Reading 19: Introduction to Financial Statement

Analysis
 Learning Outcome Statements
• Covered
• 19a, 19b, 19c, 19d, 19e, 19f

• Not Covered
• None
 Important Roles

Financial
Financial
Statement
Reporting
Analysis

The Critical Role Is to Inform

 Financial Reporting

Corporate Executives Gather Information

General Public

Bondholders Shareholders
Financial Statement Analysis
 Practice Question
The role of financial reporting is most likely:

A. To help users in making forecasts about the future performance of the company
B. To provide information that is useful to a wide range of users in making economic decisions
C. To provide historical trends about the company’s performance
Statement of Financial Position
Statement of Comprehensive Income
 Statement of Changes in Equity

Statement of Retained Earnings

Net Income or Dividends

Loss Paid

Capital Transactions with

Shareholders

Beginning Balance + Changes = Ending Balance

 Statement of Changes in Cash Flow

Cash Can Flow In or Out in Three Areas:

Operating Investing
Activities Activities

Financing Activities

Reconciles Cash Balance at Beginning of Period with Cash

Balance at End of Period
 Practice Question
A financial analyst would most likely use the income statement to:

A. Evaluate the financial performance of firm over a period of time

B. Analyze the financial position of a firm at a certain point in time
C. Compute cash inflows and outflows generated by a firm
 Practice Question
An analyst with a national ratings agency is concerned about a firm’s ability to meet its short-term
obligations. To evaluate the firm’s liquidity, the analyst would most likely refer to the:

A. Balance sheet
B. Income statement
C. Cash flow statement
 Practice Question
A research analyst is evaluating the financial statements of Tripod Photo Company (TPC). The analyst
intends to make a recommendation on the stock after careful scrutiny of TPC’s financial statements. The
analyst observes that TPC initiated a dividend payment exactly two years ago and believes its operating
cash flows appear to be able to support an even higher dividend payment next year.

The sustainability of dividends is most likely to be evaluated using the:

A. Balance sheet
B. Income statement
C. Statement of cash flows
 Notes and Supplementary Information

Provides Information Essential to Understanding the Primary

Financial Statements

Discloses the Basis for the Construction of the Primary Financial

Statements

Accounting
Methods Estimates
Policies
 Management Discussion and Analysis (MD&A)

Managers Commentary

Operational The Nature of Performance

Results the Business Measures

Management’s Firm’s Resources,

Objectives and Risks, and
Strategies Relationships
 Practice Question
A financial analyst reads the managerial discussion of a large retail firm. The least likely topic
appearing in the footnotes is:

A. A discussion on the recent expansion of operations to Canada

B. The risk associated with the firm’s outstanding long-term debt issues
C. An explanation for the granting of executive stock options to a newly hired chief operating
officer
 Audits

Examination of financial statements by an independent third party

Objective is to provide reasonable assurance that statements are

free of material error

Opinions

Unqualified Qualified Adverse Disclaimer

 Internal Controls

Company procedures to ensure

reliable preparation of financial
statements
 Practice Question
An audit is most likely described as:

A. A review of the financial statements by an internal auditor of the entity to check their
accuracy
B. An independent review of an entity’s financial statements
C. A review of the financial statements by a senior director of the entity with the purpose of
stating an opinion on their fairness and reliability
 Practice Question
If an auditor feels that a company’s financial statements are not presented fairly or significantly
deviate from accounting standards, she will most likely issue a(n):

A. Qualified opinion
B. Unqualified opinion
C. Adverse opinion
 Press Interim
Releases Reports

Other Sources of Proxy

Websites
Information Statements

Peer Technical
Analysis Specialists
 Practice Question
Which of the following is most accurate?

A. All information needed for financial statement analysis can be found in the audited
statements.
B. Thorough financial statement analysis must include sources beyond annual statements and
supplementary information.
C. Annual financial statements and supplementary information are sufficient to thoroughly
analyze a company.
 Practice Question
A research analyst with a large investment firm is evaluating the financial statements of Sunny Lumber Company
(SLC). The analyst intends to make a recommendation on the stock after careful scrutiny of SLC’s financial
statements and other publicly available information. The analyst makes the following comment during his
research:
Comment: SLC’s profitability is far superior to that of its three main competitors.

