Lesson 1: Financial Analysis and Reporting • Determining the creditworthiness of a

Primary financial statements company in order to decide whether to

• income statement,
• extend a loan to the company and if so, what
terms to offer.
• balance sheet,
• Extending credit to a customer.
• cash flow statement, and
• Examining compliance with debt covenants or
• statement of changes in equity)
other contractual arrangements.
Financial Analysis and Reporting • Assigning a debt rating to a company or bond
issue.
• Valuing a security for
making an investment recommendation to
others.
• Forecasting future net income and cash flow.
• In general, analysts seek to examine the past
and current performance and financial position
of a company in order to form expectations
about its future performance and financial
position.
• Analysts are also concerned about factors that
Financial analysis - the process of examining a affect risks to a company’sfuture performance
company’s performance in the context of its industry and financial position.
and economic environment in order to arrive at a Examination of Performance Include:
decision orrecommendation. The central focus of
financial analysis is evaluating the company’s ability • an assessment of a company’s profitability (the
to earn a ability to earn a profit from delivering goods
return on its capital that is at least equal to the cost and services) and its ability to generate
of that capital, to profitably grow its operations, and positive cash flows (cash receipts inexcess of
to generate enough cash to meet obligations and cash disbursements).
pursue opportunities. Profit versus Cash Flow
Fundamental financial analysis - starts with the
information found in a company’s financial reports. • Profit (or loss) represents the difference
These financial reports include audited financial between the prices at which goods or services
statements, additional disclosures required by are provided to customers and the expenses
regulatory authorities, and any accompanying incurred to provide those goods and services.
(unaudited) commentary by management. In addition, profit (or loss) includes other
income (such as investing income or income
ROLE OF FINANCIAL REPORTING BY from the sale of items other than goods and
COMPANIES services) minus the expenses incurred to earn
that income.
1) To provide information about a company’s
• Overall, profit (or loss) equals income minus
performance, financial position, and
expenses, and its recognition is mostly
changes in financial position that is useful to
independent from when cash is received or
a wide range of users in making economic
paid.
decisions
Profit versus Cash Flow
2) To use financial reports prepared by
companies, combined with other - Cash basis vs accrual basis
information, to evaluate the past, current, - profitability is important, so is a
and potential performance and financial company’s ability to generate
position of a company for the purpose of positive cash flow.
making investment, credit, and other
economic decisions. Major Financial Statements and other
Information Sources
Managers within a company perform financial
analysis to make operating, investing, and financing • The nature of the information collected will
decisions but do not necessarily rely on analysis of vary on the basis of the individual decision to
related financial statements. be made (or the specific purpose of the
analysis) but will typically include information
SCOPE OF FINANCIAL ANALYSIS
about the economy, industry, and company as
Analysts Specific Economic Decision: well as information about comparable peer
companies.
• Evaluating an equity investment for inclusion in • Companies prepare financial reports at regular
a portfolio. intervals (annually, semiannually, and/or
• Evaluating a merger or quarterly depending on the applicable
acquisition candidate. regulatory requirements). Financial reports
include financial statements along with
• Evaluating a subsidiary or operating division of
supplemental disclosures necessary to assess
a parent company.
the company’s financial position and periodic
• Deciding whether to make a venture capital or performance.
other private equity investment.
 • Financial statements - are the result of an form: Assets = Liabilities+ Owners’
accounting recordkeeping process that records equity.
economic activities of a company, following the
Owners’ equity - represents the excess of assets
applicable accounting standards and over liabilities. This amount is attributable to the
principles. Financial statements - are almost company’s owners or shareholders. Owners’ equity
always audited by independent accountants is the owners’ residual interest in (i.e., residual claim
who provide an opinion on whether the on) the company’s assets after deducting its
financial statements present fairly the liabilities.
company’s performance and financial position
in accordance with a specified, applicable set Current assets are defined, in general, as those
of accounting standards and principles. assets that are cash or cash equivalents; are held
for trading; or are expected to be converted to cash
Accounts (realized), sold, or consumed within 12 months or
Accounts are the categories into which the effects of the company’s normal operating cycle. All other
transactions are recorded, and from which financial assets are classified as non-current.
reports are created. Current liabilities are defined, in general, as those
5 major account categories: that are expected to be settled within 12 months or
the company’s normal operating cycle. All other
liabilities are classified as noncurrent.

