🗃️Corporate Finance Unit 3 – Working with Financial Statements

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
• Income Statement summarizes a company's financial performance over a period of time, detailing revenues, expenses, and net income or loss
  • Also known as the Profit and Loss (P&L) statement
  • Provides insights into a company's profitability and operational efficiency
• Cash Flow Statement tracks the inflows and outflows of cash during a specific period, categorized into operating, investing, and financing activities
  • Helps assess a company's liquidity and ability to generate cash
• Statement of Shareholders' Equity shows changes in a company's equity over a period of time, including retained earnings, dividends, and capital transactions
• Notes to Financial Statements provide additional information and disclosures necessary for understanding the financial statements
  • Includes accounting policies, assumptions, and explanatory details

Purpose and Importance

• Financial statements provide essential information about a company's financial health, performance, and position to various stakeholders
  • Stakeholders include investors, creditors, management, employees, and regulators
• Enable informed decision-making by presenting a clear and comprehensive view of a company's financial situation
• Allow for comparability across different periods and with other companies in the same industry
• Help identify trends, strengths, weaknesses, and potential risks within a company's financial profile
• Serve as a basis for valuation, investment analysis, and credit assessment
• Facilitate compliance with regulatory requirements and financial reporting standards (GAAP or IFRS)
• Provide transparency and accountability to stakeholders regarding the management of company resources

Financial Statement Analysis Techniques

• Horizontal Analysis compares financial statement items across different periods to identify trends and growth rates
  • Also known as trend analysis
  • Helps assess the direction and magnitude of changes in a company's financial performance over time
• Vertical Analysis expresses each financial statement item as a percentage of a base figure (total assets, total liabilities and equity, or total revenues)
  • Allows for understanding the relative importance and composition of financial statement components
• Ratio Analysis involves calculating and interpreting financial ratios to evaluate various aspects of a company's financial health and performance
  • Ratios are categorized into liquidity, profitability, efficiency, and solvency ratios
• Benchmarking compares a company's financial ratios and performance against industry averages, competitors, or historical data
  • Helps identify areas where a company outperforms or underperforms relative to its peers
• Trend Analysis examines the direction, consistency, and rate of change of financial statement items over multiple periods
  • Identifies patterns, seasonality, and potential issues in a company's financial performance

Ratio Analysis and Interpretation

• Liquidity Ratios assess a company's ability to meet short-term obligations using its current assets
  • Current Ratio = Current Assets / Current Liabilities
  • Quick Ratio (Acid-Test Ratio) = (Current Assets - Inventory) / Current Liabilities
• Profitability Ratios measure a company's ability to generate profits relative to its revenue, assets, or equity
  • Gross Profit Margin = Gross Profit / Net Sales
  • Operating Profit Margin = Operating Income / Net Sales
  • Net Profit Margin = Net Income / Net Sales
  • Return on Assets (ROA) = Net Income / Average Total Assets
  • Return on Equity (ROE) = Net Income / Average Shareholders' Equity
• Efficiency Ratios evaluate how effectively a company manages its assets and liabilities
  • Inventory Turnover = Cost of Goods Sold / Average Inventory
  • Receivables Turnover = Net Credit Sales / Average Accounts Receivable
  • Payables Turnover = Cost of Goods Sold / Average Accounts Payable
  • Asset Turnover = Net Sales / Average Total Assets
• Solvency Ratios assess a company's ability to meet its long-term obligations and its financial leverage
  • Debt-to-Equity Ratio = Total Liabilities / Total Shareholders' Equity
  • Debt-to-Assets Ratio = Total Liabilities / Total Assets
  • Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Cash Flow Analysis

• Cash Flow from Operating Activities represents cash generated or used by a company's core business operations
  • Adjusts net income for non-cash items (depreciation and amortization) and changes in working capital
• Cash Flow from Investing Activities reflects cash inflows and outflows related to long-term investments
  • Includes purchases and sales of property, plant, and equipment (PP&E), and investments in securities
• Cash Flow from Financing Activities represents cash transactions related to the company's capital structure
  • Includes proceeds from issuing debt or equity, dividend payments, and repurchases of stock
• Free Cash Flow (FCF) measures the cash available for distribution to investors after accounting for capital expenditures
  • FCF = Cash Flow from Operating Activities - Capital Expenditures
• Cash Flow Ratios help assess a company's liquidity, solvency, and ability to generate cash
  • Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities
  • Cash Flow Coverage Ratio = Cash Flow from Operations / Total Debt
  • Cash Flow to Net Income Ratio = Cash Flow from Operations / Net Income

Common-Size Statements

• Common-Size Balance Sheet expresses each balance sheet item as a percentage of total assets
  • Allows for comparing the composition of assets, liabilities, and equity across companies of different sizes
  • Helps identify trends in the relative proportions of balance sheet components over time
• Common-Size Income Statement presents each income statement item as a percentage of net sales or revenue
  • Facilitates comparison of expense ratios and profitability margins across companies and periods
  • Highlights changes in the cost structure and operating efficiency of a company
• Common-Size Cash Flow Statement expresses each cash flow item as a percentage of total cash inflows or outflows
  • Provides insights into the relative importance of different sources and uses of cash
  • Helps identify trends and significant changes in a company's cash flow composition

Forecasting with Financial Statements

• Financial forecasting involves projecting future financial performance based on historical data, assumptions, and strategic plans
• Pro Forma Financial Statements are forecasted financial statements that estimate future performance under different scenarios
  • Helps assess the potential impact of business decisions, investments, or changes in the economic environment
• Sensitivity Analysis examines how changes in key assumptions or variables affect the forecasted financial outcomes
  • Identifies the most critical factors influencing a company's future performance
• Scenario Analysis develops multiple sets of assumptions to create different potential future outcomes (best-case, base-case, and worst-case scenarios)
  • Helps evaluate the range of possible financial results and assess the company's resilience
• Rolling Forecasts involve regularly updating financial projections based on the latest available information
  • Allows for more accurate and timely decision-making in response to changing business conditions

Real-World Applications and Case Studies

• Mergers and Acquisitions (M&A) rely heavily on financial statement analysis to assess the value and potential synergies of target companies
  • Due diligence process involves in-depth analysis of financial statements, ratios, and cash flows
• Equity Research Analysts use financial statement analysis to evaluate companies and make investment recommendations
  • Fundamental analysis incorporates insights from financial statements to estimate intrinsic value and growth prospects
• Credit Analysis performed by banks and bond investors uses financial statement analysis to assess a company's creditworthiness and ability to repay debt
  • Focus on liquidity, solvency, and cash flow generation to determine credit risk and lending terms
• Management Accounting leverages financial statement analysis to support internal decision-making and performance evaluation
  • Helps identify areas for cost reduction, operational improvements, and resource allocation
• Valuation Models, such as the Discounted Cash Flow (DCF) model, rely on forecasted financial statements to estimate the present value of a company or project
  • Quality of financial statement projections directly impacts the accuracy of valuation estimates