11/16/2021

FINANCIAL STATEMENT
ANALYSIS

Nguyen Thi Thu Huyen, PhD.

Faculty of Banking and Finance

Contents

Chapter 1: Financial statement analysis: an introduction

Chapter 2: Understanding the balance sheet

Chapter 3: Understanding the income statement

Chapter 4: Understanding the cash flow statement

Chapter 5: Financial statement analysis techniques

CHAPTER 2

UNDERSTANDING
THE BALANCE SHEET

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The balance sheet

• The balance sheet presents a comprehensive

overview of total asset value and total resource
financing the assets of an enterprise at the point of
time
• Principle of the balance sheet
Total asset = Total resource = Liabilities + Equity

Balance Sheet
Liabilities and
Assets
Equity

Current
liabilities
Current Assets
Non-current
Liabilities

Non-current
Assets Shareholders’
Equity

Balance Sheet
Assets Liabilities and Stockholders’ Equity
Current Assets Current Liabilities
• Cash and cash equivalents • Current liabilities
• Marketable securities • Non-current liabilities
• Accounts receivable
• Inventories
• Other current assets

Non-current Assets Stockholders’ Equity

• Property, plant and equipment • Contributed capital
• Investment property • Preferred stock
• Intangible assets • Treasury stock
• Goodwill • Retained earnings
• Non-controlling interest
• Accumulated other comprehensive
income

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Balance sheet analysis

Liquidity Debt & Equity Value & Cost

• Current • Capital • Market value vs

Assets vs structure Book value
Non-current • Cost of capital
Asset • Retained • VAS, US GAAP: at cost
• IFRS: true market/fair
• Risk earning value
• Opportunity
cost

I. ASSETS
Economic resources are controlled by a company and expected
to provide probable economic benefit in the future
Assets can be recognized if
• There is economic benefit
• Assets have expense or value of asset can be realizably
determined
Assets are classified into two groups
• Current assets: Cash and cash equivalents, short-term
financial investment, account receivables, inventory,
other current assets
• Non current assets: long term receivable, fixed assets,
property, long term financial investment, other non
current assets

Current assets
Current assets include cash and other assets that will be
converted into cash or used up within one year or the firm’s
operating cycle, whichever is greater. Current assets include:
1. Cash and cash equivalents are short-term, highly liquid
investments that are readily convertible to cash and near
enough to maturity that interest rate risk is insignificant.
Cash and cash equivalent are reported on the balance sheet
at amortized cost and fair value.
2. Marketable securities are financial assets that are traded in
a public market and whose value can be readily
determined.

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Current assets
3. Account receivable are financial assets that represent amounts
owed to the firm by customers for goods or services sold on
credit. Accounts receivable are reported at net realized value,
which based on estimated bad debt expense.
• Bad debt expense increase the allowance for doubtful
accounts, a contra-asset account.
• A contra-asset account is used to reduce the value of its
controlling account.

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Current assets
4. Inventories are goods held for sale to customers or used in
manufacture of goods to be sold.
• Manufacturing firms separately report inventories of raw
materials, work-in-process and finished goods.
• The cost included in inventory include purchase cost,
conversion costs, and other costs necessary to bring the
inventory to its present location and condition.
• Costs that are exclude from inventory include abnormal
waste of material, labor, and overhead, storage costs (unless
they are necessary as a part of the production process),
administrative overhead, and selling costs.

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Other current assets

• Prepaid expenses are operating costs have been paid in
advance.
• Deferred tax assets are created when the amount of taxes
payable exceeds the amount of income tax expense
recognized in the income statement.

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Non-current assets
1. Property, plant, and equipment (PP&E) are tangible
assets used in the production of goods and services.
• PP&E includes land and buildings, machinery and
equipment, furniture, and natural resources.
• Under IFRS, PP&E can be reported using the cost model
or the revaluation model.
• Under [Link], only the cost model is allowed.
• Under the cost model, PP&E is reported at amortized cost
(historical cost minus accumulated depreciation,
amortization, depletion, impairment losses).
• Under the valuation model, PP&E is reported at fair value
less any accumulated depreciation.

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Non-current assets
2. Investment property includes assets that generate
rental income or capital appreciation.
• Under IFRS, investment property can either be
reported at amortized cost or fair value.
• Under the fair value model, any change in fair value
is recognized in the income statement.

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Non-current assets

3. Intangible assets are non-monetary assets that lack physical

substance.
• Identifiable intangible assets can be acquired separately or are
the result of rights or privileges conveyed to its owner over a
finite period such as patents, trademarks and copy rights. Cost
of an identifiable assets is amortized over its useful life.
• Unidentifiable intangible assets can not be acquired
separately and may have an unlimited life . Intangible asset
with infinite life are not amortized but are tested for
impairment at least annually (goodwill).