ASSET = LIABILITIES + OWNER’S EQUITY

LINK BETWEEN BALANCE SHEET AND INCOME

STATEMENT
Chart of Accounts
Profit or loss is taken from the bottom line of the
Sample Income accounts
income statement and recorded on the balance
• Sales revenue sheet in the Retained Earnings equity account.
• Other income Retained earnings accumulate over the life of the
business.
Sample Expense accounts
• Rent • When a business operates at a profit, it
• Cost of Goods Sold increases in equity (is worth more)
(COGS) • When a business operates at a loss, it
• Marketing decreases in equity (is worth less)
• Office supplies
• Payroll
• Professional fees Sample
Asset accounts

Current assets
▪ Cash
▪ Inventory
▪ Accounts receivable
Fixed assets
▪ Equipment
▪ Property
Sample Liability accounts

• Accounts payable
• Credit card payable
• Loan payable
Sample Equity accounts

• Owner’s equity
• Retained earnings Using the balance sheet and applying financial
statement analysis, the analyst can answer such
Balance sheet - (also called the statement of questions as
financial position or statement of financial condition)
presents a company’s current financial position by • Has the company’s liquidity (ability to meet
disclosing the resources the company controls short-term obligations) improved?
(assets) and its obligations to lenders and other • Is the company solvent (does it have
creditors sufficient resources to cover its
(liabilities) at a specific point in time. • obligations)?
- The relationship among the three parts • What is the company’s financial position
of the balance sheet (assets, relative to the industry?
liabilities, and owners’ equity) can be
Income statement - presents information on the
expressed in the following equation
financial results of a company’s business activities
over a period of time. The income statement
communicates how much revenue and other income - Wholly owned and partially
the company generated during a period and the owned
expenses it incurred to generate that revenue and
other income The statement of changes in equity, variously
called the “statement of changes in owners’ equity”
- shows the company’s or “statement of changes in shareholders’ equity,”
financial performance for a given primarily serves to report changes in the owners’
period (usually 1 year). investment in the business over time.

The statement of changes in equity,

- reflects the operating
activities of a company. The basic components of owners’ equity are paid-in
capital and retained earnings. Retained earnings
• Income statement - The basic equation include the cumulative amount of the company’s
underlying the income statement is profits that have been retained in the company. In
• Revenue + Other income – Expenses = addition, non-controlling or minority interests and
Income – Expenses= Net income. reserves that represent accumulated other
comprehensive income items are included in equity.
Revenue - typically refers to amounts charged for
the delivery of goods or services in the ordinary The Cash flow Statement
activities of a business. Other income includes Disclosing the sources and uses of cash helps
gains, which may or may not arise in the ordinary creditors, investors, and other statement users
activities of the business. evaluate the company’s liquidity, solvency, and
Other income - includes gains, which may or may financial flexibility.
not arise in the ordinary activities of the business. Financial Flexibility the ability of the company to
Expenses - reflect outflows, depletions of assets, react and adapt to financial adversities and
and incurrences of liabilities that decrease equity. opportunities.
Expenses typically include such items as cost of The cash flow statement classifies all cash flows of
sales (cost of goods sold), administrative expenses, the company into three categories: operating,
and income tax expenses and may be defined to investing, and financing.
include losses.
Cash flows from operating activities are those cash
Net Income - (revenue plus other income minus flows not classified as investing or financing and
expenses) on the income statement is often referred generally involve the cash effects of transactions
to as the “bottom line” because of its proximity to the that enter into the determination of net income and,
bottom of the income statement. Net income may hence, comprise the day-to- day operations of the
also be referred to as “net earnings,” “net profit,” and company.
“profit or loss.” In the event that expenses exceed
revenues and other income, the result is referred to Cash flows from operating activities functions of a
as “net loss.” business directly related to providing its goods
and/or services to the market (e.g. manufacturing,
Subsidiary - is a company that belongs to another marketing, distribution)
company, which is usually referred to as the parent
company or the holding company. - Wholly Cash flows from investing activities are those cash
owned and partially owned flows from activities associated with the acquisition
and disposal of long-term assets, such as property
Income statements are reported on a consolidated and equipment.
basis, meaning that they include the income and
expenses of subsidiary companies under the control Cash flows from financing activities are those cash
of the parent (reporting) company. The income flows from activities related to obtaining or repaying
statement is sometimes referred to as a statement of capital to be used in the business.
operations or profit and loss (P&L) statement.
activities that the company undertakes in order to
ACCOUNTING METHODS acquire funds for business needs. sources of funds
could be from equity investors (capital) or creditors
Cash-based accounting (borrowings or debt financing).

