An Insight into Financial Statements and Management - Case Study Example

Please put here Please put your here of the 11th August, 2008 Ratio analysis - A perspective Introduction A financial statement is a compilation of data, which is logically and consistently organized according to accounting principles. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show a position at a moment in time, as in the case of a balance sheet, or may reveal a series of activities over a given period of time, as in the case of an income statement. Financial statements are the major means through which firms present their financial situation to stockholders, creditors, and the general public. The majority of firms include extensive financial statements in their annual reports, which receive wide distribution. The Nature of Financial Statement Analysis Financial statement analysis consists of the application of analytical tools and techniques to the data in financial statements in order to derive from them measurements and relationships that are significant and useful for decision making (ICFAI Center for Management Research ICMR). The process of financial analysis can be described in various ways, depending on the objectives to be obtained. Financial analysis can be used as a preliminary screening tool of future financial conditions and results. It may be used as a forecasting tool of future financial conditions and results. It may be used as a process of evaluation and diagnosis of managerial, operating, or other problem areas. Above all, financial analysis reduces reliance on intuition, guesses and thus narrows the areas of uncertainty that is present in all decision making processes. Financial analysis does not lessen the need for judgment but rather establishes a sound and systematic basis for its rational application. The Principle Tools of analysis In the analysis of financial statements, the analyst has a variety of tools available from which he can choose those best suited to his specific purpose. The following are the important tools of analysis. 1. Ratio Analysis - Comparative analysis - Du-Pont analysis 2. Funds flow Analysis Ratio Analysis Ratios are well known and the most widely used tools of financial analysis. A ratio gives the mathematical relationship between one variable and another. The analysis of ratios can disclose relationships as well as bases of comparison that reveal conditions and trends that cannot be detected by going through the individual components of the ratio. The usefulness of ratios is ultimately dependant on their intelligent and skillful interpretation. Ratios are used by different people for various purposes. As ratio analysis mainly helps in valuing the firm in quantitative terms, two groups of people are interested in the valuation of the firm and they are creditors and shareholders (Blackwell publishing). Creditors are again divided into short-term creditors and long-term creditors. Short-term creditors hold obligations that will soon mature and they are concerned with the firm's ability to pay its bills promptly. In the short run, the amount of liquid assets determines the ability clear off current liabilities. These persons are interested in liquidity. Long-term creditors hold bonds or mortgages against the firm and are interested in current payments of interest and eventual repayment of principal. The firm must be sufficiently liquid in the short-term and have adequate profits for the long-term. These persons examine both the liquidity and profitability of the firm (ICFAI Center for Management Research ICMR). Ratio Analysis - A strategic tool Insight into the financial situation of a company will quickly place its condition in perspective. The critical areas in any profit or non-profit organization can be summed up as follows: Scanning and using funds Planning for securing and using funds Controlling expenditure Reporting all transactions and results to appropriate parties Facts can be gathered and tentative conclusions can be drawn in the initial scanning of operations. Later, analyzing can provide information and understanding considerable depth. A ratio analysis measures how a company is doing in comparison with past years and its competitors in the industry. The financial statements of a firm offer abundant information about the present position and also reveal the results of operations over time. The details of cash, receivables, inventories and corresponding liabilities are provided by the balance sheet. The job of the internal analyst is to make "make the figures talk." Suitable explanations and notes have to be given at the end of every financial statement so that the reader can get an idea of it in an instant. However, a common tendency is to state the conclusions rather than facts when analyzing financial statements. The response of the internal analyst to information from the financial statements should be factual and substantially quantitative. For example, an analyst after calculating ratios concludes that the company has too much debt and is heavily leveraged. But the study of the company's return on equity indicates that excellent financial practices are being employed (ICFAI Center for Management Research). The balance sheet and income statements then provide factual information within the limitations of accounting principles. Thus, inferences and conclusions are better made after considering other information in addition to the statements. Ratio analysis from the perspective of a financial analyst Ratio analysis is a popular tool among financial analysts. This mainly attributable to the simplicity in calculation and indication of the direction in which further probing is necessary. With respect to this argument, some of the important ratios that can be used for gauging the efficiency of working capital management are discussed in detail in forthcoming paragraphs. In addition to liquidity and profitability, the owners of the firm i.e. the shareholders are concerned about the policies of the firm that affect the market price of the firm's stock. Without liquidity, the firm cannot pay cash dividends. Without profits, the firm would not be able to declare dividends. With poor policies, the common stock would trade at low prices in the market. Keeping in view the above discussions regarding the category of users, financial ratios fall into three groups as follows: Liquidity ratios Profitability or efficiency ratios Ownership ratios Earnings ratios Dividend ratios Leverage ratios Capital Structure ratios