Financial Statement Analysis: Basis for Management Advice

All practicing CPAs will profit from this course, which presents the financial statements as a set of dynamic instruments that can be used for accurate, relevant and timely financial decisions.

Objectives: 

• Examine the causes of common financial problems such as reduced liquidity, increased leverage and low profitability
• Devise ways to correct liquidity problems
• Use bankruptcy prediction models
• Understand how analytic tools help management make decisions

Prerequisite:  None

Overview

Course Goals

The objective of this course is to enable you to (1) closely examine the causes of common financial problems such as liquidity, insufficient leverage, and unprofitability; (2) understand how financial statement analysis tools can be used to help make management decisions; (3) comprehend and use bankruptcy prediction models; and (4) devise ways to correct liquidity problems.

Introduction

The overall objective of this course is to analyze financial statements with an emphasis on how the analysis can be used for decision making.

This course is appropriate for CPAs in public practice. Increasingly, the CPA is being called upon not only to audit financial statements, but also to analyze them.

The accountant or financial manager of a company (other than a CPA practice) will also find this course useful. The information in this course is designed to improve financial decision making. It does not matter whether the analysis is done in-house or by the firm's CPA.

Financial statement analysis is as much an art as a science. The more one practices it, the easier it becomes. Analysis requires judgment, experience, and knowledge of a particular company.

This course will present the general tools. It will be up to you to apply them to specific situations.

Organization

Financial statement analysis requires that you use ratios. However, this course assumes that you know the basic ratios. The primary thrust of the course will be to look behind the basic ratios and to find the "causes" of a company's problems. If you take only one idea from this course it should be the idea of causality. The specific topic of causal ratios is covered in one particular section, but it will be referred to all day.

This course will also demonstrate that the same tools and techniques that can be applied to historical statements can also be applied on a pro forma basis.

A bankruptcy prediction model is also covered. It can be used to predict bankruptcy and to provide a measure of overall financial health.

The growth model will allow you to use this year's financial statements to project next year's maximum growth rate. Since rapid growth often causes company problems, this maximum sustainable growth model is very useful.

The course contains a case problem. Typically, you will work on the case for about 45 minutes; the discussion leader will cover the solution after you have completed your analysis.

If you apply the ideas in this course to your company or your clients, you will discover that they are very powerful decision making tools.

One of the co-authors of this program material and the system consultants of University Computer Stores have developed software to help you easily implement the concepts presented in this manual.

The financial analysis and graphics capabilities of Financial Status Evaluation Software allow you to create a complete presentation with one software package. For more information call:
(800) 568-4623 (Outside Dallas-Fort Worth)
(214) 434-2633 (Dallas-Forth Worth metro)
(940) 387-4731 (Local)

Chapter 1

Firm Valuation

Learning Objectives

Upon completion of this chapter you will be able to

• Value a firm utilizing a basic valuation formula.
  
• Understand who uses firm valuations.

Introduction

This section shows the correct method for determining the value of a firm using the constant growth dividend capitalization model. Explanations are presented of (1) the variables defined in the model and (2) the valuation techniques and who uses them.

Profitability
Growth
Risk
FIRM VALUE

Why Use a Valuation Technique?

Financial information is an important determinant of firm value. We need to know how the financial statements affect firm value.

• How does increased profitability affect firm value?
  – Profitability is positively related to firm value. That is, as a firm becomes more profitable its value increases.
  
• How does increased growth affect firm value?
  – Growth is defined as the firm's increasing ability to produce cash flows or profits. Growth is positively related to firm value.
  
• How does increased risk affect firm value? Liquidity risk? Financial risk?
  – All types of risk reduce firm value. Liquidity and financial risk can be measured from financial statements. As they increase, firm value declines.

A valuation technique is particularly important for small- and medium-sized companies. Largecompany values are found in the security markets. Smaller companies do not have this luxury.

The value of a firm is determined largely by its ability to earn. We want to know how the interpretation of the firm's financial statements affects the value of the firm. The value of a firm
is, after all, a reflection of the owner's wealth.