Essentials of Financial Analysis - Example

Summary Financial statement analysis is essential to not only shareholders of a business, but also to possible investors. Accounting is regarded as a form of communicating this information to the relevant parties involved. This report will seek to highlight the issues faced by financial analysts when preparing the financial statements, the strengths and weaknesses of these statements and the mistakes one can possibly expect when dealing with these documents. Accounting ethics will also be highlighted, depicting how a professional should deal with financial statements and their analysis. Introduction Financial statements should satisfy the shareholders’ and managers’ information needs and thus need to be prepared in professionalism, ethically, by qualified accountants. Analysts are professionals hired by these said people, to decide if a company is worthy to invest in or not and to evaluate a company’s performance. Financial statements are documents that bring together reports about a company’s results, its performance, and its cash flows. The Accountingtools.com (2015) notes that these financial statements are important in the following ways: They determine the company’s ability to produce cash and how this cash can be used up by the company Financial statements are able to show if financial results are generated on a trend line when or if profitability issues come about Determine the debt payback of the company. Is the company able to pay its debts and if it is, is it in good time? Financial ratios derived from the statement can be able to give outline on the performance of the company itself A company is expected to disclose any accounting transactions and this enables us to investigate certain transactions that normally wouldn’t be paid much attention to. A company, if going to expose the financial statements to the public, say investors, should portray the contents in a given type of framework, such as the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). The main contents are: Balance sheet, which highlights the assets, liabilities and stockholders’ equity. Income statement, which highlights the company’s flow of operations and its financial activities. Cash flows’ statement, depicting the company’s cash flows Supplementary notes which gives additional information on some accounts Financial analysis is defined as the evaluation of the effectiveness by which funds of a firm are taken up or the efficiency and profitability of the company’s operations. (BusinessDictionary.com, 2015, para. 1). Financial analysis is of benefit mostly to investors who use it to determine whether to invest in a business or not and what price is fair for this. According to Nazir (2012), there are several categories of financial analysis based on the following. 1) On materiality basis a) External analysis Analysis carried out on the basis of information that has been made available to the public. b) Internal analysis Internal analysis is basically the opposite of the above. It is based on information that has not been let out to the public. It is mainly done on the management’s behalf and the information is mainly used in decision-making. 2) According to analysis objectives. a) Short Term Analysis Here liquidity is determined. Does the company have enough funds ready to meet its present needs and does it have enough borrowing capacity to meet its future plans? b) Long term Analysis A company must obtain a minimum amount of money enough to maintain a sufficient rate of return on the investment. Here, the stability and gearing potential of the company is analyzed, for example, fixed assets and long term debt structure. 3) According to mode of operation. a) Horizontal analysis Also known as trend analysis. Horizontal analysis, mathematically, shows changes in between years in both monetary form and percentage form. The analyst can focus on the major factors that have had an effect on the company’s financial position and profitability using the changes in monetary form, for example, if sales go up with $1 million for a certain year from the previous one then this increase can be negated by a $1.5 million increase in cost of goods sold; while changes in percentage form helps the analyst gain perspective on the significance changes taking place. For example, an increase of, say, $150,000 in sales is more significant if the previous year’s sales were $200,000 than if they were $500,000, that is 75% increase as compared to 30% increase in the latter. Horizontal analysis can also be done by calculation of what is known as a trend percentage. A trend percentage gives a number of years’ financial information using one of the years as a base. The base is equated to 100% and the other years are calculated as a percentage of this year. For example, if we have sales ranging from the year 1995 to year 2000, then we can use say the sales from year 1997 as the base year and calculate all the others as percentages of this year. Having these percentages helps the analyst better tell how speedily sales have been decreasing or increasing and whether net income has kept up with this increase or decrease, questions that would be rather difficult to answer by looking at raw data alone. An added advantage is gained if the data is tabulated. b) Vertical analysis Vertical analysis is the type of analysis that deals with common size statements. A common size statement is usually defined as a statement that shows values on it in percentage form as well as in