HIH Insurance Limited - Strengths and Weaknesses of Financial Analysis - Case Study Example

HIH Name Institution Course Instructor Date HIH Critical Evaluation of the Strengths and weaknesses of Financial Analysis Table of Contents Critical Evaluation of the Strengths and weaknesses of Financial Analysis 2 Executive summary 2 Introduction to Financial Analysis 3 Brief Summary of HIH Insurance Limited 4 Strengths and limitations of financial analysis 5 Strengths 5 Limitations 7 Judgment in the preparation of financial statements 8 Conclusion 10 References 12 Executive summary This particular article seeks to address issues related to financial statement analysis which are considered very critical to the company’s performance. Through the review, strengths and limitations of analyzing financial statements are described. The article also takes an advisory role where the new CEO of a company has limited knowledge of accounting. Based on the strengths and limits of financial analysis, the new CEO is advised on how important or risky it is to rely solely on financial statements for decision making. HIH Insurance Limited is used as a case study to illustrate the other side of financial analysis and decisions that result from them. Introduction to Financial Analysis Financial analysis is also referred to as financial statement analysis. It is the detailed process of closely scrutinizing the company’s financial statements in order to help the top managers in the decision making process (Sinha, 2012, p. 8). This process has great significance in the company because they allow the managers to determine how well the company is operating. The operating value that can be extracted from how strong or how weak the company is are factors such as the trends and affiliations, the superiority of the company’s earnings and finally the stability of its financial positions. Using common business language, financial analysis is used to determine the company’s health. The statements that are usually reviewed in the process include the balance sheet, cash flow statements, statements of income and finally the retained earnings statements. Results obtained from the analysis are usually important in the decision making process whereby several stakeholders evaluate how well the company is doing. Apart from decision making, the results obtained can also be utilized for quantitative analysis. This article therefore seeks to assume the advisory role of informing a newly elected CEO who has limited knowledge in accounting. The advice directed to the CEO will be based on a close scrutiny of the strengths and limitations of analyzing financial statements and its implications on the future of the company. Issues related to the judgment in preparation of the financial statements will also be highlighted in the discussion. As all these issues are being discussed in this advisory article, a case study involving HIH Insurance Limited will be used to shed more light on the dangers financial statement analysis may do to a potential company. The theoretical construct of this report will be illustrated using a real world example using HIH. Brief Summary of HIH Insurance Limited HIH insurance was formed by Ray Williams and Michael Payne in 1968 (Mirshekary, Yaftian & Cross, 2005, p. 250). The original name of the organization was M W Payne Underwriting Agency Pty Limited. Mr. Williams served as the CEO of the newly formed company that was fast rising in the business of writing compensation insurance for workers at the Victorian market. In 1971, the company was bought by a British Insurer, CE Heath plc. In 1992, the company first traded shares on the stock exchange market and adopted the initials HIH on its official name. In 1995, the Company acquired CIC Insurance group. A subsidiary called CIC Holdings Limited bought and increased their shares to 50% where they sold them to Winterthur Swiss Insurance Company (Mirshekary, Yaftian & Cross, 2005, p. 250). The investment made by the Swiss insurance company fastened the growth of HIH. They were able to acquire more insurance companies in Australia and internationally. The company was at its peak when its downfall occurred. Nine months before the collapse of HIH, the company was ranked as the second largest insurance company in Australia. The fact that it collapsed is not as important as the role of auditors in the saga that shocked the whole of Australia. The question of credibility of auditors has been asked time and again. Arthur Anderson was the long time auditing company that rented its services to HIH. They played a role of not being able to disseminate the correct information to the public. The rise and fall of HIH highly depended on auditors who were task to review and analyze the company’s financial statements. Strengths and limitations of financial analysis A coin always has two sides and so is the financial analysis to an organization. Analysis of financial statements has its own benefits to the company while at the same time; it may be of no help to the company if the information is misused or mutilated (Fridson & Alvarez, 2011, p. 184). Strengths Financial statements are used to pass relevant information that is useful in the financial decisions that are made by the company. The first significance of statement analysis is to determine the correct financial standing of the company. Data received from the analysis of financial statements enables the company to inform their stakeholders how the management makes use of its resources and whether they do it in an acceptable manner (Stickney, Weil, Schipper & Francis, 2009, p. 7). The government may also use the information from the analysis to determine legality of the fiscal decisions made by the company. The government can also monitor whether the acceptable accounting