Finance and AccountingFinancial Analysis

---

• Key Points:
• Financial statement analysis helps in making informed economic decisions.

• It involves examining financial statements to evaluate past performance and project future performance.

• Action Steps:

• Regularly read annual reports of companies you are interested in investing in.
• Familiarize yourself with the different types of financial statements: balance sheet, income statement, cash flow statement, and statement of changes in equity.

• Key Points:
• Assets are categorized as current (cash, receivables, inventory) and non-current (property, plant, equipment).
• Liabilities include current (accounts payable, short-term debt) and long-term (bonds payable, long-term loans).

• Shareholders’ equity represents the residual interest in assets after deducting liabilities.

• Examples:

• Example of current assets: A manufacturing company’s inventory of raw materials.

• Example of non-current liabilities: A corporate bond that matures in 10 years.

• Action Steps:

• Calculate the current ratio (Current Assets / Current Liabilities) to assess liquidity.
• Analyze the composition of shareholders’ equity to understand a company’s financial structure.

• Key Points:
• Revenues represent the income generated from normal business operations.
• Expenses are the costs incurred to earn revenues.

• Net income (or profit) is calculated as revenues minus expenses.

• Examples:

• Example of revenue: Sales income from a retail chain.

• Example of expense: Salary payments and utility bills of a company.

• Action Steps:

• Use the gross margin ratio ((Revenue – Cost of Goods Sold) / Revenue) to assess profitability.
• Examine trends in operating expenses to identify potential cost-saving areas.

• Key Points:
• Operating activities involve the cash effects of transactions related to net income.
• Investing activities reflect purchases and sales of long-term assets.

• Financing activities account for transactions with the company’s owners and creditors.

• Examples:

• Example of cash inflow from financing: Proceeds from issuing stock.

• Example of cash outflow from investing: Purchase of new machinery.

• Action Steps:

• Monitor the cash flow from operations to gauge a company’s ability to generate cash.
• Assess free cash flow (Operating Cash Flow – Capital Expenditures) to evaluate financial flexibility.

• Key Points:
• Liquidity ratios (e.g., current ratio, quick ratio) measure a company’s ability to meet short-term obligations.
• Solvency ratios (e.g., debt to equity ratio) assess long-term financial stability.

• Profitability ratios (e.g., return on assets, return on equity) evaluate the efficiency of profit generation.

• Examples:

• Quick ratio = (Current Assets – Inventory) / Current Liabilities.

• Return on equity (ROE) = Net Income / Average Shareholders’ Equity.

• Action Steps:

• Calculate and analyze key financial ratios every quarter for the companies you follow.
• Compare the ratios against industry benchmarks to contextualize the performance.

• Key Points:
• Earnings quality reflects the sustainability and reliability of earnings.

• Management may use creative accounting techniques (like changing depreciation methods) to paint a favorable picture.

• Examples:

• Example of creative accounting: Manipulating provisions for bad debts to manage earnings.

• Action Steps:

• Assess the consistency of accounting policies over time.
• Look beyond the numbers in financial statements to understand the underlying business context.

• Key Points:
• Revenue recognition should align with the earning process and when collectibility is reasonably assured.

• Expenses should be matched with related revenues under the accrual basis of accounting.

• Examples:

• Recognizing revenue at the point of delivery for a software company.

• Matching advertising expenses with the period in which the related sales are made.

• Action Steps:

• Scrutinize revenue recognition policies for signs of aggressive or conservative estimates.
• Ensure expense matching principles are consistently applied when reviewing financial statements.

• Key Points:
• Historical cost accounting may distort true financial performance during inflation.

• Constant dollar accounting and current cost accounting are methods to account for inflation.

• Examples:

• Example of current cost accounting: Adjusting the value of non-monetary assets based on current prices.

• Action Steps:

• Use inflation-adjusted financial statements for better comparability and analysis over time.
• Factor in the inflation rate when evaluating the historical performance of assets.

• Key Points:
• A detailed analysis is performed on the financial health of the case study company.

• The case study emphasizes the integration of various financial statement analysis techniques.

• Examples:

• Examples include ratio analysis sections, cash flow analysis, and assessment of earnings quality.

• Action Steps:

• Conduct similar case studies on companies in your portfolio or of interest.
• Integrate various financial analysis tools to form a holistic view of the company’s performance.

1. Read annual reports and familiarize yourself with financial statements.
2. Calculate and analyze key ratios (current ratio, quick ratio, return on assets, etc.).
3. Monitor cash flow from operations and assess free cash flow.
4. Evaluate the consistency of accounting policies and earnings quality.
5. Scrutinize revenue and expense recognition policies for aggressive estimates.
6. Adjust for inflation in financial statements for comparability.
7. Conduct comprehensive case studies to integrate various analytical tools.

Finance and AccountingFinancial Analysis