Use of a Framework to Analyze a Firm’s Financial Statements

Financial analysis is crucial as it aids investors and other financial decision-makers to work out effective economic decisions. This ensures that the possibility of a successful outcome is on the decision maker’s side.

A basic framework to aid in financial analysis has been developed. It enables users to make decisions about an equity ownership interest, a lending resolution, assessing a credit rating, or forecasting the impact on a firm of a change in the accounting standards. The framework is as shown in the following table:

$$ \textbf{Framework for Financial Analysis} $$

$$\small{\begin{array}{l|l|l} \textbf{Phase} & \textbf{Input} & \textbf{Output}\\ \hline\textbf{Setting the objective} & {\text{Understanding the purpose of}\\ \text{the analysis such as equity}\\ \text{investment, lending or}\\ \text{acquisition}} & \text{Statement of purpose}\\ \hline{}& {\text{Discuss with the client and the}\\ \text{employer on their needs and}\\ \text{concerns}} & {\text{Particular questions to be}\\ \text{answered}}\\ \hline{}& \text{Institutional guidelines} & {\text{Timelines and resources}\\ \text{required}}\\ \hline\textbf{Data collection} & \text{Financial statements and annual reports} & \text{Well-structured financial information}\\ \hline{}& {\text{Discussing with management,}\\ \text{customers, suppliers and}\\ \text{looking at press releases}} &{}\\ \hline\textbf{Data processing} &{\text{Pinpoint the modifications to be}\\ \text{made on the well-structured}\\ \text{Financial information from phase 2}} & {\text{Modified financial}\\ \text{statements}}\\ \hline {}& {}& \text{Common-size statements}\\ \hline{}& {}& \text{Ratios and forecasts}\\ \hline\textbf{Data analysis} & \text{Data from phases 2 and 3} & \text{Analytical results}\\ \hline{\textbf{Conclusions and}\\ \textbf{recommendations}} & \text{Analytical results} & {\text{Analytical report answering}\\ \text{questions raised in phase 1}}\\ \hline{}& \text{Published report guidelines} & \text{Recommendations}\\ \hline\textbf{Update the analysis} & \text{New updated data periodically} & {\text{Updated analysis and}\\ \text{recommendations}}\\  \end{array}}$$

The data to be processed and analyzed depends on the specific objectives of the analysis. Here, we consider the analysis of a purchase decision for a long-term equity investment. The key points to consider for this analysis include:

• A DuPont or extended DuPont analysis which assesses the return on equity (ROE).
• Sources of income: Are the company’s earnings from operating revenue or non-operating revenue?
• Asset base: Involves evaluating the composition of the balance sheet over time.
• Capital structure: Proportion of loans, other long-term liabilities and equity.
• Segment analysis and capital allocation.
• Earnings quality and cash flow analysis.
• Market value decomposition.
• Off-balance-sheet financing.
• Forecasting changes in accounting standards.

In the learning outcomes that follow, we will look at a detailed example of financial statement adjustments and analysis to demonstrate these critical points in the other learning outcomes.

Question

When employing the financial analysis framework to the valuation of an equity investment, discussing with management, suppliers, customers, and competitors of a firm is an input that is more likely to occur while:

     A. Setting the objective of the analysis.

     B. Processing data.

     C. Collecting data.

Solution

The correct answer is C.

Discussing with management, suppliers, customers, and competitors are input during the data collection phase.

A is incorrect. The inputs for the first phase of analysis, i.e., setting up the objective, include understanding the purpose of the analysis, discussing with the client and the employer on their needs and concerns, and institutional guidelines.

B is incorrect. Well-structured data from the data collection phase is the input for the data processing phase.

Reading 16: Integration of Financial Statement Analysis Techniques 

LOS 16 (a) Demonstrate the use of a framework for analyzing financial statements, given a particular problem, question, or purpose. For example, valuing equity-based on comparable, critiquing credit rating, obtaining a comprehensive picture of financial leverage, evaluating the perspectives given in management’s discussion of financial results).