monetary form. Items are depicted as percentages of a certain total of which that item pertains to. Common size statements can be useful in highlighting financial changes and trends. They do come in handy when comparing information from several different companies or firms at a time. Say we have two companies, A and B, of different size. Company A has a net income of $100 million and sales revenue of $1 billion while B has $2 billion net income and $4 billion sales revenue. Comparison can be better done when we put these into percentages since it is not sensible to directly compare companies of different sizes. So Company A’s income as a percentage of sales is 10% while B’s is 50%. Each item in common size statements is expressed as a percentage of which it is related to. Liabilities are expressed as a percentage of total liabilities for example. In a balance sheet, showing all assets in common size statement form shows the significance of current assets as compared to non-current ones. It shows the important changes that have come up in the constitution of the current assets over the past year. An advantage of analyzing the balance sheet in this form is that different balance sheets from different companies of different sizes can be compared easily. Also, in one stand-alone business, it is relatively easy to compare annual changes. The common size statement does not limit us to only balance sheets, but we can also apply the same to income statements. All items here can be placed as a percentage of sales of the company. By doing this we can see how each coin of sales is supplied among the costs, expenses and profits. It actually gets interesting when we put the statements from successive years side by side. We can notice different trends and this can actually be helpful in decision-making when it comes to profitability. Common size statements are also helpful in highlighting inefficiencies and efficiencies that may go without noticing. c) Ratio analysis This is the most common way of analyzing financial statements. It is the analysis of financial ratios. A ratio, in simple terms, is the expression of one number over another, that is, a number in terms of another. In mathematical terms, it is a benchmark by means of which the connection between two or more figures can be measured. An accounting ratio shows the relationship between values shown on a balance sheet, an income statement or in any other accounting document. It is the relationship between accounting information. Ratios may be shown in form of percentages, proportions, co-efficient or rates. Take for example, assets and liabilities of a business as $600 and $500 respectively. The ratio of assets to liabilities could be written as 120% or 1.2 (600/500) or 6:5. As a rate we could say that the assets are 1.2 times the liabilities. Advantages of Ratio Analysis It assists management in planning and forecasting. It simplifies the understanding of the financial statement to those it is relevant to. Ratios help in identifying the changes in the financial state of the business. Helps the investors in decision-making and helps bankers in decision-making for lending purposes. Helps in the comparison of firms. Ratios give data for this use. They highlight factors about successful and unsuccessful firms. They show strong firms and weak firms, overvalued firms and undervalued ones. Ratios also help a firm to analyze its different divisions and their performance. They analyze their efficiency in the past and possible performance in the future. Challenges of Ratio Analysis Ratios may be simple to calculate and comprehend but they also come with several disadvantages: Limitations of financial statements. Ratios are generally derived from financial statements only and their information. The financial statements themselves are prone to limitations, so it follows that the ratios are also prone to these limitations. Statements are controlled greatly by accounting conventions and principles. Personal judgment may influence values for financial statements. Ratios alone are not enough. They are indicators. They cannot be solely relied upon to tell good or bad financial position of the business. Other items also have to be put up into consideration. Ratios are only useful when comparing with past results of the business. They are not sensible when acting as stand-alones. These comparisons may not be correct because factors like market conditions, policies, etc. may affect future activities. Price level changes may affect the cogency of ratios within different time periods. In these cases, the ratio analysis may not really show solvency and profitability trends of a company. If comparisons are made through accounting ratios then financial statements should be adjusted with consideration of the price level changes. Ratios have to be interpreted by professional and qualified people. These people may not interpret in the same way. A single ratio would not make sense, so for better interpretations, a number of ratios should be calculated and this may prove to be confusing to the analyst. Ratios may prove difficult and misleading when comparing firms and businesses that differ in size and accounting techniques. Classification of Accounting Ratios The following table gives the various methods by which ratios can be classified: Traditional Classification or Statement Ratios Functional Classification or Classification According to Tests Significance Ratios or Classification According to Importance Revenue or income statement ratios