Discussion 2: Cash Flow and Financial Analysis

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Analyzing Financial Statements

Overview of Financial Statement Analysis

Boundless Accounting

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Using Financial Statements to Understand a

Business

Internal and external users rely on a company’s �nancial statements to

get an in-depth understanding of the company’s �nancial position.

LEARNING OBJECTIVES

Explain how a company would use the �nancial statements to

perform risk analysis and pro�tability analysis

KEY TAKEAWAYS

Key Points

By using a variety of methods to analyze the �nancial

information included on the statements users can

determine the risk and pro�tability of a company.

Financial statement analysis consists of reformulating

reported �nancial statement information and analyzing

and adjusting for measurement errors.

Two types of ratio analysis are performed, analysis of

risk and analysis of pro�tability.

Analysis of risk typically aims at detecting the

underlying credit risk of the �rm.

Analysis of pro�tability refers to the analysis of return

on capital.

Key Terms

reformulation: A new formulation

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pro�tability ratio: measurements of the �rm’s use of its

assets and control of its expenses to generate an

acceptable rate of return

ratio: A number representing a comparison between

two things.

pro�tability: The capacity to make a pro�t.

The Role of Financial Statements

Internal and external users rely on a company’s �nancial statements to

get an in-depth understanding of the company’s �nancial position. For

internal users such as managers, the �nancial statements o�er all the

information necessary to plan, evaluate, and control operations. External

users, such as investors and creditors, use the �nancial statements to

gauge the future pro�tability and liquidity of a company.

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The Balance Sheet: If an error is found on a previous year’s �nancial statement, a correction must be made and the �nancials reissued.

Financial Statement Analysis

By using a variety of methods to analyze the �nancial information

included on the statements, users can determine the risk and pro�tability

of a company. Ideally, the analysis consists of reformulating the reported

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�nancial statement information, analyzing the information, and adjusting

it for measurement errors. Then the various calculations are performed

on the reformulated and adjusted �nancial statements. Unfortunately,

the two �rst steps are often dropped in practice. In these instances

�nancial ratios are calculated on the reported numbers without thorough

examination and questioning, though some adjustments might be made.

An example of a reformulation used on the income statement occurs

when dividing the reported items into recurring or normal items and non-

recurring or special items. This division separates the earning into

normal earnings, also known as core earnings, and transitory earnings.

The idea is that normal earnings are more permanent and therefore

more relevant for prediction and valuation.

Normal earnings are also separated into net operational pro�t after taxes

(NOPAT) and net �nancial costs. In this example the balance sheet is

grouped in net operating assets (NOA), net �nancial debt, and equity.

Types of Analysis

Two types of ratio analysis are analysis of risk and analysis of

pro�tability:

Risk Analysis: Analysis of risk detects any underlying credit risks to the

�rm. Risk analysis consists of liquidity and solvency analysis. Liquidity

analysis aims at analyzing whether the �rm has enough liquidity to meet

its obligations. One technique used to analyze illiquidity risk is to focus

on ratios such as the current ratio and interest coverage. Cash �ow

analysis is also useful in evaluating risk. Solvency analysis aims at

determining whether the �rm is �nanced in such a way that it will be able

to recover from a loss or a period of losses.

Pro�tability analysis: Analyses of pro�tability refer to the analysis of

return on capital. For example, return on equity (ROE), is de�ned as

earnings divided by average equity. Return on equity could be furthered

re�ned as:

ROE = ( RNOA )+ (RNOA – NFIR ) * NFD /E

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RNOA is return on net operating assets, NFIR is the net �nancial interest

rate, NFD is net �nancial debt and E is equity. This formula clari�es the

sources of return on equity.