Advanced financial statement analysis
1. Introduction
Lecture 1
The focus in this course is about listed companies. Not purely focus on financial analysis
(ratio, cashflow,..), but we are also going to analyse the industry and the strategy the
company uses to survive in the industry.
We will create a new financial statement, that reflects the real reality of the company
(critical look at the financial statement). We will make sure that the underlying statements
reflect the reality, only then the results will be worth something.
The focus of the course will be spread over 4 big blocks:
1. Accounting analysis
2. Financial analysis
3. Prospective analysis
4. Credit analysis
Accounting analysis is a big block, important for the points you can earn for you exam. You
can earn more points on accounting analysis than the rest. The exam consist of 4 big
questions; 1 question about accounting analysis (more points); 1 question about financial
analysis, prospective analysis (forecasting) & credit analysis (definitions, definitions about
credit analysis, research papers discussed in class). During the lectures there will be hints
about exam questions.
1.1. Framework for business analysis and valuation
Capital markets play an important role in channelling financial resources from savers to
business enterprises that need capital. Financial statement analysis is a valuable activity
when managers have complete info on a firm’s strategies, and a variety of institutional
factors make it unlikely that they fully disclose this info to suppliers of capital. In this setting,
outside analysts attempt to create “inside information” from analysing the financial
statement data, thereby gaining valuable insights about a firm’s current performance and
future prospects.
1
,Analysis step 1: Business Strategy analysis
This step involves developing an understanding of the business and competitive strategy of
the firm being analysed. In this step you identify key profit drivers & business risks and
assess the company’s profit potential at a qualitative level. So first of all, it is important to
look at the strategy of a business because if you’re not able to follow a strategy, you are not
able to survive. Identify the industry where the company operates.
Look at the strategy: differentiation → low cost.
Important: why? Identify the business and know what you have to evaluate. Depending on
the strategy, there will be other key success factors.
Price differentiation → high profit margin (earnings over sales) of low asset turnover.
Low cost → create profit not by having a huge margin, create profit by selling A LOT
(aldi), they sell so much amounts, they can still have profit.
Depending on the strategy you can survive in industry. You will have to know what key
performing indicators are. For different businesses, the key performance indicators will be
different.
Analysis step 2: Accounting analysis,
This step involves examining how accounting rules and conventions represent a firm’s
business economics and strategy in its financial statements, and, if necessary, developing
adjusted accounting measures of performance. In this step you evaluate the degree to
which a firm’s accounting captures the underlying business reality. Critical look at financial
statements: industries often tend to choose a certain method for their own interest.
The numbers in balance sheet, do NOT reflect the reality. This can lead to a
= something that prevents the financial statements to reflect the underlying business
reality. Could be accounting standards themselves or choices managers make.
Revenues are higher,…
This can result into acceleration or differentiation, higher or lower results.
2
, Payments for R&D : as a company you do further research and development in the
hope that this will create new products in the future, which you will be able to sell & .
Most accounting standards do NOT see R&D as an investment (example: buying a
machine is an investment which you can depreciate over the next years). You could
think this is the same with R&D, but that’s not allowed. Companies who do a lot of
R&D are not allowed to account this as an investment. Why? It’s very hard to assess
which part of the R&D will eventually lead to sellable products. Not every R&D will
lead to a new product that you will be able to sell and thus generate cash flow.
Consequence: a lot of assets for companies that do a lot of research, do not appear
on the balance sheet. This is actually an understatement of the company (example:
pharmaceutical companies). Performance ratios like ROA, Earnings/TA,… will not
reflect the reality. In Accounting analysis, we will look at these distortions. These
distortions could be caused by the standards or by the accounting choices managers
make.
Analysis step 3: financial analysis,
In the third step you use financial data to evaluate the current and past performance of a
firm and to assess its sustainability. Ratio’s, cash flow analysis…
Analysis step 4: prospective analysis,
This step indicates on how to develop forecasted financial statements and how to use these
to make estimates of a firm’s value. → creditworthiness of a business (credit analysis).
