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Financial Statement Analysis

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Financial Statement Analysis-FIN621
VU
Lesson-31
FINANCIAL STATEMENT ANALYSIS
Analysis of income statement and balance sheet:
Financial Statements are like the Instrument panels of a business. There are different needs of different
users of these statements. Users can be outside users and internal users. Identity of user is important, so
as to provide him/her with relevant information.
Financial statement analysis is the process of examining relationships among financial statement
elements and making comparisons with relevant information. It is a valuable tool used by investors and
creditors, financial analysts, and others in their decision-making processes related to stocks, bonds, and
other financial instruments. The goal in analyzing financial statements is to assess past performance and
current financial position and to make predictions about the future performance of a company. Investors
who buy stock are primarily interested in a company's profitability and their prospects for earning a
return on their investment by receiving dividends and/or increasing the market value of their stock
holdings. Creditors and investors who buy debt securities, such as bonds, are more interested in liquidity
and solvency: the company's short-and long-run ability to pay its debts. Financial analysts, who
frequently specialize in following certain industries, routinely assess the profitability, liquidity, and
solvency of companies in order to make recommendations about the purchase or sale of securities, such
as stocks and bonds.
Analysts can obtain useful information by comparing a company's most recent financial statements with
its results in previous years and with the results of other companies in the same industry. Three primary
types of financial statement analysis are commonly known as horizontal analysis, vertical analysis, and
ratio analysis.
Fundamental Analysis
Fundamental analysis at company level involves analyzing basic financial variables in order to estimate
intrinsic value. These variables include sales, profit margins, depreciation, the tax rate, sources of
financing, asset utilization, and other factors. Additional analysis could involve the firm's competitive
position in its industry, labor relations, technological changes, management, foreign competition, and so
on. The end result of fundamental analysis at the company level is an estimate of the two factors that
determine a security's value: cash flow stream and a required rate of return (alternatively, a P/E ratio)
Industry analysis
Industries as well as the market and companies, are analyzed through the study of a wide range of data,
including sales, earnings, dividends, capital structure, product lines, regulations, innovations, and so on.
Such analysis requires considerable expertise and is usually performed by industry analysts employed
by brokerage firms and other institutional investors.
A useful first step is to analyze industries in terms of their stage in the life cycle. The idea is to assess
the industry's general health and current position. A second step is to assess the position of the industry
in relation to the business cycle and macro economic conditions. A third step involves qualitative
analysis of industry characteristics designed to assist investors in assessing the industry's future
prospects.
Uses and limitations of financial analysis
Ratio analysis is used by three main groups: (1) managers, who employ ratios to help analyze, control,
and thus improve their firms' operations; (2) credit analyst, including bank loan officers and bond rating
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analysts, who analyze ratios to help ascertain a company's ability to pay its debts; and (3) stock analyst,
who are interested in a company's efficiency, risk, and growth prospects.
Many large firms operate different divisions in different industries, and for such companies it is
difficult to develop a meaningful set of industry averages. Therefore, ratio analysis is more
useful for small, narrowly focused firms than for large, multidivisional ones.
Most firms want to be better than average, so merely attaining average performance is not
necessarily good. As a target for high-level performance, it is best to focus on the industry
leaders' ratios. Benchmarking helps in this regard.
Inflation may have badly distorted firms' balance sheet- recorded values are often substantially
different from "true" values. Further, because inflation affects both depreciation charges and
inventory costs, profits are also affected. Thus, a ratio analysis for one firm over time, or a
comparative analysis of firms of different ages, must be interpreted with judgment.
Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a
food processor will be radically different if the balance sheet figure used for inventory is the one
just before versus just after the close of the canning season. This problem can be minimized by
using monthly averages for inventory (and receivables) when calculating turnover ratios.
Firms can employ "window dressing" techniques to make their financial statements look
stronger.
Different accounting practices can distort comparisons. As noted earlier, inventory valuation
and depreciation methods can affect financial statements and thus distort comparisons among
firms. Also, if one firm leases a substantial amount of its productive equipment, its assets may
appear low relative to sales because leased assets often do not appear on the balance sheet, at
the same time, the liability associated with the lease obligation may not be shown as a debt.
Therefore leasing can artificially improve both the turnover and the debt ratios. However
accounting professional has taken steps to reduce this problem.
It is difficult to generalize about whether a particular ratio is "good" or "bad". For example, a
high current ratio may indicate a strong liquidity position, which is good or excessive cash,
which is bad (because excess cash in the bank is a non-earning asset). Similarly, a high fixed
assets turnover ratio may denote either that a firm uses its assets efficiently or that is
undercapitalized and can not afford to buy enough assets.
A firm may have some ratios that look "good" and others that look "bad," making it difficult to
tell whether the company is, on balance, stronger or weak. However statistical procedures can
be used to analyze the net effects of a set of ratios. Many banks and other lending organizations
use discriminant analysis, a statistical technique, to analyze firms' financial ratios, and then
classify the firms according to their probability of getting into financial trouble.
Accounting Information
Different Accounting Policies
The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows
valuation of assets to be based on either revalued amount or at depreciated historical cost. The business
may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will
result in lower profit.