procedures are being used by the company in question. Financial statements from a particular company can be used by government revenue services to determine the correct taxation for the corporation. Financial analysis is very significant in determining the liquidity ratio. Liquidity ratio determines the amount of money the company should be able to use in a single day and accomplish fully the already set objectives (Jane, n.d, p. 1). Analysis of the statements ensures that the amount allocated is enough to meet the company’s obligations. Without the analysis, most companies will not be able to operate on their full capacity and some projects will lag behind. Calculating the assets that can easily be turned into liquid cash is also one of the benefits that can arise from this particular analysis. Another advantage is determining what amount is on the shareholders account and what amount is on the creditors’ side. With that particular analysis it is easy to determine whether the creditors or shareholders own the company. The probability of creditors support the company highly depends on the financial statement analysis. A company that is financially healthy will attract more creditors because of their high indications of paying them back. Other ratios covered in the analysis of financial statements include activity ratio, leverage ratio and profitability ratio. Activity ratio from financial statement analysis determines how fast the company accomplishes its activities (Sinha, 2012, p. 13). A good illustration is the ability of the company to generate income from certain fixed assets or the ability of the organization to pay its suppliers. Leverage ratio account for matters such as how far the company is willing to fund a certain project with a debt. The ability of the company to pay its debts does strongly fall under this category. Profitability ratios are very significant in determining the time that the company is able to break even. Net profit is calculated under this ratio by considering all profits and expenses incurred by the company. The mandate of confirming the company’s financial statements to the public belongs to the auditors. The company may hire its own accountants but it takes the work of external auditors to certify the position of the company financially (Gitman, Juchau & Flanagan, 2010, p. 49). It is justified to say that the time HIH was at the top of its game, everything was good with the auditing department. The company was able to make a number of investments acquiring multiple numbers of insurance corporations from different countries. The fact that the company was diving into a new market was the risk they were willing to take. The financial statements indicated that they were viable to make such investments. The fact that nobody knew the company will crumble down a few years after the tremendous investments indicates the limits of financial statement analysis. Limitations Both good and bad things have their own limits. Financial statement analysis is not an exception. A number of limitations have been identified from financial statement analysis. One of the significant factors is that they are not able to predict the future (Jane, n.d, p. 1). The fact that a company sold a million copies of books in the previous year does mean the same will be replicated in the following year. However, financial statement analysis can provide need for holding further investigations. This is in a scenario that the company’s revenues are constantly decreasing. The figures obtained through this analysis only reflect the past. What happened at HIH was unpredictable. Nine months before the event, no one, even the financial statement analysis could not have predicted the event. However, on the positive side, the analysis was used to indicate the loopholes that were used to embezzle the company’s funds. Another limitation is the rules and methods that accountants use to calculate their final values and ratios. Accountants use different methods to get their values (Fridson & Alvarez, 2011, p. 184). This implicates that the result obtained by different methods will not be the same. Some figures may be misleading and injure the financial health of the company. Auditors may also not give exact figures of the analysis due to pressure from the top management. Reports indicate that HIH management colluded with their auditors to give wrong values to the public. HIH had already miscalculated their investment capital and needed to have the faith of the public indicating that the company was still good financially. The collapse was shocking simply because the external world did not know that the company was suffering from inside (Sexton, 2001, p.62). Another possible limitation of the analysis is the fact that the analysis cannot consider factors like the market, laws and regulation, changing trends in technology. Generally, financial statement analysis does not factor in other areas of critical analysis. HIH was less experienced in the international market. They made their full investments without realizing the changes that were occurring to the international market. Such small changes such as the currency stability usually have a larger effect to such large multinationals (Mardjono, 2005, p. 272). The analysis could not have provided for the fluctuations in the market and the fact that technology is ever changing increases operating costs. Based on this provided limitations, decision making becomes a hard task to the managers. Judgment in the preparation of financial statements Preparation of financial statements is usually a job for the experts. To a manager who is handling a company and he/she has limited accounting knowledge, makes the situation tricky. Preparation of financial statements highly depends on every financial detail