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Lesson-
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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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
- 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, (90% decline) (900% increase)
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