Creative accounting
The businesses apply creative accounting in trying to show the better financial performance or position
which can be misleading to the users of financial accounting. Like the IAS 16 mentioned above,
requires that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense
in income statement, but if it results in revaluation surplus the surplus should be credited to revaluation
reserve. So in order to improve on its profitability level the company may select in its revaluation
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programme to revalue only those assets which will result in revaluation surplus leaving those with
revaluation deficits still at depreciated historical cost.
Information problems
Ratios are not definitive measures
Ratios need to be interpreted carefully. They can provide clues to the company's performance or
financial situation. But on their own, they cannot show whether
Performance is good or bad.
Ratios require some quantitative information for an informed analysis to be made.
Outdated information in financial statement
The figures in a set of accounts are likely to be at least several months out of date, and so might not give
a proper indication of the company's current financial position.
Historical costs not suitable for decision making
IASB Conceptual framework recommends businesses to use historical cost of accounting. Where
historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios
based on this information will not be very useful for decision making.
Financial statements certain summarized information
Ratios are based on financial statements which are summaries of the accounting records. Through the
summarization some important information may be left out which could have been of relevance to the
users of accounts. The ratios are based on the summarized year end information which may not be a true
reflection of the overall year's results.
Interpretation of the ratio
It is difficult to generalize about whether a particular ratio is `good' or `bad'. For example a high current
ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly
Non current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is
under capitalized and cannot afford to buy enough assets.
Comparison of performance over time
Price changes
Inflation renders comparisons of results over time misleading as financial figures will not be within the
same levels of purchasing power. Changes in results over time may show as if the enterprise has
improved its performance and position when in fact after adjusting for inflationary changes it will show
the different picture.
Technology changes
When comparing performance over time, there is need to consider the changes in technology. The
movement in performance should be in line with the changes in technology. For ratios to be more
meaningful the enterprise should compare its results with another of the same level of technology as this
will be a good basis measurement of efficiency.
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Changes in Accounting policy
Changes in accounting policy may affect the comparison of results between different accounting years
as misleading. The problem with this situation is that the directors may be able to manipulate the results
through the changes in accounting policy. This would be done to avoid the effects of an old accounting
policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the
business's profits are low.
Changes in Accounting standard
Accounting standards offers standard ways of recognizing, measuring and presenting financial
transactions. Any change in standards will affect the reporting of an enterprise and its comparison of
results over a number of years.
Impact of seasons on trading
As stated above, the financial statements are based on year end results which may not be true reflection
of results year round. Businesses which are affected by seasons can choose the best time to produce
financial statements so as to show better results. For example, a tobacco growing company will be able
to show good results if accounts are produced in the selling season. This time the business will have
good inventory levels, receivables and bank balances will be at its highest. While as in planting seasons
the company will have a lot of liabilities through the purchase of farm inputs, low cash balances and
even nil receivables.
Inter-firm comparison
Different financial and business risk profile
No two companies are the same, even when they are competitors in the same industry or market. Using
ratios to compare one company with another could provide misleading information. Businesses may be
within the same industry but having different financial and business risk. One company may be able to
obtain bank loans at reduced rates and may show high gearing levels while as another may not be
successful in obtaining cheap rates and it may show that it is operating at low gearing level. To un
informed analyst he may feel like company two is better when in fact its low gearing level is because it
can not be able to secure further funding.
Different capital structures and size
Companies may have different capital structures and to make comparison of performance when one is
all equity financed and another is a geared company it may not be a good analysis.
Impact of Government influence
Selective application of government incentives to various companies may also distort intercompany
comparison. One company may be given a tax holiday while the other within the same line of business
not, comparing the performance of these two enterprises may be misleading.
Window dressing
These are techniques applied by an entity in order to show a strong financial position. For example,
ABC Trucking can borrow on a two year basis, K10 Million on 28th December 2006, holding the
proceeds as cash, then pay off the loan ahead of time on 3rd January 2007. This can improve the current
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and quick ratios and make the 2006 balance sheet look good. However the improvement was strictly
window dressing as a week later the balance sheet is at its old position.
Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as
necessary. Ratios analysis conducted in a mechanical, unthinking manner is dangerous, but if used
intelligently and with good judgment, it can provide useful insights into the firm's operations.
Three broad areas of evaluating a business are its solvency, stability and profitability, which are studied
through analysis of financial statements. There are four techniques of Financial Statements Analysis.
ANALYSIS TECHNIQUES
1.
Rupee and percentage changes: figures of Financial Statements from one year to the next i.e.
year-to-year are considered.
Income Statement for the year ending June, 30
2001
2002
2003
Net sales
400
500
600
Cost of Good Sold.
235
300
370
Gross profit.
165
200
230
Other expenses.
115
160
194
Net income.
50
40
36
Percentage change cannot be computed for negative amount or zero amount in base
year. Mere figure of rising sales are not sufficient. We have to look at the volume of sales vis-à-vis sale
price. Quarterly or monthly measurement is also done. It compares results of current quarter or month
with those of the same quarter or month in the previous year in order to take care of distortion by
seasonal fluctuations. Size of base amount has to be reasonable (Example: 90% decline to be followed
by 900% increase just to get back to the starting point). Percentage become misleading when base is
small:
1st year
2nd year
3rd year
Income
100,000
10,000
100,000
(90% decline)
(900% increase)
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