Question

1. Discuss the tools that you have learned for analyzing financial statements. Be sure to discuss what information is found on the Income statement and Balance sheet, and how this information can be used to determine the financial health of a company.

2. You have a friend who tells you that they are a conservative investor. They would like your advice on choosing 2 stocks to invest in. What 2 stocks would you recommend and why? Be sure to discuss risk, the Expected return for the portfolio, and how that compares with the actual returns.

Answer 1

You have asked two unrelated questions in the same post. I will answer the first one. Please post the other question in a separate post.

Q - 1

Financial reporting is the way companies show their performance to outside world. The objective behind financial statement analysis is to use the company’s financial statements & other relevant information to make economic decisions. Such an analysis is used to evaluate a company’s past performance & current financial position and project company’s ability to earn profits and future cash flows so that economic decisions like whether to invest in the company's securities or whether to extend bank credit to the company can be taken.

Financial statements are the different formats which have been prescribed by the law (accountancy) to be used for the purpose of financial reporting. Each format communicates a separate aspect of the business. Different Financial Statements are:
1.   Statement of Financial Position (Balance Sheet)
2.   Statement of Earnings (Income Statement)
3.   Statement of Cash Flows
4.   Statement of change in Shareholders’ Equity

Information is found on the Income statement and Balance sheet, and how this information can be used to determine the financial health of a company.

Sl. No.	Statement	Information	Use to determine the financial health
1.	Income Statement (or P&L statement or Statement of earnings or Statement of Operations)	Provide information about the financial performance of the company in a specified period. It contains all the revenues and expenses of the organization.	To assess the profitability and growth of the company To identify the sources of revenue and costs
2.	Balance Sheet	It is the statement of financial position of business as on a particular date; shows balances of assets, liabilities and equity on a date	To assess sources and uses of funds To assess growth rates in them To assess what company owns and who has claims on them
3.	Cash Flow	Summarizes the cash flowing into / out of the organization over a period of time	To assess the sources and uses of cash (further split across three heads of operations, investing & financing) To assess the liquidity position Helps to understand company’s requirement of financing, ability to pay interest, dividends or incur capital expenditure
4.	Statement of changes in shareholders’ equity	Displays the changes in equity of the company over a period of time	To analyse all the transactions between the company and its owners / shareholders / investors

The tools that you have learned for analyzing financial statements.

Some of the commonly used techniques of financial statement analysis:
1.   Ratio Analysis (most Important)

Ratio analysis is used to describe relationships between different variables used in financial statements. It is extensively used to make comparison between different companies and between different time periods. Ratios can aid an analyst in judging a company's financial health, projecting earnings & free cash flow and evaluating activity and efficiency. There are certain limitations of ratios arising due to heterogeneity of a company’s operating activities, inconsistency in the results of ratio analysis, judgment required for interpretation and different accounting methods used by different companies.

Five categories of ratios dealt in this section are:

Sl. No.	Ratio Category	Indications
1.	Liquidity	Indicator of the ability to pay off liabilities in the short term as they come due. Examples: Current ratio, Quick ratio, Cash ratio.
2.	Leverage / Solvency	Indicator of the firm's cost structure (proportion of fixed vs variable costs) financial leverage and ability to meet its longer-term obligations. Examples: Degree of operating leverage, degree of financial leverage, debt-to-equity, debt-to-capital, debt-to-assets, interest coverage, and fixed charge coverage ratios.
3.	Activity / Efficiency	Indicator of how efficiently a company utilizes its various assets. Examples: inventory turnover, receivable turnover, asset turnover etc.
4.	Profitability	Indicator of how well the company generates operating profits and net profits from its sales. Examples: net, gross, and operating profit margins, pretax margin, return on assets, operating return on assets, return on total capital, return on total equity, and return on common equity.
5.	Market / Valuation	Sales per share, earnings per share, and price to cash flow per share are examples of ratios used in comparing the relative valuation of companies.

2.   Common Size Analysis

Common size statement analysis, as the name suggests, first converts the financial statement as a percentage of a selected parameter from the financial statement. The parameter should usually be the most important and largest item on the statement. Useful to make comparison against – Industry average, Competitors/Peers of varying size or Company’s own performance over years.

There are two types of common size statement analysis:
1.   Vertical common size statements analysis: Entire P&L statement is recast as %age of net sales. All the line items on P & L are divided by the value of net sales thus resulting into a common size statement where net sales is expressed as 100% and all other line items in the P&L are expressed as a %age of net sales. Similarly, the entire Balance Sheet is recast as a %age of total assets. Useful to understand the cost structure and compare it with the cost structure of peers or industry average. Companies from the same sector have more or less the same relationship with the key constituent while the same varies for companies operating in different sectors. Any significant variation in the cost structure should be checked further to identify the issues.
2.   Horizontal common size statement analysis: Such an analysis sets the base year value for each of the line item on the financial statements at 100% and then tracks their variation in subsequent years. All the subsequent year figures in a financial statement is expressed as a %age of base year figure. This method is used to compare the performance of the same company over a period of time. This method is also called variation analysis or trend analysis. Useful to determine revenue, cost, asset, liabilities and working capital trend over the months/quarters/years for the same company. Trend analysis helps in quickly identifying grey areas such as trend reversal in revenue, higher % increase in variable costs in comparison to % increase in sales. The base year should be carefully selected as a year with unusual performance can skew the whole trend analysis. To address this issue, companies can use average of 3 or more years as base year figures It becomes difficult to compare in case of companies with losses.

Other Methods: There are other methods of analysis as well such as:

• Regression Analysis
• Graphical Analysis: Line Graph; Stacked Graph