In accounting, you have different kinds of financial statements: consolidated and statutory
Financial Statements. But what exactly is the difference between the two?
Statutory Financial Statement Consolidated Financial Statement
The statements of 1 identity, Consolidated financial statement is a statement about
which is best known by more than 1 business identity. Consolidated means that
everyone. a parent company has control over other companies. A
parent has control if it has 50+1% shares in another
company.
3
, You have a Parent company that holds 50+1% of shares
in another company (S1), 75% in S2 and 20% in C1. This
means that S1 and S2 are subsidiaries. In this case, the
parent determines what happens in the company. C1 is
not a subsidiary: the parent only has 20% of the stocks.
In this case, the consolidated group op companies are P,
S1 and S2 (not C1).
The parent and the subsidiaries, make financial
statements of their own. If S1 is a Belgian company, it
makes standards to the law in Belgium. It is the parent
company who also makes a consolidated financial
statement, next to the financial statement of it’s own.
How do companies make this consolidated financial
statement? They take the balance sheet of P, S1 and S2
and they sum up every line of the financial statement.
They add the assets of all the companies together, all
the inventories,…. But companies need to eliminate
intercompany transactions. If parent sold items to S1,
it is a transaction within groups, this transaction needs
to be eliminated. A loan between P & S2, this needs to
be eliminated.
After the consolidation the financial statement present
the situation of all companies whithin the group &
outside the group. It gives a picture of how the group
of companies perform.
How can you recognize the consolidated financial
statement? How do you know you’re dealing with a
consolidated balance sheet?
Equity which is called “non-controlling interest” or
“minority interest” = part of shares and liabilities that
are not 100% owned.
Does P owns S1 completely? No! It’s going to add all
assets, liabilities to its own account, but it doesn’t owns
everything, actually only 50+1%.
The company does not completely own the company,
there also exist minority stake holders.
Non-controlling assets: part of the net assets that is
not owned by the parent company. That’s how you can
recognise.
Net result: part that is not owned by the parent
company but to the minority stake holders.
4
1. Introduction
Lecture 1
The focus in this course is about listed companies. Not purely focus on financial analysis
(ratio, cashflow,..), but we are also going to analyse the industry and the strategy the
company uses to survive in the industry.
We will create a new financial statement, that reflects the real reality of the company
(critical look at the financial statement). We will make sure that the underlying statements
reflect the reality, only then the results will be worth something.
The focus of the course will be spread over 4 big blocks:
1. Accounting analysis
2. Financial analysis
3. Prospective analysis
4. Credit analysis
Accounting analysis is a big block, important for the points you can earn for you exam. You
can earn more points on accounting analysis than the rest. The exam consist of 4 big
questions; 1 question about accounting analysis (more points); 1 question about financial
analysis, prospective analysis (forecasting) & credit analysis (definitions, definitions about
credit analysis, research papers discussed in class). During the lectures there will be hints
about exam questions.
1.1. Framework for business analysis and valuation
Capital markets play an important role in channelling financial resources from savers to
business enterprises that need capital. Financial statement analysis is a valuable activity
when managers have complete info on a firm’s strategies, and a variety of institutional
factors make it unlikely that they fully disclose this info to suppliers of capital. In this setting,
outside analysts attempt to create “inside information” from analysing the financial
statement data, thereby gaining valuable insights about a firm’s current performance and
future prospects.
1
,Analysis step 1: Business Strategy analysis
This step involves developing an understanding of the business and competitive strategy of
the firm being analysed. In this step you identify key profit drivers & business risks and
assess the company’s profit potential at a qualitative level. So first of all, it is important to
look at the strategy of a business because if you’re not able to follow a strategy, you are not
able to survive. Identify the industry where the company operates.
Look at the strategy: differentiation → low cost.
Important: why? Identify the business and know what you have to evaluate. Depending on
the strategy, there will be other key success factors.
Price differentiation → high profit margin (earnings over sales) of low asset turnover.
Low cost → create profit not by having a huge margin, create profit by selling A LOT
(aldi), they sell so much amounts, they can still have profit.
