Evaluation of the Different Methods of Financial Statement Analysis - Research Paper Example

Critique financial ment analysis and suggest a new approach of the Introduction The scope of thisresearch paper is to critically analyze the process of financial statement analysis and to try and suggest a new method of doing the same. Financial statement analysis is the process that is used in reviewing and evaluating the company’s financial statements. The company’s financial statements include documents such as the balance sheet and profit and loss statement. By the process of analysis of financial statements of a company it is possible to gain an insight or understanding of the financial health of the company thereby facilitating the process of more effective decision making. The financial data of the company is recorded through the use of financial statements. The data becomes more effective when they are analyzed through the process of financial statement analysis. Financial statement analysis is a process that is used to evaluate the past, present and financial performance of the company in future as projected. Currently there are plethoras of methods that are used to analyze the financial statements. Some of the common methods of analysis of financial statements are horizontal analysis, vertical analysis and ratio analysis. In horizontal analysis the financial data of two or more years are compared both in the dollar and in the percentage form. In the vertical analysis each of the financial data that is present in the balance sheet is shows as the percentage of the total so that is easier to compare. Then there is the ration analysis which is used to calculate the statistical relationship between different data. Financial statement analysis has long been used by different investor in order to value the investment decisions. However, the wide scale use of financial statement analysis does not mean that they are full proof and do not have any limitations. In view of the fact that there exists several limitation is the methods that are used to analyze the financial statements, the following research paper does a critical analysis of the methods that are used to analyze the financial statements and suggest a new methods for doing the same. Research objective The statements which help in gaining access and understanding of the health of the company are the financial statements of the company. The financial statements of the company are published in the form of balance sheet, cash flow statement and profit and loss statements. The financial statements become more useful when they are analyzed through the process of financial statement analysis. Financial statement analysis gives an easy to understand picture of the financial statements of the company. Financial statement analysis is a valuable and important step to the analysis and management of portfolio and in selecting the profitable firms. However, there are several limitations to the financial statement analysis. The following research is an important direction to the critical analysis of the financial statement analysis methods and thereby suggesting a new method for doing the same. The research is useful in the fact that it provides valuable insight and direction into this type of research and may serve as a stepping stone to increase future prospects of research in this domain. Research Question The research question that the following research tries to address is a critique of the financial statement analysis and suggesting a new method. The research question is important as because it provides an important breakthrough into this domain and provides an important tool that can be used by the portfolio investors to base their investments on. Literature review Financial statement and the analysis of the financial statement is a powerful tool that is used to determine the strengths and weakness that exists with an enterprise. However, according to Peddina Mohana Rao there exist several limitations with the methods that are used to analyze the financial statements. In describing the limitations that exists with the financial statements Rao states that the limitations of the financial statement analysis are associated with the limitations that exist in the financial statements themselves. Rao also states that since there are limitations that are associated with the financial statements and hence financial statement analysis care should be taken when one tries to analyze financial statements by analyzing the various components of balance sheet and profit and loss statements. The various limitations that exist with financial statements analysis are: 1. Inflation: Inflation often has a very bad effect on the balance sheet of the company. Inflation also has an effect on the profits of the company. Since, inflation has an effect on the profits of the company; hence the financial statements of the company should be interpreted carefully. 2. Seasonal variations: There are several factors which may cause seasonal variations and cause distortion in the ratio analysis. There are several seasonal factors which can cause a misinterpretation of the ratios. Hence, while analyzing the ratios the seasonal factors should be taken into consideration. 3. Accounting standards: The accounting standards and the practices that the company follows can also have an effect on the financial rations of the company. According to Rao the financial statements of a company reflect the past performances of a company and are interim reports. Any error that lies in the financial statements is reflected in the financial statement analysis (Rao, 2011). Another fact also remains that is judging the future of a company solely based on the financial statement analysis may not be justified. According to authors led by Patrick H Sullivan the no. of companies whose value lies in the intangible assets is on the rise. These companies have little or no value associated with the tangible assets of the company. Thus in case of these companies the tradition method of valuations which is based on the accounting principles and where the value of the firm is a function of the assets of the firm undervalues such firms (Sullivan Jr. and Sullivan Sr, 2000). A major problem that exists with the current financial statements is the fact that they do not measure the value of the intellectual properties. In other words the methods of statement analysis are incapable of