The comment is most likely made after evaluating the:

A. Balance sheet and the income statement

B. Statement of cash flows and the proxy statement
C. Income statement and external financial data sources
Financial Statement Analysis Framework
 Practice Question
An analyst produces a table of financial ratios on liquidity and profitability for a healthcare firm.
The most likely phase of the financial statement analysis framework is:

A. Analyzing data
B. Processing data
C. Collecting data
 Practice Question
A junior research analyst with a commercial bank is evaluating the financial statements of Troy Technology
Company (TTC). The analyst intends to make a recommendation on the stock after completing the steps of the
financial statement analysis framework. The analyst notes that TTC’s liquidity and capital structure ratios are
consistent with the industry averages.

The conclusion regarding liquidity and capital structure ratios is most likely made during the:

A. Analyzing
B. Collecting
C. Processing
 Practice Workbook 1
Financial Statements and Management Commentary
Description Primary Location Management Commentary

The firm’s capital structure

Earnings per share

Gross margin as % of revenue

Planned expansion of
domestic facility

Planned global expansion

Sale of business segment

 Practice Workbook 1
Financial Statements and Management Commentary
Description Primary Location Management Commentary

The firm’s capital structure Balance Sheet

Earnings per share Income Statement

Gross margin as % of revenue Income Statement

Planned expansion of
None
domestic facility

Planned global expansion None

Income Statement and

Sale of business segment
Cash Flow Statement
 Practice Workbook 1
Financial Statements and Management Commentary
Description Primary Location Management Commentary

The firm’s capital structure Balance Sheet Credit risk of the bond issue

Earnings per share Income Statement Result of operations

Critical performance
Gross margin as % of revenue Income Statement
measures
Planned expansion of
None Management strategies
domestic facility

Planned global expansion None Currency risk

Income Statement and

Sale of business segment Company resources
Cash Flow Statement
 Practice Workbook 2
Financial Statement Analysis Framework
Activity Completed in Phase
Define audience for finished report
Read and evaluate financial data
Project earnings for upcoming quarter
Evaluate skill of executives
Complete periodic review to confirm decision was
appropriate
Gather historical dividend yields
 Practice Workbook 2
Financial Statement Analysis Framework
Activity Completed in Phase
Define audience for finished report Articulate purpose of analysis
Read and evaluate financial data Process data
Project earnings for upcoming quarter Develop conclusions
Evaluate skill of executives Interpret processed data
Complete periodic review to confirm decision was
appropriate
Follow up

Gather historical dividend yields Collect data

Practice Questions with Solutions
 Practice Question and Solution
The role of financial reporting is most likely:

A. To help users in making forecasts about the future performance of the company
B. To provide information that is useful to a wide range of users in making economic decisions
C. To provide historical trends about the company’s performance

LOS 19a
Correct Answer: B

The critical role of financial reporting is to inform. A wide range of users rely on this information to
make important economic decisions. Users make forecasts and attempt to locate trends using this
information, but those are not part of the roles of financial reporting.
 Practice Question and Solution
A financial analyst would most likely use the income statement to:

A. Evaluate the financial performance of firm over a period of time

B. Analyze the financial position of a firm at a certain point in time
C. Compute cash inflows and outflows generated by a firm

LOS 19b
Correct Answer: A

Financial performance refers to the ability of a firm to generate a profit. One of the main roles of
the income statement is to show a firm’s profitability.
 Practice Question and Solution
An analyst with a national ratings agency is concerned about a firm’s ability to meet its short-term
obligations. To evaluate the firm’s liquidity, the analyst would most likely refer to the:

A. Balance sheet
B. Income statement
C. Cash flow statement

LOS 19b
Correct Answer: A

The balance sheet shows the firm’s short-term assets and its short-term liabilities. The analyst
would evaluate the relationship between those two accounts to determine the firm’s liquidity.
 Practice Question and Solution
A research analyst is evaluating the financial statements of Tripod Photo Company (TPC). The analyst
intends to make a recommendation on the stock after careful scrutiny of TPC’s financial statements. The
analyst observes that TPC initiated a dividend payment exactly two years ago and believes its operating
cash flows appear to be able to support an even higher dividend payment next year.