Depending on the strategy you can survive in industry. You will have to know what key
performing indicators are. For different businesses, the key performance indicators will be
different.
Analysis step 2: Accounting analysis,
This step involves examining how accounting rules and conventions represent a firm’s
business economics and strategy in its financial statements, and, if necessary, developing
adjusted accounting measures of performance. In this step you evaluate the degree to
which a firm’s accounting captures the underlying business reality. Critical look at financial
statements: industries often tend to choose a certain method for their own interest.
The numbers in balance sheet, do NOT reflect the reality. This can lead to a
= something that prevents the financial statements to reflect the underlying business
reality. Could be accounting standards themselves or choices managers make.
Revenues are higher,…
This can result into acceleration or differentiation, higher or lower results.
2
, Payments for R&D : as a company you do further research and development in the
hope that this will create new products in the future, which you will be able to sell & .
Most accounting standards do NOT see R&D as an investment (example: buying a
machine is an investment which you can depreciate over the next years). You could
think this is the same with R&D, but that’s not allowed. Companies who do a lot of
R&D are not allowed to account this as an investment. Why? It’s very hard to assess
which part of the R&D will eventually lead to sellable products. Not every R&D will
lead to a new product that you will be able to sell and thus generate cash flow.
Consequence: a lot of assets for companies that do a lot of research, do not appear
on the balance sheet. This is actually an understatement of the company (example:
pharmaceutical companies). Performance ratios like ROA, Earnings/TA,… will not
reflect the reality. In Accounting analysis, we will look at these distortions. These
distortions could be caused by the standards or by the accounting choices managers
make.
Analysis step 3: financial analysis,
In the third step you use financial data to evaluate the current and past performance of a
firm and to assess its sustainability. Ratio’s, cash flow analysis…
Analysis step 4: prospective analysis,
This step indicates on how to develop forecasted financial statements and how to use these
to make estimates of a firm’s value. → creditworthiness of a business (credit analysis).
In accounting, you have different kinds of financial statements: consolidated and statutory
Financial Statements. But what exactly is the difference between the two?
Statutory Financial Statement Consolidated Financial Statement
The statements of 1 identity, Consolidated financial statement is a statement about
which is best known by more than 1 business identity. Consolidated means that
everyone. a parent company has control over other companies. A
parent has control if it has 50+1% shares in another
company.
3
, You have a Parent company that holds 50+1% of shares
in another company (S1), 75% in S2 and 20% in C1. This
means that S1 and S2 are subsidiaries. In this case, the
parent determines what happens in the company. C1 is
not a subsidiary: the parent only has 20% of the stocks.
In this case, the consolidated group op companies are P,
S1 and S2 (not C1).
The parent and the subsidiaries, make financial
statements of their own. If S1 is a Belgian company, it
makes standards to the law in Belgium. It is the parent
company who also makes a consolidated financial
statement, next to the financial statement of it’s own.
How do companies make this consolidated financial
statement? They take the balance sheet of P, S1 and S2
and they sum up every line of the financial statement.
They add the assets of all the companies together, all
the inventories,…. But companies need to eliminate
intercompany transactions. If parent sold items to S1,
it is a transaction within groups, this transaction needs
to be eliminated. A loan between P & S2, this needs to
be eliminated.
After the consolidation the financial statement present
the situation of all companies whithin the group &
outside the group. It gives a picture of how the group
of companies perform.
How can you recognize the consolidated financial
statement? How do you know you’re dealing with a
consolidated balance sheet?
Equity which is called “non-controlling interest” or
“minority interest” = part of shares and liabilities that
are not 100% owned.
Does P owns S1 completely? No! It’s going to add all
assets, liabilities to its own account, but it doesn’t owns
everything, actually only 50+1%.
The company does not completely own the company,
there also exist minority stake holders.
Non-controlling assets: part of the net assets that is
not owned by the parent company. That’s how you can
recognise.
Net result: part that is not owned by the parent
company but to the minority stake holders.
4