Statement of Position Ratios Composite or Mixed Ratios/Inter statement Ratios Profitability Ratios Liquidity Ratios Activity Ratios Long Term Solvency Ratios Primary Ratios Secondary Ratios Most Common Accounting Ratios Profitability Analysis: General Profitability: The gross profit ratio percentage is given by gross profit divided by the net sales. The operating profit ratio percentage is stated as operating profit net sales. The operating ratio is given by operating cost divided by the net sales multiplied by 100. Expense ratio follows as the calculation of particular expense over the net sales multiplied by 100. Overall Profitability: The return on shareholders' investment or net worth is the net profit after interest and tax divided by the shareholders' funds. The return on equity capital can be calculated as the net profit after tax subtracting the preference dividend divided by the paid up equity capital. An earnings per share (EPS) ratio is the net profit after tax minus the preference dividend over the number of equity shares. Return on gross capital employed is calculated as the adjusted net profit divided by the gross capital employed multiplied by 100. The return on net capital employed is given as the adjusted net profit divided by the net capital employed multiplied by 100. A dividend yield ratio is given as the dividend per share over the market value per share. The dividend payout ratio or payout ratio is the dividend per equity share over earnings per share Solvency Tests The most used is the current ratio calculated as the current assets divided by the current liabilities. The quick or acid test of liquid ratio for immediate solvency takes the liquid assets over the current liabilities. The absolute liquid ratio is calculated as absolute liquid assets over current liabilities. Activity Ratios The inventory or stock turnover ratio calculates the cost of goods sold over the average inventory at cost. The debtors of receivables turnover ratios calculate the net credit sales over the average trade debtors. The average collection period is taken as the trade debtors’ number of working days divided by the net credit sales. Creditors or payables turnover ratio calculates net credit purchase over the average trade creditors. The average payment period takes the trade creditors number of working days over the net credit purchase. The working capital turnover ratio is calculated as the cost of sales divided by net working capital. Analysis of Long Term Solvency The debt to equity ratio takes the outsiders’ funds over the shareholders funds or external funds divided by the internal funds. The ratio of long-term debt to shareholders funds also known as debt equity calculates the long-term debt over shareholders’ funds. Proprietary of equity ratio is the shareholders’ funds over the total assets. The fixed asset to net worth ratio is the fixed asset after depreciation taken over the shareholders' funds. The fixed assets give the fixed asset ratio or fixed asset to long-term funds after depreciation over the total long-term funds. The ratio of current assets proprietors' funds gives the current assets divided by the shareholders' funds. The debt service or interest coverage ratio is given by the net profit before interest and tax over fixed interest charges. The capital-gearing ratio is calculated by taking the equity share capital over the fixed interest bearing funds. Conclusion We need to understand the limitations portrayed by analysis of financial statements in order to know how to combat these weaknesses. 1) Financial data comparison Differences of accounting techniques of organizations sometimes make it hard to compare their financial data. They can prove to be misleading if, say for example, one firm uses the LIFO (Last In First Out Method) and another uses the average cost method to value its inventories. 2) The need to look beyond ratios An analyst with no experience may make the assumption that ratios can act as stand-alones. They are not sufficient in themselves as a basis for judgment about the future. They should be viewed as the beginning point in analysis. Other sources of data can prove to be useful. The analyst can look at, for example, industry trends, changes in consumer tastes, etc. References Accountingtools.com, (2015). What is financial analysis? - Questions & Answers - AccountingTools. [online] Available at: http://www.accountingtools.com/questions-and-answers/what-is-financial-analysis.html [Accessed 27 Feb. 2015]. Berk, J. and Rees, B. (2008). Corporate financial management supplement. Harlow, Essex: Pearson Education. Bragg, S. (2006). Financial analysis. New Jersey: Wiley. Bragg, S. (2012). Business ratios and formulas. Hoboken, N.J.: Wiley. BusinessDictionary.com, (2015). What is financial analysis? definition and meaning. [online] Available at: http://www.businessdictionary.com/definition/financial-analysis.html [Accessed 27 Feb. 2015]. Friedlob, G. and Schleifer, L. (2003). Essentials of financial analysis. Hoboken (N.J.): John Wiley. Helfert, E. (1987). Techniques of financial analysis. Homewood, Ill.: Irwin. Koop, G. (2006). Analysis of financial data. Chichester: John Wiley & Sons. Muro, V. (1998). Handbook of financial analysis for corporate managers. New York: AMACOM. Nazir, A., Nazir, A. and profile, V. (2012). MBA NOTES:MBA NOTES: MBA NOTES:TYPES OF FINANCIAL ANALYSIS. [online] Mbatop.blogspot.com. Available at: http://mbatop.blogspot.com/2012/10/types-of-financial-analysis.html [Accessed 27 Feb. 2015]. Read More