The sustainability of dividends is most likely to be evaluated using the:

A. Balance sheet
B. Income statement
C. Statement of cash flows

Los 19b
Correct Answer: C

The statement of cash flows will show current dividend payments together with operating cash flows.
The analyst could make a reasonable sustainability comment using this statement.
 Practice Question and Solution
A financial analyst reads the managerial discussion of a large retail firm. The least likely topic
appearing in the footnotes is:

A. A discussion on the recent expansion of operations to Canada

B. The risk associated with the firm’s outstanding long-term debt issues
C. An explanation for the granting of executive stock options to a newly hired chief operating
officer

LOS 19c
Correct Answer C

Managers typically do not express opinions on compensation issues, which would be contained in
the footnotes under accounting policies or methods.
 Practice Question and Solution
An audit is most likely described as:

A. A review of the financial statements by an internal auditor of the entity to check their
accuracy
B. An independent review of an entity’s financial statements
C. A review of the financial statements by a senior director of the entity with the purpose of
stating an opinion on their fairness and reliability

LOS 19d
Correct Answer: B

Neither internal auditors nor senior directors are independent and are not a part of the audit.
 Practice Question and Solution
If an auditor feels that a company’s financial statements are not presented fairly or significantly
deviate from accounting standards, she will most likely issue a(n):

A. Qualified opinion
B. Unqualified opinion
C. Adverse opinion

LOS 19d
Correct Answer: C

When the auditing firm believes there is a significant deviation from accepted accounting
standards, it will offer an adverse opinion.
 Practice Question and Solution
Which of the following is most accurate?

A. All information needed for financial statement analysis can be found in the audited
statements.
B. Thorough financial statement analysis must include sources beyond annual statements and
supplementary information.
C. Annual financial statements and supplementary information are sufficient to thoroughly
analyze a company.

LOS 19e
Correct Answer: B

Analysts should never rely solely on the audited financial statements or the supplementary
information. They should locate any relevant information that is reliable and use it as part of their
analysis.
 Practice Question and Solution
A research analyst with a large investment firm is evaluating the financial statements of Sunny Lumber Company
(SLC). The analyst intends to make a recommendation on the stock after careful scrutiny of SLC’s financial
statements and other publicly available information. The analyst makes the following comment during his
research:
Comment: SLC’s profitability is far superior to that of its three main competitors.

The comment is most likely made after evaluating the:

A. Balance sheet and the income statement

B. Statement of cash flows and the proxy statement
C. Income statement and external financial data sources

LOS 19b, 19e

Correct Answer: C

Profitability is found at the bottom of the income statement, and industry averages are found on the competitor
websites or other sources of competitor’s financial information.
 Practice Question and Solution
An analyst produces a table of financial ratios on liquidity and profitability for a healthcare firm.
The most likely phase of the financial statement analysis framework is:

A. Analyzing data
B. Processing data
C. Collecting data

LOS 19f
Correct Answer: B

Processing data includes the creation of financial tables on liquidity and profitability.
 Practice Question and Solution
A junior research analyst with a commercial bank is evaluating the financial statements of Troy Technology
Company (TTC). The analyst intends to make a recommendation on the stock after completing the steps of the
financial statement analysis framework. The analyst notes that TTC’s liquidity and capital structure ratios are
consistent with the industry averages.

The conclusion regarding liquidity and capital structure ratios is most likely made during the:

A. Analyzing
B. Collecting
C. Processing

LOS 19f
Correct Answer: A

Analyzing data includes interpreting liquidity and capital structure ratios and comparing them to industry
averages.