measuring the value of those firms whose main value lies in the intangibles or intellectual property. In the particular research paper the researchers led by Mr. Sullivan discusses the problem of valuing the companies whose main assets is intellectual property and suggests two methods which will be effective in the analysis. A common use of financial statements analysis has been in the field of prediction of future bankruptcy of the firm. However according to Tyler Shumway models that are based on single period and are used to predict bankruptcy are not that accurate. He finds that there are inconsistencies that exist with the single period models. He finds that as compared to the single period models the hazard models are more appropriate and are consistent in time (Shumway, 2001). He finds that most of the accounting ratios that have used in the previous models which have tried to predict bankruptcy are not that statistically significant. He also finds that there are other important things like market size, variability of idiosyncratic returns, returns from past stock performance etc. which are related to the prediction of bankruptcy. In his research paper, the researcher describes a model which is based on both ratios and other variables that are market driven to produce more accurate forecasts than other models. According to Beaver, Correia and McNichols the problems with the use of financial ratios to predict financial distress lies in the fact that the variables which are used in the model are only expected values and not the values which are directly observed. The problem that is associated with this approach is the fact that historical financial data is not an accurate predictor of the future net cash flows from operations that might occur (Beaver, Correia, and McNichols, 2011). Another fact that is to be noted is that the act of an organization defaulting on the loan obligations of the company or the act of going to bankruptcy on the part of the company is based on the consideration of multiple periods. That is to say that it is based on the consideration of the variability of the amount of net asset flows that the company will be able to generate over several periods is reflected in the prediction of bankruptcy. What happens when multi period is that default of the company can take place before the cash balance of the company equals zero. There are other limitations too that is inherent in the financial statements and are based on the nature of the conventions of GAAP. Some of these limitations are: 1. many of the items that are present in the financial statements are actual based on the historical costs which may not provide a true estimate of the future cash flows that are expected or of the current market prices. 2. The intangible assets are not reflected in the balance sheet of the company but are expensed in the year in which the expenditure takes place. The fact that these assets are omitted from the balance sheet has an effect on the effectiveness with which the ratios can predict financial distress. Financial statements additionally do not provide any direct measure of the volatility of past data and can be exposed to subjective error. According to Stickney, Roman, Schipper and Francis the financial analysts who use financial ratio analysis as the analysis techniques should be aware of the fact that the limitations which have an effect on the financial statements also have an effect on the financial statement analysis. They should be also aware of the fact that changes in one ratio have an effect on another ratio (Stickney, Weil, Schipper and Francis, 2009). When the analyst is comparing the size of ratios between two periods for a particular firm the analyst must be aware of and take a note on the environmental changes that might have occurred in the period. Similarly while comparing the ratios of a particular firm with that of other the differences that exists in between the firms should be taken into consideration. Methodology In a research there are two types of methods that are used. These are quantitative and qualitative analysis. For the analysis of the collected data there are two sources from which the data is normally collected. One is the primary sources of data collection and another is the collection of data from secondary sources. For the purpose of this particular research paper both the sources of data collection are used. In order to meet the objective of the research paper and conduct a critical analysis of the methods of analysis of financial statements that currently exists a literature review has been conducted. Through the literature review, the drawbacks that are associated with the current methods of financial statement analysis have been identified. The literature review has also helped in the development of a better model of analysis of financial statement in the form of pointing the direction. In the development of the analysis of the financial statement other sources which have provided important data are the reports by the investment firms and the reports by other research firms. Te reports by other investments firms and interviews that have been conducted with investment analysts pointed out the various factors that need to be incorporated into the ration analysis and other common methods of financial statement analysis in order to make them better and more efficient. The various suggestion that have been provided by the investment analysts along with the relevant guidelines from the literature have been used in the development of new model of financial statement analysis. Analysis and findings In analyzing and finding out the critical analysis of the methods of financial statement analyses that are in existence it is found that there are several drawbacks of the current methods of financial statement analysis. Some of the drawbacks that exist with the current methods of financial statement analysis are: 1. The financial statement analysis analyzes the financial position of the firm based on the finance side only. This method of the analysis of the financial statements does not focus on the non financial factors that might have an impact on the firm. For instance the current method of financial statements does not take into consideration the intangible assets of the firm. Another main drawback of this method is that the past financial data is used to predict the financial data of the future. However there are several factors, which might have an effect on the firm in the future and similarly have an effect on the financial data of the firm in the future. 