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Non-current assets

• Goodwill is the excess of purchase price over the fair

value of identifiable assets and liabilities acquired in a
business acquisition.
• Economic goodwill derives from the expected future
performance of the firm
• Accounting goodwill is the result of past acquisition

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Example

Wood corporation paid $600 million for the outstanding stock of

Pine Corporation. At the acquisition date, Pine reported the
following balance sheet
Pine corporation Book value (millions)
Current assets 80
Plant and equipment, net 760
Goodwill 30
Liabilities 400
Stockholders’ equity 470

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Example (continued)

The fair value of the plant and equipment was $120 million
more than its recorded book value. The fair value of all other
identifiable assets and liabilities were equal to their recorded
book values. Calculate the amount of goodwill Wood should
report on its consolidated balance sheet.

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Solution

Answer :
• Fair value of net asset = fair value of plant and equipment,
net- fair value of liabilities
= 80+880-400=560 million (USD)
• Goodwill = purchase price-fair value of net assets
=600-560=40 million USD
Notes:
• Firms can manipulate net income upward by allocating more
of the acquisition price to goodwill and less to the identifiable
assets
• Analyst should eliminate goodwill from balance sheet and
goodwill impairment charges from income statement

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Financial assets

• Financial assets include investment securities (stocks

and bonds), derivatives, loans, and receivables.
• Financial instruments are measured at historical cost
(unlisted equity investments, loans, receivables),
amortized cost (held-to-maturity securities), or fair
value (trading securities, available-for-sale securities
and derivatives).

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II. LIABILITIES
• Are obligations owned by entity from previous transactions that
are expected to result in an outflow of economic benefits in the
future.
• Amount has been received but not been recorded as revenue on the
income statement or will have to be returned.
• Amount has been recorded as expense on the income statement but
has not been paid yet.

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Current liabilities

• Current liabilities are obligations that will be

satisfied within one year or operating cycle,
whichever is greater.
1. Accounts payable are amounts the firm owes to suppliers
for goods or services purchased on credit.
2. Notes payable are obligations in the form of promissory
notes owed to creditors and lenders.
3. Current portion of long-term debt is the principal portion
of debt due within one year or operating cycle, whichever
is greater.

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Current liabilities

4. Accrued liabilities (accrued expenses) are expenses

that have been recognized in the income statement
but are not yet contractually due.
5. Unearned revenue (unearned income, deferred
revenue, or deferred income) is cash collected in
advance of providing goods and services.

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Non-current liabilities

1. Long-term financial liabilities include bank loans,

notes payable, bonds payable and derivatives.
• If the financial liabilities are not issued at face
amount, the liabilities are usually reported on the
balance sheet at amortized cost.
• In some cases, financial liabilities are reported at fair
value. (held-for-trading liabilities, derivatives
liabilities,…)

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Non-current liabilities

2. Deferred tax liabilities are the amounts of income

taxes payable in future periods as a result of taxable
temporary differences.
• Deferred tax liabilities are created when the amount
of income tax expense recognized in the income
statement is greater than taxes payable.
• This can occur when expenses or losses are tax
deductible before they are recognized in the income
statement.

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V. SHAREHOLDERS’ EQUITY

Stockholders’ equity is the residual interest in asset that

remains after subtracting a firm’s liabilities.
Shareholders’ equity is classified into:
• Contributed capital
• Preferred stock
• Treasury stock
• Retained earnings
• Non-controlling interest
• Accumulated other comprehensive income

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V. SHAREHOLDERS’ EQUITY
 Contributed capital
• Total amount paid in by the common and preferred
shareholders
• Par value is a legal value and has no relationship to fair
value
• Authorized shares are the number of shares that may be
sold under the firm’s articles of incorporation
• Issued shares are the number of shares that have
actually been sold to shareholders
• Outstanding shares is equal to the issued shares less
treasury shares

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Component of balance sheet

 Treasury stock is stock that has been reacquired by the issuing
firm but not yet retired. Treasury stock reduces stockholders’
equity and has no voting rights as well as dividends
 Retained earnings are the undistributed earnings (net income)
of the firm since inception
 Minority interest is the minority shareholders’ pro-rata share of
equity of a subsidiary that is not wholly owned by the parent
 Accumulated other comprehensive income (IFRS and U.S
GAAP) includes all changes in stockholders’ equity except for
transactions recognized in the income statement (net income)
and transactions with shareholders such as issuing stock,
reacquiring stock and paying dividends. Example : differences
from asset revaluation, differences from foreign exchange