that is related to the company. Any figure missing would totally yield other different results that may put the company in jeopardy. The first thing to do as the new CEO is to hire the services of most reputable auditors. Auditors are hired to act in the best interest of every stakeholder that is directly linked to the company. They are able to analyze all the financial statements of the company and record how the company is performing (Gibson, 2010, p. 47). The procedure of preparing financial statements should work as per the guidelines of the certified public accountants in their respective countries. The rules are very important since the government investigates the procedures used to arrive to the final ratio. The involvement of the government is to ensure that they are able to set the correct value that they can tax the company. Accounting solutions for normal operations in the company require company accountants to accomplish them. Private auditors should only concentrate on more public matters that are in the best interest of creditors and shareholders. HIH Insurance Limited failed on that particular instance. They hired an auditing company, Arthur Anderson to assess their financial statements. The only mistake the company did was to allow an external auditing firm to handle their private matters. The fact that Arthur Anderson was involved in the internal services of HIH, there was no way they were going to scrutinize themselves perfectly (Westfield, 2003, p. 25). The result was what happened nine months after HIH was announced to be the second largest insurance company on assets in Australia. Professional conduct was not followed and from a moral point of view, it is unethical to conspire and steal from the same investors that support the company. After a close review of the events that took place at HIH, it is important for the new manager to understand the intensity of these financial reviews. Significant decisions are made using the ratios obtained from the analysis. For instance, the Australian Accounting Standards oblige managers to consider the analysis and determine whether the company will be able to pay off its debt over the next 12 months. To be sure of this, the manager has to make use of both internal and external auditors to make sure accurate ratios are deduced. Wrong ratios could put the company’s ability to pay debts in jeopardy. External auditors should be able to work independent to avoid the scenario that happened at HIH (Mirshekary, Yaftian & Cross, 2005, p. 252). The strengths of financial statement analysis are the ability to record how the company is performing currently and their ability to make investments (Stickney, Weil, Schipper & Francis, 2009, p. 26). As a new CEO, one should be able to analyze these ratios critically for a span of five years down the line. Given the fact that the analysis does little in predicting the future and does not factor in potentially significant external factors, a new manager should not rely solely on the analysis to make big investments. HIH Limited based only on financial statement analysis to make their investments. The company did not factor external factors such market stability and the exchange ratios. What happened is that they used a lot of money in the investments leaving the company with a larger financial gap to fill and increased limited liabilities (Mardjono, 2005, p. 272). For the new CEO, it is significant to consider all these factors in order to make correct judgments/decisions. Financial statements have numerous strengths to the company. Releasing of the results by Independent auditors usually has great implications to the investment community, lenders, customers and even employees. There are also limits which is why it is advisable for the CEO not to make decisions basing only on the financial statements. Conclusion This article acts as an enlightenment report to the new CEO of the company who has limited knowledge in accounting. In this article, the strengths and limits of financial statement analysis are discussed. HIH as provided in the case study is used for possible illustrations. The new CEO has to understand first the limits and strengths of the analysis before reaching to his/her final conclusions. As illustrated by HIH, high dependence on financial statement analysis can be dangerous. The new CEO should also be able to understand how the general process of financial analysis occurs and rules as required by the law. Financial statement analysis is very significant in determining the financial health of the company but its limits are very significant to CEO during decision making. References Fridson, M & Alvarez, F 2011, Financial Statement Analysis Workbook a Practitioner's Guide, 4th ed, John Wiley & Sons, Hoboken. Gibson, C 2010, Financial reporting and analysis: Using financial accounting information, Cengage Learning, Mason, OH. Gitman, LJ, Juchau, R & Flanagan, J 2010, Principles of managerial finance, 6th ed, Australia, Pearson Higher Education. Jane, M n.d, Advantages of a Financial Statement Analysis, viewed February 25, 2015, . Mardjono, A 2005, ‘A tale of corporate governance: lessons why firms fail’ Managerial Auditing Jornal, vol. 20, no. 3, pp272-273. Mirshekary, S, Yaftian, AM & Cross, D 2005, ‘Australian corporate collapse: The case of HIH Insurance,’ Journal of Financial Services Marketing, vol. 9, no. 3, pp. 249-258. Sexton, T 2001, ‘Corporate Collapse,’ Australian CPA, December, pp. 58-63. Sinha, G 2012, Financial Statement analysis, 2ed, PHI Learning Private Limited, New Delhi. Stickney, C, Weil, R, Schipper, K & Francis, J 2009, Financial accounting: an introduction to concepts, methods and uses, Cengage Learning, Mason, OH. Westfield, M 2003, ‘Why did HIH Collapse?’ CA Charter, vol. 74, no. 3, pp. 24-29. Read More