2. Another problem that exists with the financial statement analysis is the problem of seasonal variability of the data and the variability of the data over the years. When the financial statement is analyzed over different months there may be factors such as seasonal variability in the sales of commodity that might have an effect on the financial statements and hence its analysis. When the financial data of different time periods is considered the effect of inflation as an important factor should be taken into consideration. 3. Normally in the case of financial statement analysis the financial ratios are compared with the industry average. However there exists a severe drawback with this method. This method does not give an insight into whether the business is following a growth model that is sustainable in the long run. 4. Another drawback that exists with the current methods of financial statement analysis is the fact that the ratio is depended to a lot of fact on the financial statement of the firms. This on one hand provides just a one sided view on the future sustainability of the firm. There are other factors too that should be taken into consideration in order to provide a more accurate picture. On the other hand, other drawbacks that exists are the fact that different accounting principles that are used by different firms have an effect on the financial statement and hence on the analysis of the financial statements. In designing a new model of financial statement analysis which is another objective of this research paper the factors that needs to be considered are those that helps in overcoming the limitations that exists with the current methods of analysis of the financial statement analysis. Any model that only focuses on the financial data of the company in order to perform the analysis is incomplete as it does not provide the true and accurate picture. In light of this fact, the new model of financial statement analysis should encompass factors that not only reflect on the financial data but other data too so that the analysis is more accurate. The new model should be tentatively termed as integrated model of financial statement analysis. The new model of financial statement analysis should be based on the similar lines as the models that calculate the probability of bankruptcy. The new model of the financial statement analysis should take into consideration the summation of several different variables. The different variables that should be taken into consideration are data on the marketing, financial ratios, data on sustainable growth of the firm etc. The new model will include the following variables. Financial ratios: The data of the financial ratios should be used as one of the variables of the new model. This is the most basic component of the model and is the base on which other variables should be added. Marketing data: The data that should be considered in the first place is the data on the marketing. The past data on financial data gives only a probabilistic estimate of the future financial data and future performance of the firm. However the future financial condition of the market demand is an important factor that needs to be considered. This is due to the fact that the variability of the sales data has a major effect on the financial statement of the firm and the financial position of the firm. The marketing data that needs to be considered are the competition that the firm has to face in the future, change in the demand of the product, change in the socio-economic trends and its effect on the demand of the product. This data of the marketing should be included along with the data on the financial ratios in order to make the data on the financial statement analysis more effective. Checking sustainability of growth: Instead of comparing the ratios of the particular firm with the industrial average the strategy that should be used is to compare the growth pattern of the ratios of the particular firm with that of another firm in the industry to check if the growth is sustainable. Investment in intellectual property: Now a day’s an important asset of the firm is the intellectual capital of the firm. However, one of the major drawbacks with the traditional financial statement analysis methods is the fact that it does not take into consideration the intellectual property of the firm. To overcome this limitation the integrated model of financial statement analysis will take into consideration the amount of capital investment that the firm will be making towards acquisition of intellectual capital. Conclusion In the above pages the research paper has focused on conducting a critical evaluation of the different methods of financial statement analysis. As a next step the research has focused on finding a new method to analyze the financial statement which overcomes the limitations of current models. In analyzing the current models that does analysis of the financial statements it is found that although the current methods of financial statement analysis is simple and easy to apply there are several drawbacks from which it suffers. The drawbacks are based on the fact that the financial statements in themselves are filled with certain lacunae and there are in turn reflected on the analysis of financial statements. In proposing the new model of financial statement analysis there are several factors that needs to be considered. The factors that need to be considered are marketing data, investment in the intellectual property, checking sustainability of growth and investment in intellectual property by the firm. References Beaver, W. H., Correia, M. and McNichols, M. (2011). Financial statement analysis and the prediction of financial distress.AD: Now Publishers Inc. Rao, P.M. (2011). Financial statement analysis and reporting. New Delhi: PHI Learning Pvt. Ltd Shumway, T. (2001). Forecasting bankruptcy more accurately: A simple hazard model*. The Journal of business, 74(1), pp. 101-124. Stickney, C., Weil, R., Schipper, K. and Francis, J. (2009). Financial accounting: an introduction to concepts, methods and uses. OH: Cengage Learning. Sullivan Jr, P. H., and Sullivan Sr, P. H. (2000). Valuing intangibles companies-An intellectual capital approach. Journal of intellectual capital, 1(4), pp. 328-340. Read More