one year, and liabilities that are due within the operating cycle or within the year
  • Short Term Assets: Account Receivable, Inventory
  • Short Term Liabilities: Account Payable, Wages Payable, Interest Payable and all the payables within the year
• Long Term or Non-Current: assets that are liquidated beyond the operating cycle and liabilities that are due beyond the operating cycle
  • Long Term Assets: Notes Receivable, Property, Plant and Equipment
  • Long Term Liabilities: Notes Payable, Loans, Bonds

The first criterion of presenting assets and liabilities on the Balance Sheet, that is liquidity, is the criterion that is used to check the synchronization of the duration of the assets and the duration of the liabilities because the assets are supposed to generate cash and the liabilities are supposed to absorb cash, so we want to see whether with the generation of cash (which is implicit) into the assets the company is able to cover the obligations and these timings are in some way synchronized.

Activity-related criterion

But there is also another way of looking at the assets and the liabilities of a company, which is the activity-related criterion, according to which assets and liabilities are split not based on the duration but based on the link that they have with pure operations (core business).

• Related to the operating cycle – Operating
• Nonrelated to the operating cycle – Non Operating
  • Investing activity
  • Financing activity

The income statement presentation

Before investing in any company, an investor can use the income statement to examine the following:

• How much are sales?
• What kind of expenses does the company pay?
• How is the economic result interesting compared with competitors?
• Is the operating income positive?

The typical presentation of the income statement is a single section with multiple steps. Steps are intermediate results, and they are like paragraphs in the overall chapter that describes how the profit is generated. This is how a typical consolidated income statement is organized:

1. The first step calculates the gross profit, which tells what the difference between the revenues and the cost of goods sold is. However, when a company sells a product, it has to endure high advertising and promotional costs to keep the business alive.
2. The second step consists in calculating the contribution margin: once you subtract the advertising and promotional costs from the gross profit, you obtain the contribution margin, which contributes to cover all the other overheads.
3. The third step shows the operating result (operating profit), obtained by subtracting all the overheads from the contribution margin. The operating income is the company’s earnings from its core operations after it has deducted its cost of goods sold and its operating expenses. Operating income does not include interest expenses or other financing costs.
4. Then, as a fourth step, you have to consider the impact of financing and funding decisions (for example the interest expense), and if you subtract these expenses from the operating profit, you come to the profit before tax.
5. Eventually, by detracting the income tax expense from the profit before tax, you obtain the final profit for the period.

The number of steps depends on the narratives: if the company wants to organize your income statement with more details, it breaks it up in more steps and vice versa.

The statement of cash flow presentation

Before investing in any company, an investor can use the cash flow statement to examine the following:

• Is this company able to pay interests, debts, dividends?
• Is this company able to generate cash for financing new investments?
• How has the management used the cash generated by the company?

In the cash flow statement, there are:

• (+) Cash inflows, which correspond to cash receipts
• (-) Cash outflows, which correspond to cash payments

These items explain why there is a change in cash balance over a period of time. Cash flows are classified according to three reasons why the cash balance might change:

• Cash flow from operations: cash inflows and outflows concerned with ordinary activities of the organization (related to the core business); you want this cash flow to be positive.
  • Collections from customers (+)
  • Cash payments to suppliers (-)
  • Cash payments to employees (-)
  • Tax payments (-)
• Cash flow from investing: cash inflows and outflows concerned with transactions to acquire or to dispose of long-lived assets; you expect this cash flow to be negative because you expect a company to invest continuously.
  • Collections from sales of PPE or any long-term assets (+)
  • Payments on purchases of PPE or any long-term assets (-)
• Cash flow from financing: cash inflows and outflows concerned with transactions to get cash or to repay debts.
  • Borrowings of cash from creditors (+)
  • Issuance of debt securities (+)
  • Issuance of equity (+)
  • Repayments of loans (-)
  • Payments of dividends (-)

By summing these three cash flows together, what we obtain is the net cash flow.

Main assets evaluation principles

We zoomed into the financial statements: the framework is the annual report and now we look at the numbers. When we look at the numbers we have these evaluation principles, so criteria, and methods that are used to determine the value of Assets, Liabilities, and therefore the Equity.

Fundamental rules in assets evaluation

• Accounting Standards represent a set of concepts and techniques that are used to identify, measure, and communicate financial information about an economic unit to various users.
• In particular, IFRSs are designed as a common global language for business affairs, so that company accounts are understandable and comparable across international boundaries.
• Nevertheless, managers can exercise the so-called accounting discretion, which is the ability to make a judgment, a choice, or a responsible decision, which ultimately impacts on the Financial Statements presentation.
• Therefore, it is important to be aware of which are some of the main valuation issues that companies face during their day-by-day operations.
• General principles applicable to the asset evaluation distinguish between:
  • Monetary assets, which carry a fixed value in terms of currency units. They are stated as a fixed value in monetary terms even when macroeconomic factors such as inflation decrease the purchasing power of the currency.
    • Cash
    • Bank deposits
    • Trade receivables
    • Other receivables meant for settlement through cash
    • Investments in debt capital markets instruments
  • Non-monetary assets, conversely speaking, are those that do not have a value determinable in exact money terms. The value of assets that are non-monetary changes or fluctuates a lot over time and whose cash convertibility is limited.
    • Property, plant & equipment
    • Intangible assets (including goodwill)
    • Equity shares (some companies treat shares issued in foreign currency as monetary assets due to the absence of clear-cut directives)
    • Inventories
  • A non-monetary asset like plant & machinery can see its value decline as the technology becomes obsolete. Its value depends upon certain factors such as changes in technology, supply-demand factors, etc. These factors are not relevant when it comes to the valuation of monetary assets.
• The evaluation rules are different for monetary (fair value) or non-monetary assets (cost), but assets can either be Monetary or Non-Monetary depending on circumstances.
  • Prepayments or advance payments can either be monetary or non-monetary, based on a contract with a third party (the party to which payment was made). If as per the contract, the pre-paid amount is non-refundable (which it usually is) or if there is no contract and the probability of getting the amount back is very low, then it should be treated as a non-monetary asset.
  • Investments in preference shares shall be treated as monetary assets if there is a clause in the contract, by virtue of which, the redemption of preference shares has to be undertaken by the issuing entity after a certain time in the future. Otherwise, investments in preference shares will be treated as assets that are non-monetary.

Accounts receivable and allowance for bad debts

Accounts receivable are the amounts owed to a company by customers as a result of delivering goods or services and extending...