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Measurement bases of assets and liabilities

• Historical cost is the value that was exchanged at the acquisition
date. Historical cost is verifiable and objective; however its
relevance to investment analysis declines over time as prices
change.
• Fair value is the amount at which an asset can be bought or sold,
or a liability can be incurred or settled between knowledgeable,
willing parties in an arms’length transaction. Fair value is
relatively subjective.
• Because the mixture of measurement bases, the balance sheet
value is not the value of the firm. Analyst must adjust the balance
sheet to better asses a firm’s investment potential or
creditworthiness.

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• Inventories
• Capitalizing and expensing

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INVENTORIES

Method Assumption COGS consist of… Ending inventory

consists of…
FIFO (US and The items first first purchased most recent
IFRS) purchased are the purchases
first to be sold
LIFO (US only) The items last last purchased earliest purchases
purchased are the
first to be sold

Weighted average Items sold are a mix Average cost of all Average cost of all
cost (US and IFRS) of purchases items item

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Example 1

• Use the inventory data in the following figure to calculate the

COGS and ending inventory under the FIFO, LIFO, and
weighted average cost methods.
Inventory Data
January 1 (beginning inventory) 2 units @ $2 per unit
January 7 purchase 3 units @ $3 per unit
January 19 purchase 5 units @ $5 per unit
COGS available 10 units
Units sold during January 7 units

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Inventories

FIFO LIFO

COGS

Ending inventory

Gross profit

Tax

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CAPITALIZING AND EXPENSING

• When a firm makes an expenditures, it can either capitalize the

costs as an asset on the balance sheet or expense the cost in the
income statement in the period incurred.
• An expenditure that is capitalized is initially recorded as an
asset on the balance sheet at cost, typically its fair value at
acquisition plus any costs necessary to prepare the asset for
use.
• The cost is allocated to the income statement over the life of
the asset as depreciation expense (for tangible assets) or
amortization expense (for intangible assets with finite lives).

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Example 2

• Northwood Corp. purchased new equipment to be used in

its manufacturing plant. The cost of the equipment was
$250,000 including $5,000 freight and $12,000 of taxes.
In addition to the equipment cost, Northwood paid
$10,000 to install the equipment and $7,500 to train its
employees to use the equipment. Over the asset’s life,
Northwood paid $35,000 for repair and maintenance. At
the end of five years, Northwood extended the life of the
asset by rebuilding the equipment’s motors at a cost of
$85,000. What amounts should be capitalized on
Northwood’s balance sheet and what amounts should be
expensed in the period incurred?

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Example 3
• CAP Inc. and NOW Inc. start up with $1,000 cash and $1,000
common stock. Each year the companies receive total revenues
of $1,500 cash and pay cash expenses, excluding an equipment
purchase, of $500. At the beginning of operations, each
company spends $900 to purchase equipment. CAP estimates
the equipment will have a useful life of three years and an
estimated salvage value of $0 at the end of the three years.
NOW estimates a much shorter useful life and expenses the
equipment immediately. The companies have no other assets
and make no other assets purchases during the three years
period. Assume the companies pay no dividends, earn zero
interest on cash balances, have a tax rate of 30%, and use the
same accounting method for financial and tax purposes.

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Example 3

1. Which company reports higher net income over the

three years? Total cash flow? Cash from operations?
2. Based on ROE and net profit margin, how do the
two companies profitability compare?
3. Why NOW Inc. report change in cash of $70 in year
1 while CAP Inc. reports total change in cash of
($110)?

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Solution
CAP Inc. 1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash

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Solution
NOW Inc. 1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash

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Solution

Question 1
Neither company reports higher net income nor total cash flow
over the three years. The sum of net income over the three years
is identical ($1,470 total) whether the $900 is capitalized or
expensed.
The sum of the change in cash ($1,470 total) is identical under
either scenario. CAP Inc. reports higher cash from operation by
an amount of $900 because, under the capitalization scenario, the
$900 purchase is treated as an investing cash flow.

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Solution

0 1 2 3
Retained earning
Common stock
Total shareholders’ equity
ROE
Net profit margin

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Financial Statement Effects of Capitalizing vs. Expensing

Capitalizing Expensing
Total assets
Shareholders’ equity
Income variability
Net income (first year)
Net income (subsequent years)
Cash flow from operations
Cash flow from investing
Debt ratio & Debt to equity
Interest coverage (first year)
Interest coverage (subsequent years)

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