Before beginning to analyze a firm’s financial statements, the analyst should know and be able to define the end result being sought. Only if fully aware of objectives - both interim and ultimate - can the analyst focus attention on the relevant details.
Establishing objectives is therefore essential to the process of conducting a truly effective and efficient analysis: effective in that the conclusions reached will be correct and useful for the purposes of the analysis; efficient in that the analyst will achieve the best results with a minimum expenditure of time and effort.
With that said, the analyst’s accurate input of data is a must if the final output is to be correct and complete, and second, the spreadsheet utilized is of the utmost importance to ensure that the desired output is reliable.
In general, financial statement analysis has two basic objectives with respect to a given business enterprise: evaluation of past operating results (horizontal analysis) and current financial condition (vertical analysis) and forecasting of future trends in the firm’s operating performance and financial position. Regardless of who is doing the analysis or what firm is being analyzed, these objectives are always paramount, although their relative importance may vary from one situation to another.
Capital Equipment Objectives of Statement Analysis
Commercial banks generally aim their analysis at evaluating a commercial loan applicant’s financial position to determine the degree of his creditworthiness, or right of access to bank credit. Since the borrower’s creditworthiness also depends on the ability to service and repay as scheduled, an attempt usually is made to forecast, or assess, the extent of that ability. Commercial bankers, however, deal principally in "productive credits" - short term, seasonally self-liquidating loans to businessmen and others - and application of the second test is seldom necessary. For borrowers seeking only productive credits, a satisfactory current financial condition is adequate proof of creditworthiness.
In contrast to the short-term debt claims of commercial bankers, Equipment transactions tend to be intermediate to long-term (3-8 years). Accordingly, the emphasis is on the lessee/borrower’s ability to repay its obligations, based not solely on its present financial condition, but on its historic operations and anticipated future income and operating cash flow. The analysis of financial statements of a particular customer focuses on: the relatively long-term (3-5 years) historical profitability of the firm, together with future anticipated financial results, from which we must make an assessment of the degree of risk in extending longer-term financing based on a given rate of return and a certain amount of underlying collateral support.
Nature of Financial Statements
Financial statements are prepared by the management of a company for periodic review or to report on its progress. The statements deal with the status of the investment in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting standards/conventions, personal judgments, and company policies. The judgments and conventions applied affect the financial statements materially, and the soundness of the judgments depends on the competence and integrity of those who make them and on their adherence to generally accepted accounting principles.
Accounting is the body of knowledge concerned with the systematic originating, authenticating, recording, classifying, processing, summarizing, analyzing, interpreting, and supplying of dependable and significant information covering transactions and events which are, in part at least, of a financial character. These functions are required for the management and operation of an entity and for the reports that have to be submitted to meet fiduciary and other responsibilities.
It is generally recognized that:
(1) financial statements are representations by management;
(2) the public accountant has the responsibility for conducting his examination in accordance with accepted auditing standards; and
(3) the accountant (certified or otherwise) has the sole responsibility for writing his opinion stating, among other things, whether the financial statements are presented in accordance with accounting principles applied on a consistent basis.
A short-form accounting report is given below, and it usually is referred to as an "unqualified" opinion. Limitations on the scope of the examination typically are included in the first paragraph, and qualifications of the opinion are expressed in the second paragraph.
"We have examined the balance sheet of ABC Company as of December 31, 2000, and the related statements of income, stockholder’s equity and changes in financial position for the year then ended. Our examination was made in accordance with generally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures that we considered necessary in the circumstances. We previously examined and reported upon the financial statements of ABC Company for the year ended December 31, 2000. In our opinion, the aforementioned financial statements present fairly the financial position of ABC Company at December 31, 2000, and the results of operations and the changes in financial position for the year then ended, in conformity with generally accepted accounting principles applied on a consistent basis."
Accountant’s statements basically make the same representations. A careful phrase by phrase reading of the unqualified opinion provides the meaning of the accountant’s report. The use of the word examined is considered notice to all concerned that the accountant is neither engaged nor expected to disclose all minor discrepancies. Since accountants usually do not examine accounts in detail, the accountant avoids the use of the word audit in his report. The accountant limits his balance sheet responsibility to one date and not to any interim date. He is required, however, to report any material events (disclosure) occurring between the date of the balance sheet and the date of his report. It should be noted that the operating period covered is defined, and the related statements are limited. The phrase generally accepted auditing standards is an unqualified statement of fact, and it implies that the auditor knows the auditing standards generally accepted by his profession. The auditor also gives notice that the examination included all types of accounting records and not just the ledgers. A statement is made that the auditor has no reservations regarding the scope of his examination, and he has done everything in his judgment necessary to warrant an expression of opinion on the accounts examined. (At this point it might be useful to consider the distinction between auditing standards and auditing procedures. The former deals with measures of the quality of performance of those acts and objectives to be attained in applying the procedures. The latter relates to acts to be performed, as outlined in an audit program). The opinion expressed can be evaluated in terms of the reputation, experience, and professional standing of the auditor. He is liable for negligence, bad faith, and dishonesty, but not for losses resulting solely from errors of judgment. The auditor links his opinion with the financial statements and states that the statements present fairly the financial condition of the company in the sense that he believes they are substantially correct. Bear in mind, however, that the judgment involved is an informed judgment, and it is aided by generally accepted accounting principles.