• You record transactions when Financial Notes and Supplementary Schedules

payment is made or received (cash
The notes (also sometimes referred to as footnotes)
exchanges hands), not when the
that accompany the four financial statements are
business event occurs
required and are an integral part of the complete set
Accrual-based accounting of financial statements. The notes provide
information that is essential to understanding the
• You record transactions when the information provided in the primary statements.
business event occurs, regardless of
The notes disclose the basis of preparation for the
whether payment has yet been made
financial statements. For example,
or received
Volkswagen discloses in its first note that its fiscal
year corresponds to the calendar year, that its
• Accounts payable and accounts
financial statements are prepared in accordance with
receivable accounts are used
IFRS as adopted by the European Union, that the
Subsidiary - is a company that belongs to another statements are prepared in compliance with
company, which is usually referred to as the parent German law,
company or the holding company.
Overall, flexibility in accounting choices is necessary
because, ideally, a company will select those
policies, methods, and estimates that are allowable
and most relevant and that fairly reflect the unique 1. Introductory paragraph- financial statement
economic environment of the company’s business and responsibility- both management and
and industry. Flexibility can, however, create independent auditor
challenges for the analyst because the use of
different policies, methods, and estimates reduces 2. Scope -paragraph describes the nature of
comparability across different companies’ the audit process
financial statements.

Management Commentary or Management’s 3. Opinion-paragraph expresses the auditor’s

Discussion and Analysis opinion on the fairness of the audited
financial statements.
The framework identifies five content elements of
a “decision-useful management An unqualified audit opinion states that the
commentary.” Those content elements include 1) the financial statements give a “true and fair view”
nature of the business; 2) management’s objectives (international) or are “fairly presented” (international
and strategies; 3) the company’s significant and US) in accordance with applicable accounting
resources, risks, and relationships; 4) results of standards. This is often referred to as a “clean”
operations; and 5) critical performance opinion and is the one that analysts would like to see
measures. (International Accounting Standard in a financial report.
Board)
An unqualified audit opinion states that the
Auditor’s Reports financial statements give a “true and fair view”
(international) or are “fairly presented” (international
The independent auditor then provides a written and US) in accordance with applicable accounting
opinion on the financial statements. This opinion is standards. This is often referred to as a “clean”
referred to as the audit report. Audit reports take opinion and is the one that analysts would like to see
slightly different forms in different in a financial report.
jurisdictions, but the basic components,
including a specific statement of the auditor’s An adverse audit opinion is issued when an auditor
opinion, are similar. Audits of financial statements determines that the financial statements materially
may be required by contractual arrangement, law, or depart from accounting standards and are not fairly
regulation. presented. An adverse opinion makes analysis of
the financial statements easy: Do not bother
Under international standards for auditing (ISAs), the
analyzing these statements, because the company’s
objectives of an auditor in conducting an audit of
financial statements cannot be relied on. Other
financial statements are
Sources of Information
A. To obtain reasonable assurance about a disclaimer of opinion occurs when, for some
whether the financial statements as a whole reason, such as a scope limitation, the auditors are
are free from material misstatement, unable to issue an opinion.
whether due to fraud or error, thereby
enabling the auditor to express an opinion companies also provide information on management
on whether the financial statements are and director compensation, company stock
prepared, in all material respects, in performance, and any potential conflicts of interest
accordance with an applicable financial that may exist between management, the board, and
reporting framework; and. shareholders. This information may appear in the
Under international standards for auditing company’s annual report or other publicly available
(ISAs), the objectives of an auditor in documents
conducting an audit of financial statements When performing financial statement analysis,
are analysts should review all these company sources of
B. To report on the financial statements, and information as well as information from external
communicate as required by the ISAs, in sources regarding the economy, the industry, the
accordance with the auditor’s findings. company, and peer (comparable) companies.

