From Financial Statement to Business Analysis

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From Financial Statementto Business Analysis
Step 1 Business strategy analysis
Step 2 Accounting analysis
Step 3 Financial analysis
Step 4 Prospective analysis
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Financial Accounting Analysis
Financial Analysis
Accounting Analysis
Financial Statement
Unbiased Accounting
Recasting Financial Statement firms could adopt
different classifications
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Financial statements

• Four documents

• Income statement operating performance during a
  time period
• Balance sheet assets and how they are financed
• Cash flow statement level of the cash flow
  gerated by the firm
• Statement of changes in equity outlines the
  sources of changes in equity during the period
  between consecutive balance sheets.

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Accrual Accounting
Fundamental features of corporate financial
reports
Recording of economic transactions
On the basis of expected cash receipt and payments
Not necessarily actual
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Income statement
Expenses
Revenues
economic resources
economic resources
earned during
used up in
a time period
realization principle
matching and conservatism principle
Profit revenues - expenses
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Balance sheet
Liabilities
Assets
economic obbligations arising from past benefit
economic resources owned by a firm
future economic benefit
met with reasonable certainty
measurable with reasonable certainty
time reasonably well defined
Equity assets - liabilities
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Delegation of reporting to management
Corporate managers
accounting discretion
intimate knowledge of firms businesses
management manipulation of accounting numbers
Benefits
Costs
preserved
reduced
Accounting rules and auditing
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Accounting analysis
Identify key accounting policies (1)
Evaluate accounting strategy (3)
Assess accounting flexibility (2)
Six steps to evaluate a firms accounting quality
Evaluate the quality of disclosure (4)
Identify potential red flags (5)
Undo accounting distortions (6)
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Accounting analysis
Identify key accounting policies (1)
Business strategy analysis

• How well the success factors and risks are being
  managed by the firm
• Bank interest and credit risk management
• Retail inventory management
• Pharmaceuticals research and development

Accounting measures
Business events
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Accounting analysis
Assess accounting flexibility (2)

• Expense or capitalize costs
• Estimate expected defaults on loans
• Estimate long-terms projects
• Depreciation policy (straight.line or accelerated
  methods)
• Inventory accounting policy (LIFO, FIFO, or
  average cost)

More flexibility
Trade Off
Less flexibility
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Accounting analysis
Evaluate accounting strategy (3)

• How do the firms accounting policies compare to
  the norms in the industry?
• Do managers face strong incentives to use
  accounting discretion to manage earnings? (tax
  policy)
• What is the impact of the changes in policies?
  (warranty expenses)
• Have the companys policies and estimates been
  realistic in the past?

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Accounting analysis

• Does the company provide adequate disclosure to
  assess the firms business strategy and its
  economic consequences? (industry condition,
  competitive position, plans for the future)
• Does the firm adequately explain its current
  performance? (financial notes)
• Does the firm provide adequate additional
  disclosure to help outsiders understand how key
  success factors are being managed? (decrasing in
  profit)
• If a firm is in multiple business segments, what
  is the quality of segment disclosure?
• How forthcoming is the management with respect to
  bad news?
• How good is the firms investor program?

Evaluate the quality of disclosure (4)
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Accounting analysis

• Certain items must be examined more closely
• Unexplained changes in accounting, especially
  when performance is poor
• Unexplained transaction that boost profits
• Unusual increases in trade receivables in
  relation to sales increases
• Unusual increases in inventories in relation to
  sales increases
• An increasing gap between a firms reported
  profit and its cash flow from operations
• An increasing gap between a firms reported
  profit anche its tax profit
• Unexpected large asset write-offs
• Large year-end adjustments
• Qualified audit opinions or changes in
  independent auditors that are not well justified
• Poor internal governance mechanisms

Identify potential red flags (5)
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Accounting analysis

• Restate numbers to reduce the distortion to the
  extent possible
• Impossibility to perfectly undo the distortion
  using outside information alone
• Use the cash flow statement and the notes to the
  financial statements
• Use the tax notes

Undo accounting distortions (6)
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Accounting analysis pitfalls
Potential pitfalls and common misconceptions
Conservative accounting is not the same as good
accounting
Not all unusual accounting is questionable
An accounting choice might be justified if the
companys business is unusual
The financial statement users want to evaluate
how well a firms accounting captures business
reality in a unbaised manner and conservative
accounting can be as misleading as aggressive
accounting in this respecy
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Accounting analysis
The Airline Industry Most airlines have frequent
flyer programs that promise customers free
flights once they have accumulated 25,000 miles
of travel with the same airline. How should these
programs be reflected in the airlinesfinancial
statements?
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Accounting analysis
Liabilities
Promises that require future expenditure
economic obbligation arising from past benefit
ticket sales in the past
met with reasonable certainty
for example 1.2 milion free trips
within 3 to 5 years after the revenue ticket
sales are made
time reasonably well defined
Balance sheet
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Accounting analysis
Expenses
cost associated
Free-trip tickets in the future
with benefit that are comsumed in this time period
increase in revenue ticket sales
matching concept

• Administrative cost
• Costs related to the flight
• Opportunity cost

Income statement
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Implement accounting analysis
Process
Analyst
Accounting Analysis
Undo distortions
Balance Sheet
Adjustments to the financial statement
Income Statement (revenue/expenses)
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Implement accounting analysis
RECASTING FINANCIAL STATEMENT
DIFFERENCES
Nomenclature
Classifications
Formats
New Template
Time-series cross sectional comparison
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Implement accounting analysis
Different format
IFRS format for operating expenses
By nature
By function
Cause
Purpose
- Cost of materials - Cost of personnel - Cost
of non current assets

• - Cost of sold
• SGA (selling,
• General
• Administrative)

Recast using Financial Notes