When financial statements have been prepared in conformity with these principles, they should reflect financial facts fairly, even though approximations and estimates have been necessary. The concluding phrase, applied on a consistent basis, is self-explanatory. Recognize that statements may represent fairly the company’s financial position and results of operations and be in conformity with generally accepted accounting principles, but still not be on a basis consistent with the previous year. Furthermore, the balance sheet may be consistent, but the income statement may be inconsistent.
Accounting and auditing literature is replete with references to items that are material, significant, of substantial importance, materially distorting, immaterial, etc. These references make it abundantly clear that the concept of materiality plays an important part in auditing, accounting, and reporting of financial information.
"A statement, fact or item is material, if giving full consideration to the surrounding circumstances, as they exist at the time, it is of such a nature that its disclosure, or the method of treating it, would be likely to influence or to make a difference in the judgment or conduct of a reasonable person. The same tests apply to such words as significant, consequential, or important".
A lease/loan request frequently will involve a company that is a subsidiary of a larger concern or a member of a holding company. When leasing to companies of this nature, the analyst may receive consolidating and/or consolidated financial statements. Consolidating statements are presentations of all individual entities comprising the consolidated group, with the accounting entries of consolidation or examination clearly stated. This applies to both balance sheets and income statements. Recognize that consolidated statements may not represent the financial position and operating results of a single legal entity. Consolidated statements may show the data of an economic unit consisting of a group of legal corporate entities. In this case, each subsidiary corporation is a legal entity with distinct and separate rights and obligations. While consolidated statements are of great use in determining the earning power and stability of the economic unit, creditors, especially term creditors, wish to analyze the consolidating statements to ascertain the financial soundness and operating efficiency of each of the holding-company or Group entities; especially if a significant portion of debt rests at the holding company level with the servicing of such debt solely dependent on the operating companies financial results.
A significant portion of most reports consists of illustrative graphs, diagrams, and pictures of various company operations. To facilitate comparisons, it has become increasingly popular to include financial data for numbers of prior years as well as for the current year. There have also been examples of the inclusion of competitive financial data. Some reports include supporting schedules or units produced. Stockholder, or annual reports, of publicly held companies are quite helpful in credit analysis, revealing physical facilities, production results, employees, major shareholders, etc. In addition, most annual reports of leading companies contain a substantial amount of data describing operations, expectations for the future, affiliated company results, etc.
Company prepared interim-financial statements can be meaningful (when attested to and signed by corporate officers). This depends on the quality of the internal accounting system. Constantly seek to have an interim company-prepared financial statement signed by a corporate official, if possible. This is a warranty that the statement is true to the best of their knowledge. Additional sources of financial information include statements of corporate officials to the press and speeches to public organizations. Such releases may provide information about financial conditions and policies, plans for future expansion, labor relations, government controls, contemplated financing, etc. Many corporate spokespersons appear before financial analysts. Their remarks are usually detailed and frequently reproduced and distributed to other members and occasionally to the press.
Pro Forma Projection
The analyst may have projections, pro forma statements, budgets, or forecasts. Pro forma statements purport to reflect the receipt and application of the proceeds of a financing transaction and other material events. When pro forma statements involve economic projections, the basis for the changes should be clearly stated and documented in detail. Changes reflected in pro forma income statements and balance sheets should be reviewed for reasonableness, and they should be accompanied by notes clearly indicating the facts and assumptions employed. Revenue increases and cost reductions are the norm and should be scrutinized. Accomplishment is a question of probabilities.
Cash Basis Accounting
One of the analyst's major concerns is to note whether financial statements are prepared on an accrual, cash, or regulatory basis. Statements prepared on a cash basis reflect only income and expenditures resulting from actual cash receipts and disbursements. Such a statement is not a true reflection of costs incurred during a period. Since most businesses are conducted on a credit basis, a statement which portrays only cash transactions usually fails to reflect all the transactions affecting gains and losses for the period under review. Cash basis accounting, however, has distinct applications in many areas. It is prevalent in real estate venture operations and installment sales businesses. "Regulatory Basis" statements are issued primarily by banks and insurance companies under regulation.
Accrual accounting takes into consideration transactions during the period under review, whether on a cash or credit basis. Unless it is specifically stated to the contrary, a financial statement is presumed to have been prepared on the accrual basis. When the company closes its books at the end of an accounting period, there invariably exist certain unrecorded items of income and expense. Unless these items are reflected in the accounts, income for the current and subsequent years will be distorted. Such items include accrued and deferred income and expense. Omission of accrued income and deferred expense will understate current income, and omission of accrued expenses and deferred income will overstate earnings. Since the determination of amounts charged against or taken into income in an operating period rest with management, net income obviously may be manipulated to show a greater or lesser amount, depending on the objective.
Options and Objectives
Constantly be aware of the accounting alternatives available to management. Depending on management objectives, conservative or liberal policies can be applied to the balance sheet and/or the income statement. For instance, if management is primarily interested in earnings per share, straight-line depreciation will be used rather than accelerated; capitalized costs and interest expenses as opposed to expensed; rapid recognition of earnings rather than more conservative alternatives; and possible reluctance to reserve for or write-off doubtful accounts and notes receivable. Again, depending on the objectives of management, both the quality of the balance sheet and the income statement can be suspect.