Because audits are designed and conducted using

audit sampling

techniques and financial statement line items may

be based on estimates and assumptions,
independent auditors cannot express an opinion that
provides absolute assurance about the accuracy or
precision of the financial statements.

Instead, the independent audit report provides

reasonable assurance that the financial statements
are fairly presented, meaning that there is a high
probability that the audited financial statements are
free from material error, fraud, or illegal acts that
have a direct effect on the financial statements.

Auditor’s Reports

The standard independent audit report for a publicly

traded company normally has several paragraphs
under both the international and US auditing
standards.
Financial Statement Analysis Framework b. Borrowing capacity (leverage) ratios
that measure the degree of protection of
suppliers of longterm funds.
c. Profitability ratios that measure the
earning ability of a firm.
d. Cash flow ratios can indicate liquidity,
borrowing capacity, or
profitability

4. Cash Flow Analysis

• The analysis of financial data employs various - Primarily used as a tool to evaluate the
techniques to emphasize the comparative sources and uses of funds. It provides
and relative importance of the data insights into how a company is obtaining
presented and to evaluate the position of its financing and deploying its resources.
the firm.
5. Valuation
FINANCIAL ANALYSIS TECHNIQUES
This refers to estimating the intrinsic value
1. Comparative FS Analysis of a company or its stock.

2. Common-Size FS Analysis
a. Debt Valuation. The value of a
3. Ratio Analysis security is equal to the present value
of its future payoffs discounted at an
4. Cash Flow Analysis appropriate rate. The future payoffs
5. Valuation of the debt security are its interest
and principal payments.
1. Comparative FS Analysis
- presents and reviews consecutive balance
sheets, income statements, or statements of
cash
flows from period to period

2. Common-Size FS Analysis
- useful for intercompany comparisons
because financial statements of different
companies are recast in commonsize
format

3. Ratio Analysis
Financial ratios are usually expressed as a
percent or as times per period. The following are
relevant categories for financial ratios:
a. Liquidity ratios measure a firm’s ability to
meet its current obligations. They may
include ratios that measure the efficiency
of the use of current assets and current
liabilities.
 b. Equity Valuation. The basis of (PFRSs) and Philippine Accounting
equity valuation is the present value Standards (PASs). Philippine standards
of future payoffs discounted at an apply to all entities with public
appropriate rate – payoffs coming accountability.
from dividend payments and capital Lesson 2: Financial Reporting Standards

Financial Reporting Standards

appreciation.
Financial Statement Analysis Framework

Financial reporting standards provide principles

for preparing financial reports and determine the
Major Financial Statements and other
types and amounts of information that must be
Information Sources
provided to users of financial statements, including
▪ Financial Reporting Framework in the investors and creditors, so that they may make
Philippines informed decisions.

