22. Financial Statement Analysis An Introduction
A. Roles of financial reporting and financial statement analysis :
The role of financial reporting is to provide a variety of users with useful information about a company’s performance and financial position.
The role of financial statement analysis is to use the data from financial statements along with other relevant information to support economic decisions and to assess a company’s past performance in order to draw conclusions about the company’s ability to generate cash and profits in the future. Examples include whether to invest in the company’s securities or recommend them to investors and whether to extend trade or bank credit to the company.
B. Roles of the key financial statements :
The balance sheet (statement of financial position or statement of financial condition) reports the firm’s financial position at a point in time.
The income statement (statement of operations or profit & loss statement) reports on the financial performance of the firm over a period of time.
The statement of cash flows reports the company’s cash receipts and payments over a period of time.
The statement of comprehensive income reports all changes in equity except for shareholder transactions.
The statement of changes in equity reports the amounts and sources of changes in equity investors’ investments in the firm over a period of time.
C. Importance of financial statement notes and supplementary information and management’s commentary :
Financial statement notes (footnotes), which are audited, disclose important information about :
- accounting methods, estimates and assumptions ;
- items such as business acquisitions or disposals, legal actions, employee benefit plans, contingencies and commitments, significant customers, sales to related parties, and segments of the firm ;
- fiscal period covered by the statements and the inclusion of consolidated accounts.
Management’s commentary (management’s discussion and analysis MD&A) contains an overview of the company and important information about business trends, future capital needs, liquidity, significant events, and significant choices of accounting methods requiring management judgment. For publicly held firms in the U.S., MD&A is required by the SEC to discuss results of operations, capital resources, liquidity and a general overview based on known trends.
D. Objectives of audits of financial statements, types of audit reports and importance of internal controls :
The objective of audits financial statements is to provide an opinion on the statement’s fairness and reliability.
The auditor’s opinion gives evidence of an independent review of the financial statements that verifies that appropriate accounting principles were used, that standard auditing procedures were used to establish reasonable assurance that the statements contain no material errors, and that management’s report on the company’s internal controls have been reviewed.
The standard auditor’s opinion contains three parts and states that :
- Whereas the financial statements are prepared by management and are its responsibility, the auditor has performed an independent review.
- Generally accepted auditing standards were followed, thus proving reasonable assurance that the financial statements contain no material errors.
- The auditor is satisfied that the statements were prepared in accordance with accepted accounting principles and that the principles chosen and estimates made are reasonable.
An auditor can issue :
- An unqualified (clean) opinion if the statements are free from material omissions and errors.
- A qualified opinion that notes any exceptions to accounting principles.
- An adverse opinion if the statements are not presented fairly in the auditor’s opinion.
- A disclaimer of opinion if the auditor is unable to express an opinion.
The auditor’s opinion will also contain an explanatory paragraph when a material loss is probable but the amount cannot be reasonably estimated. These uncertainties may relate to the going concern assumptions, the valuation or realization of asset values; or to litigation.
A company’s management is responsible for maintaining an effective internal control system to ensure the accuracy of its financial statements. Under US GAAP, the auditor must express an opinion in the firm’s internal controls.
E. Additional information sources for analysts :
Security and Exchange Commission (SEC) filing are available from EDGAR (Electronic Data Gathering, Analysis, and Retrieval system).
Along with financial statements, important information for analysts include :
- Quarterly and semiannual reports (Interim reports)
- Proxy statements: Issued to shareholders when there are matters that require a shareholder vote. They are a good source of information about the election (and qualifications) of board members, compensation and the issuance of stock options. Form DEF-14A has to be filed with the SEC when a company prepares a proxy statement for its shareholders.
- Press releases and corporate reports are written by management and are often viewed as public relations or sales materials.
- Earnings guidance are issued before the financial statements are released.
F. Steps in the financial statement analysis framework :
The framework has six steps :
- State the objective and context.
- Gather data.
- Process the data (make adjustments for analysis, common-size, graphs…).
- Analyze and interpret the data (answer first step and decide what conclusions and recommendations the information supports).
- Report the conclusions and recommendations.
- Update the analysis.
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