Notes

We said that financial statements are important because investors decide whether to invest or not based on financial statements and analysts also make their evaluation on the basis of accounting numbers.

We demonstrated the importance of accounting numbers for investors in two ways:

• Remember the initial graph that put together market returns and earnings;
• Correlation between bond yield and some accounting data as total assets and operating income.

Now that we know how the financial statements are prepared and the rules that firms follow to prepare them, let's see the tools that investors and analysts use to make their evaluations namely how accounting numbers are transformed to decide whether to invest or not in the company -> financial statement analysis (FSA).

We already saw something:

• If you remember, in the case study relative to Facebook, we used information contained in the S-1 document to understand Facebook's business, the main source of revenues, the main type of financing and the level of capital intensity of the firm, We also looked at the information to understand why analysts suggested to buy facebook's shares (i.e. expected growth in the number of users);
• The other case was Pepsi and Coke. In this case we compared the strategies of the two companies (both operating and investing) by looking at the accounting numbers.

In all these cases, I was implicitly pushing you to transform accounting data to understand what was going on inside the firm and use those transformations to make evaluations:

• Evaluated whether to invest or not in the firm;
• Evaluate two firms and understand which one is more successful the other and why;
• Evaluate firms' changes over time.

These are all goals of the financial statement analysis and the reasons why investors are interested in the financial statement analysis. In the next sessions, we will go more in depth focusing on the most common tools that external subjects use to analyze financial statements and make evaluation.

Making evaluations is not easy as it requires a relevant amount of judgment. Yet, a key "rule" of the financial statement analysis is that companies should not evaluated in isolation. Instead, we need a benchmark with respect to which the company is evaluated. The benchmark can be temporal (i.e. past) or cross-sectional (other firms belonging to the same industry or companies that have similar characteristics).

Remember that firms' earnings do not only depend upon firms' characteristics and judgment but also on economy --wide factors (gdp, inflation) and industry factors (existing trend in the industry).

Types of FSA:

• Component percentages;

We divide items from the income statement by net sales and items from the balance sheet by total assets. Then, we compare these percentages with prior firm's percentages or with the component percentages of other firms. So far, we discussed some examples of common percentages:

• Comparison of the percentage of investments in other corporations of Coke and Pepsi;
• Computation of the main source of financing of Facebook.
• Ratio analysis.

Focus on ratios belonging to diverse financial statements. This is our main focus. We can distinguish four main types:

• Profitability:
  • ROA
  • ROE
  • EPS
• Activity ratios:
  • Asset Turnover Ratio
  • Fixed Asset Turnover Ratio
  • Accounts Receivable Turnover Ratio
  • Inventory Turnover Ratio
  • Accounts Payable Turnover Ratio
  • Operating Cycle
• Liquidity ratios:
  • Current Ratio
  • Quick Ratio
  • Cash Ratio
• Solvency ratios:
  • Capital Structure:
    • Financial Leverage
    • Debt-To-Equity
  • Coverage Ratios:
    • Time Interest Earned Ratio
    • Cash Coverage Ratio

As we already said, financial statement analysis is not something mechanical and requires a lot of judgment so that some refer to the financial statement analysis as an art. This has also implications about how the ratios are computed. Some ratios are more meaningful than others depending on the industry and the circumstances. Moreover, they can be computed in a different way.

I will refer to the ratios used in the textbook and how the textbook suggests to compute them. Yet, bear in mind that they are not the only ones and there are alternatives in the way they are computed.

Magnitude of Accruals So far, we focused on the evaluation of firm's characteristics on the basis of accounting numbers assuming that such numbers are reliable and trustworthy. In other words, we assumed that accounting numbers properly reflect firms' operating, investing and financing activities so that they can be used to make our evaluations and take our investment decisions. This is not only the case as managers can make accounting choices and "adjust" accounting numbers to appear better than in reality. For this reason, financial analysts run an additional analysis to assess the extent to which financial statements reflect firms' operations (i.e. quality of financial statements) and, hence, are trustworthy.

One of the tools used by the financial analysts is to consider the magnitude of total accruals. Total accruals represent the amount of net income that did not turn into cash yet. Indeed, they are computed as net income less cash flow from operations. As they did not turn into cash yet, they are more exposed to managers' adjustments and manipulation. Given that, analysts usually evaluate the trustworthiness of firm's financial statements by dividing the absolute value of total accruals by the absolute value of cash flow from operations.

A greater value of the ratio indicates a greater discrepancy between cash and the net income reported by the firm and, hence, a higher probability that managers adjusted accounting numbers to appear better.

Overall Evaluation First of all, it is important to point out that equityholders and debtholders look for different firms' characteristics. If equityholders are more concerned with profitability, debtholders may be more concerned with the solvency. Hence, the evaluation of the firm and, hence, the use of the ratios based on accounting numbers differ depending on the type of investor (equityholder vs debtholder) and their preferences.