▪ Accounting standards in the Philippines are

adopted by the Philippines Financial • GAAP Generally Accepted Accounting
Reporting Standards Council (PFRSC) and stand- (GAAP)
approved by the Securities and Exchange
Commission (SEC). The PFRSC has
• Financial Accounting standard Board
(FASB) (US)(SEC)
formed the Philippine Interpretations
Committee (PIC), which issues • International Account Standard Board
implementation guidance on PFRSs. (IASB)

▪ Publicly Accountable Entities

• International Financial Reporting
Standard (IFRS)
▪ The PFRSC has adopted most IFRSs, in some • IFRS VS GAAP (Convergence/
cases with modifications, and in some cases Uniformity)
the most recent amendments to IFRSs have
not been adopted. These standards are
known as Philippine Financial Reporting
Standards
The Objective of Financial Reporting Information about accounting choices will
enhance a user’s ability to compare the
- The International Accounting Standards companies’ financial statements.
Board (IASB), which sets financial reporting
standards that have been adopted in many • Standards are developed in accordance
countries, expressed it as follows in its with a framework so it is useful to have an
Conceptual Framework for Financial agreed upon framework to guide the
Reporting 2010 (Conceptual Framework development of standards. The joint
2010) conceptual framework project of the IASB
and the US Financial Accounting Standards
- The body of standards issued by the Board (FASB) aimed to develop a common
International Accounting Standards Board foundation for standards.
(IASB) is referred to as International • Standards based on this foundation were to
Financial Reporting Standards. be principles-based, internally consistent,
and converged.
STANDARD-SETTING BODIES AND
REGULATORY AUTHORITIES
• 2008-2009 economic crisis- on of the
contributor is the independent standard
The objective of general-purpose financial reporting setting.
is to provide financial information about the reporting • The IASB and the FASB have developed
entity that is useful to existing and potential similar financial reporting frameworks which
investors, lenders, and other creditors in making specify the overall objective and qualities of
decisions about providing resources to the entity. information to be provided
Those decisions involve buying, selling or holding • Understanding the financial reporting
equity and debt instruments, and providing or framework—including how and when
settling loans and other forms of credit. judgments and estimates can affect the
numbers reported
THE OBJECTIVE OF FINANCIAL REPORTING
Difference of Conceptual framework (2010) and • Benefits from the Financial Reporting
Frame work for the Preparation and Framework
presentation of Financial Statement (1989) • 2. enables an analyst to evaluate the
information reported and to use the
information appropriately when assessing a
company’s financial performance.

STANDARD- SETTING BODY AND

REGULATORY AUTORITIES

Standard- Setting bodies

1. IASB
THE OBJECTIVE OF FINANCIAL REPORTING
2. FASB
To facilitate comparisons across companies
(cross sectional analysis) and over time for - are typically private sector, selfregulated
a single company (time series analysis), it is organizations with board members who are
important that accounting methods are experienced accountants, auditors, users of
comparable and consistently applied. financial statements, and academics.
However, accounting standards must be
flexible enough to recognize that differences
exist in the underlying economics between Regulatory Authorities
businesses.
1. Accounting and Corporate regulatory Authority
Financial statements of two companies with identical (Singapore)
transactions in the fiscal year, prepared in
2. Securities and Exchange Commission
accordance with the same set of financial reporting
(SEC)- US
standards, are most likely to be:
A. identical. enforce financial reporting requirements and
B. consistent. exert other controls over entities that participate in
the capital markets within their jurisdiction.
C. comparable.
Standard-setting bodies set the standards and
• C is correct. The companies’ financial regulatory authorities recognize and enforce the
statements should be comparable (possible, standards. Without the recognition of the standards
to compare) because they should reflect the by the regulatory authorities, the private sector
underlying economics of the transactions for standard-setting bodies would have no authority.
each company. The underlying economics Solution:
may vary between companies, so the B is correct. An analyst should familiarize him/herself
financial statements are not likely to be with the regulations and reporting standards that
identical. Choices made by each company affect the company and/or industry being analyzed.
with respect to accounting methods should This can be quite challenging but, given the potential
be consistent but the choice across effects, necessary.
companies is not necessarily consistent.