Coverage ratios All the above mentioned categories of ratios are discussed in detail as under. Liquidity Ratios Liquidity implies a firm's ability to pay its debts in the short run. This ability can be measured by the use of liquidity ratios. Short-term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital i.e. excess of current assets over current liabilities, then the firm is assumed to have enough liquidity. The current ratio and the quick ratio are the two ratios, which are commonly used to measure liquidity directly. The ratios like receivable turnover ratios and inventory turnover ratios measure the liquidity of the firm indirectly ((ICMR)). Liquidity or solvency ratios are used as measures of the company's ability to finance its short-term obligations by its cash and near cash items. Included in these ratios are current, acid test or otherwise known as the "quick ratio", and cash ratios. Current ratio expresses the "working capital' relationship of current assets available to meet the company's current obligations. Cash ratio is an indicator of the extent to which a company can pay current liabilities without relying on the sale of inventory and without relying on the receipts of the accounts receivables (al.., 2000). Higher ratios indicate more liquidity. The table given below shows the different formulae used in the computation of the aforementioned liquidity ratios ((ICMR)). Computation of Liquidity Ratios Turnover Ratios As already mentioned above, receivables turnover ratios and inventory turnover ratios measure the liquidity of a firm in an indirect way. Here the measure of liquidity is concerned with the speed with which inventory is converted into sales and accounts receivables converted into cash. The turnover ratios give the speed of conversion of current assets (liquidity) into cash in the above way. Two different ratios are used to measure the liquidity of a firm's account receivables. They are: a. Accounts receivable turnover ratio b. Average collection period The following table shows the different formulae used in the computation of the aforementioned turnover ratios. Computation of Turnover Ratios Ratios Computation Accounts receivable turnover ratio Net credit sales Average accounts receivable Average collection period 360 Average accounts receivable turnover Profitability or Efficiency Ratios Profitability ratios are also called as the Efficiency ratios. As described above they measure the firm's activities and its ability to generate profits. Gross profit Margin: the gross profit margin ratio (GPM) is defined as follows: Gross Profit ------------- Net Sales Where net sales = Sales - Excise duty This ratio shows the profits relative to sales after the direct production costs are deducted. It may be used as an indicator of the efficiency of the production operation and the relation between production costs and selling price. Net profit Margin: This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing, and tax management. Net profit margin, on the other hand, is the ratio of net income to sales. Return on common equity (ROCE) is a variant of return on investment. The return on common equity assesses the rate of return on the investments of common stockholders in the company (Analyzing Company Reports 2005). Another ratio is the turnover ratio which shows to what the extent the company uses its assets to produce revenue. Logically, higher profitability ratios indicate a healthier financial condition. Computation of Profitability Ratios Financial Leverage Ratios Financial leverage ratios provide an indication of the long-term solvency of the firm. They indicate the extent of non-owner claims on the firm's profits as well as the firm's operating capability to meet its obligation. Gearing is the long-term debt to equity ratio which assesses the balance between liabilities and equity in the firm's long term resource structure. Another is the interest coverage ratio which measures the extent to which earnings cover the interest obligation of the company (Strickland, 2002). The table given below shows the different formulae used in the computation of the aforementioned financial leverage ratios. Computation of Financial Leverage Ratios Market value ratios/investor ratios: Investor ratios are financial ratios especially designed to covey to investors the asses the profitability of the company's stock as an investment. Earnings per share shows the return to common stock shareholder for each share owned. Shows the rate earned by shareholders from dividend relative to the stock price, while price to earnings ratio expresses the multiple that the market attributes to a common stock relative to its price (Ormiston, 2004) the following table shows the different formulae used in the computation of the aforementioned investor ratios. Computation of Investor Ratios From the Market Value Ratios, we can get information on earnings of the firm and their effect on price of common stock. PE Ratio: The price-earnings ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firm's stock (Morningstar). Ratio Analysis and Information Technology Now-a-days, many accounting packages are available to enable the implementation of forecasting of future conditions of a company, ratio analysis and financial budgeting. In such kind of systems, a company's portfolio is managed by collecting all information relating to investment and security trading. Both the present and the projected financial performance of a business can be evaluated by using electronic spreadsheets and other financial planning software. Conclusion Financial data can provide insight into the future when analyzed properly in a strategic context. Regardless of the type of institution, the finance function must be examined in order to gain some insight into its health. It also reveals whether revenues have been increasing profitability. A ratio analysis identifies the financial sources of the firm and how well they have been and are being utilized. All this is important when considering the appropriateness and implementation of past, present and future strategies. Bibliography (ICMR), ICFAI Center for Management Research. Financial Management for Managers. Hyderabad: ICFAI Center for Management Research , 2003. Blackwell publishing. "Financial Managment - An Insight." Journal of International financial Management (2003): 23-26. ICFAI Center for Management Research ICMR. Financial Accounting & Financial Statement Analysis. Hyderabad: ICFAI Center for Management Research, 2004. Read More