💹Business Valuation Unit 2 – Financial statement analysis

Key Financial Statements

• Balance Sheet provides a snapshot of a company's financial position at a specific point in time, including assets, liabilities, and equity
  • Assets are resources owned by the company that have future economic benefits (cash, inventory, property, plant, and equipment)
  • Liabilities represent the company's obligations or debts (accounts payable, loans, bonds)
  • Equity represents the residual interest in the assets after deducting liabilities (common stock, retained earnings)
• Income Statement presents the company's financial performance over a specific period, typically a year or quarter
  • Includes revenue, expenses, and net income or loss
  • Provides insights into the company's profitability and operational efficiency
• Cash Flow Statement reports the inflows and outflows of cash during a specific period
  • Categorizes cash flows into operating, investing, and financing activities
  • Helps assess the company's ability to generate cash and meet its obligations
• Statement of Changes in Equity shows the changes in the company's equity components over a specific period
  • Includes transactions such as issuance of new shares, dividends, and comprehensive income
• Notes to the Financial Statements provide additional disclosures and explanations to support the information presented in the main financial statements

Purpose of Financial Statement Analysis

• Assess the financial health and performance of a company by examining its financial statements
• Identify trends, strengths, weaknesses, and potential risks in the company's financial position and operations
• Evaluate the company's profitability, liquidity, solvency, and efficiency using various financial ratios and metrics
• Compare the company's financial performance against its historical results, industry peers, and benchmarks
• Forecast future financial performance based on historical trends and assumptions
• Support decision-making for various stakeholders, including investors, creditors, management, and regulators
• Identify red flags or warning signs that may indicate financial distress or potential fraud

Fundamental Analysis Techniques

• Horizontal Analysis compares financial statement items over time, typically using a base year as a reference point
  • Helps identify trends, growth rates, and changes in the company's performance
• Vertical Analysis expresses each financial statement item as a percentage of a base figure (total assets, total revenue)
  • Allows for comparison of the relative importance of each item and changes in the company's financial structure
• Common-Size Analysis standardizes financial statements by expressing each item as a percentage of a common base
  • Facilitates comparison across companies of different sizes or industries
• Ratio Analysis involves calculating and interpreting financial ratios to assess various aspects of a company's performance
  • Includes profitability ratios (ROE, ROA), liquidity ratios (current ratio, quick ratio), and solvency ratios (debt-to-equity)
• Dupont Analysis breaks down return on equity (ROE) into its components: profit margin, asset turnover, and financial leverage
  • Helps identify the drivers of a company's profitability and efficiency

Ratio Analysis and Key Metrics

• Profitability Ratios measure a company's ability to generate profits relative to its revenue, assets, or equity
  • Examples include gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE)
• Liquidity Ratios assess a company's ability to meet its short-term obligations using its current assets
  • Key ratios include current ratio (current assets / current liabilities) and quick ratio ((current assets - inventory) / current liabilities)
• Solvency Ratios evaluate a company's ability to meet its long-term obligations and its financial leverage
  • Debt-to-equity ratio (total debt / total equity) and interest coverage ratio (EBIT / interest expense) are commonly used
• Efficiency Ratios measure how effectively a company uses its assets and manages its operations
  • Examples include inventory turnover (COGS / average inventory), receivables turnover (revenue / average receivables), and asset turnover (revenue / total assets)
• Valuation Ratios help assess the relative value of a company's stock compared to its earnings, growth, or assets
  • Price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and dividend yield are frequently used valuation metrics

Trend Analysis and Forecasting

• Trend Analysis involves examining the historical patterns and changes in a company's financial performance over time
  • Helps identify positive or negative trends in revenue, expenses, profitability, and other key metrics
• Time-Series Analysis uses statistical techniques to analyze and model the behavior of financial data over time
  • Includes moving averages, exponential smoothing, and autoregressive integrated moving average (ARIMA) models
• Regression Analysis explores the relationship between a dependent variable (e.g., revenue) and one or more independent variables (e.g., economic indicators)
  • Helps identify the factors that influence a company's financial performance and can be used for forecasting
• Scenario Analysis considers different possible future outcomes by varying key assumptions and inputs
  • Helps assess the potential impact of various scenarios (best-case, base-case, worst-case) on a company's financial performance
• Sensitivity Analysis examines how changes in specific variables affect the company's financial outcomes, holding other factors constant
  • Identifies the key drivers of a company's performance and the extent to which they influence the results

Industry Comparisons and Benchmarking

• Industry Analysis involves examining the financial performance and characteristics of companies within the same industry
  • Helps identify industry trends, competitive landscape, and best practices
• Peer Group Analysis compares a company's financial performance and ratios to a group of similar companies or direct competitors
  • Provides context for evaluating a company's relative strengths and weaknesses
• Benchmarking compares a company's financial metrics to industry averages or best-in-class performers
  • Helps set performance targets and identify areas for improvement
• Industry-Specific Metrics are financial or operational measures that are particularly relevant to a specific industry
  • Examples include same-store sales growth for retailers, occupancy rates for hotels, and subscriber churn for telecommunications companies
• Normalizing Financial Statements adjusts for differences in accounting policies, one-time events, or other factors to facilitate comparability across companies

Red Flags and Warning Signs

• Aggressive Revenue Recognition practices, such as recording revenue prematurely or inflating sales through channel stuffing
• Inconsistent or Unsustainable Growth in revenue or earnings that is not supported by underlying business fundamentals
• Deteriorating Liquidity or Solvency, as indicated by declining cash balances, increasing debt levels, or worsening financial ratios
• Frequent Changes in Accounting Policies or Estimates that may be used to manipulate financial results
• Large or Unusual Transactions, especially those that occur near the end of a reporting period or involve related parties
• High Executive Turnover or Insider Selling, which may signal underlying problems or a lack of confidence in the company's prospects
• Qualified Audit Opinions or Restatements that raise concerns about the reliability of the company's financial statements

Limitations and Considerations

• Historical Focus of financial statements, which may not fully reflect a company's current or future performance
• Accounting Policies and Estimates that can vary across companies and industries, affecting comparability
• Off-Balance Sheet Items, such as operating leases or contingent liabilities, that may not be fully captured in the financial statements
• Non-Financial Factors, such as management quality, brand reputation, and competitive advantages, that are not directly reflected in the financial statements
• Limitations of Ratio Analysis, as ratios can be affected by one-time events, accounting choices, or industry-specific factors
• Forward-Looking Assumptions and Estimates used in forecasting and valuation models are subject to uncertainty and potential bias