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Financial Statement Analysis

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Financial Statement Analysis-FIN621
VU
Lesson-24
ANNUAL REPORT GENERATED BY BUSINESS
(Continued)
Five-Year Summary:
This is also a very important part of Annual Report prepared by the management of a corporation. It
offers quick look at some overall trends, and it includes net sales or operating revenues, income/loss
from continuing operations, total assets, long-term obligations and cash dividend per common share.
Management Discussion & Analyses (MD&A)
This last part of the Annual Report is also labeled as' Financial Review'. It contains
information that cannot be found in the financial data e.g. internal/external sources of liquidity, any
material deficiencies in liquidity and suggested remedial measures, commitments for capital expenditure
and sources of funding, and anticipated changes in the mix and cost of financing resources.
MD&A records events causing material changes in cost/revenue relationships e.g. future
price increase. It also gives breakdown of sales increases in price and volume components, and also
gives explanation about why changes have occurred in profitability and liquidity.
Quality of Financial Reporting
Ideally, financial statements should reflect an accurate picture of the financial position
and performance of a business, and should convey information useful to assess the past and predict the
future. However discretion/potential exists within GAAP to "manipulate/window-dress" the financial
statements.
Opportunities for management to affect the quality of financial statements are available in
the form of Accounting Policies, Estimates i.e. choices, (of Accounting Policies) and changes (of
Accounting Policies and Estimates). There is also opportunity to Management for timing of Revenues
and Expenses. Since Matching process requires matching revenues and expenses of a particular
accounting period, it gives the management, discretion regarding timing of expenses. For example,
management  may  postpone  expenditures  for  many  items  like  Advertisement/marketing,
Repairs/Maintenance, and Research & Development and Capital expansion; in order to
"window-
dress" its financial statements.
Limitations of Financial Statements.
Financial Statements  assume constant real-value of money. It should be noted that net
income is not absolutely accurate and precise, since assumptions, estimations & approximations are
involved as regards estimated useful life of plant assets, their residual value etc. Events not measurable
objectively are not reflected in Income Statement. Also the Financial Statements give no "valuation" as
such of the enterprise because assets are valued on "going-concern assumption", and the fixed assets are
valued at Book Value which may be more or less than realizable market value.
Financial Statements have the limitation that assessment of future profitability is not
possible by reading these. Future profitability depends on a number of factors e.g. quality of products,
activities of competitors, general economic situation etc., a picture of which cannot emerge from
financial statements.
Financial Statements thus give limited picture of an enterprise in monetary terms, without
taking into account outside non-monetary factors.
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Financial Statement Analysis-FIN621
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One other limitation of Financial Statements is that information is not available in
financial statements about employees' relations with management, morale/efficiency of employees,
reputation/public perception of the enterprise, effectiveness of management team and potential exposure
to regulatory changes. These impact operational results but are difficult to quantify from Financial
Statements.
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.
Financial accounting deals with the preparation of financial statements, namely, Income statement,
Statement of changes in owner's equity, Balance sheet and Statement of Cash flows.
These financial statements enable users of accounting information to make informed decisions about a
company's performance. In order to make decisions, the information presented must be
Relevant (useful for the purpose of decision making)
Reliable (verifiable)
However, some people argue that due to the rules that accountants use, financial statements are not as
useful as they could be.
Limitations of Financial Statements.
Limitation # 1
Assets on the balance sheet are always shown at the original purchase price (historical cost) even
though the current value may be different.
Example: XYZ Company started their business five years ago and at that time; they purchased some
land for Rs. 200,000. Today, the same land is worth Rs. 500,000. However, the land will be shown on
the balance sheet at Rs. 200,000.
Implication: The value of the land is not realistic.
Limitation # 2
Some figures on the financial statements are based on subjective estimates and assumptions.
Management could possibly change net income by changing these estimates.
Depreciation is one example where estimates and assumptions are used.
Definition of Depreciation
Depreciation is the loss in value of assets as the assets are used to generate revenue. Depreciation is an
expense.
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Financial Statement Analysis-FIN621
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Example: XYZ Company is in the business of manufacturing 'ball-point' pens. It needs a special
machine to make these pens. This machine is used continuously for 20 hours everyday.
The cost of this machine is Rs. 100,000. It is expected to last for 5 years after which it needs to be
replaced.
The machine will lose value each year as it is used to produce pens. These pens are sold to generate
revenue for the company.
Therefore, this loss in value or depreciation is considered to be an expense of the business.
Different depreciation methods
Calculation of depreciation is an estimate. There are many methods used to calculate depreciation.
Two most common examples are:
Straight line method
Declining/Reducing balance method
Straight line depreciation method.
In this method, the "amount of depreciation" (loss in value) is the same every year.
The reasoning behind this is that the firm gets equal benefits over the useful life of the asset.
How to calculate?
Depreciation=Original cost - salvage value
Number of years of useful life
Salvage value is the amount of money that you would receive if you sold the asset at the end of its
useful life. The useful life is the length of time that you expect to use the asset.
Both the salvage value and the number of years of useful life are estimates.
Example:
A firm has purchased a machine for Rs.100, 000. It is expected to last for 5 years. At the end of its life,
it has zero salvage value.
Rs.100, 000 ­ Rs.0
Depreciation = --------------- = Rs. 20,000
Therefore, each year the firm shows depreciation ( loss in value) of this machine as Rs. 20,000 .
Implications:
1. Different depreciation methods and estimates will give different net income figures.
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Financial Statement Analysis-FIN621
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2. The value of assets shown in the balance sheet will also differ depending on the depreciation
method and the estimates used.
Limitation # 3
There are certain other items which are not reported in the balance sheet even though the firm may
consider them to be of considerable value.
Examples
Image/reputation of the firm
The value of its human resources (people)
Summary
Financial statements have always been prepared with the emphasis of being
Relevant & reliable to the various users of accounting information.
In spite of trying to be relevant and reliable, there are certain limitations:
1. Historical accounting methods have a tendency to undervalue the assets of the firm.
2. Different depreciation methods and estimates will report different net income figures in the income
statement and different value of assets in the balance sheet.
3. There are certain assets which are not reported in the balance sheet such as the image / reputation of
the firm or the value of a firm's human resources causing the value of the company to appear to be
lower than it actually is.
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