FINANCIAL STATEMENTS ANALYSIS Prepared by: Alipipi, Emmanuel CPA (T), MBA (Accounting) Financial statements A complete set of financial statement comprises: 1. Statement of profit or loss and other comprehensive income. 2. Statement of financial position 3. Statement of Cash flow 4. Statement of changes in Equity 5. Notes to the Accounts FINANCIAL STATEMENTS ANALYSIS 1.0 INTRODUCTION OF FINANCIAL ANALYSIS Financial statement analysis is a method of reviewing and analyzing a company’s accounting reports (financial statements) in order to measure its past, present or projected future performance. According to Meigs and Meigs (2003), financial statement are a structured representation of the financial position and financial performance of an entity. 1.2 USERS OF FINANCIAL STATEMENTS ANALYSIS There are different users of financial statement analysis. According to Akpan (2002), financial statement may be used by users for different purposes. These can be classified into internal and external users. Internal users refer to the management of the company who analyses financial statements in order to make decisions related to the operations of the company. FINANCIAL STATEMENTS ANALYSIS External users refer to the shareholders and stakeholders whose do not necessarily belong to the company but still hold some sort of financial interest. These include owners, investors, creditors, government, employees, customers, and the general public. These users are elaborated below; 1. Management The managers of the company use their financial statement analysis to make useful decisions about their performance. For example; How much cash they have left, from their accounting reports and make decisions from these analysis results. FINANCIAL STATEMENTS ANALYSIS 2. Owners Small business owners need financial information from their operations to determine whether the business is profitable. It helps in making decisions like whether to continue operating the business or whether to give up on the business altogether. 3. Investors Investors who have purchased shares in a company need financial information to known the method which used by the company in performance evaluation process. The investors use financial statement analysis to determine what to do by through their investments in the company. They make use of financial statements to assess the viability of investing in a business FINANCIAL STATEMENTS ANALYSIS 4. Creditors Creditors are interested in working if a company will be able to pay its debts or loans as they become due. Also use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long term bank loan or debentures) to finance expansion and other significant expenditures. The creditors use cash flow analysis of the company’s accounting records to measure the company’s liquidity. 5. Government Governing and regulating bodies of the state look at financial statement analysis to determine how the economy is performing in general so they can plan their financial and industrial policies Tax authorities also analyze a company’s statements to calculate the tax burden that the company has to pay. FINANCIAL STATEMENTS ANALYSIS 6. Employees Employees want to know if their employment is secure and if there is a possibility to increase their salaries. Also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labour unions or for individuals in discussing their compensation promotion and rankings Employees may also be interested in knowing the company’s financial position to see whether there may be plans for expansion and hence, career prospects for them 7. Customers Customers want to know the ability of the company to service its clients into the future. They need to know about the company’s stability of operations if the customer is dependent wholly on the company for its supplies. FINANCIAL STATEMENTS ANALYSIS 8. General Public General public means anyone in the public, students, analysts and researchers, may be interested in using a company’s financial statement analysis. They may wish to evaluate the effects of the firm on the environment, or the economy or even the local community. If the company is running corporate social responsibility programs for improving the community, the public may want to be aware of the future operations of the company. FINANCIAL STATEMENTS ANALYSIS Objective of analysis of financial statements To be more specific, the analysis is undertaken to serve the following purposes (objectives): i. To assess the current profitability and operational efficiency of the firm as a whole as well as its different departments so as to judge the financial health of the firm. ii. To ascertain the relative importance of different components of the financial position of the firm. iii. To identify the reasons for change in the profitability/financial position of the firm. iv. To judge the ability of the firm to repay its debt and assessing the short-term as well as the long-term liquidity position of the firm. Classification of financial statements 1. Statement of Profit or loss and other comprehensive income or Income statement Income statements are also known as profit and loss account. The button line on an income statement is income less expenses. If when income is more than expenses it is known as net profit and when expense is more than income it is a net loss. 2. Statement of financial position or balance sheet Accounting equation; Asset = Liability + Equity. The balance sheet shows the health of a business from day one to the date on the balance sheet. Balance sheet are always dated on the late day of the reporting period. Classification of financial statements 3. Statement of Cash flows The statement of cash flows the ins and outs of cash during the reporting period. The statement of cash flows takes aspects of the income statement and balance sheet and kind of crams them together to show cash sources and uses for the period. 4. Statement of changes in equity The statement of retained earnings shows the break down of retained earnings. Net income for the year is added to the beginning of year balance, and dividends are subtracted. This results in the end of year balance for retained earnings. FINANCIAL STATEMENTS ANALYSIS Tools of analysis of financial statements The most commonly used techniques of financial analysis are as follows; 1. Comparative statements; These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when same accounting principles are used in preparing these statements. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’. FINANCIAL STATEMENTS ANALYSIS 2. Common size statements; These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’. FINANCIAL STATEMENTS ANALYSIS 3. Trend Analysis It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected. FINANCIAL STATEMENTS ANALYSIS 4. Ratio Analysis It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency and efficiency of an enterprise through the technique of ratio analysis. FINANCIAL STATEMENTS ANALYSIS 5. Cash Flow Analysis It refers to the analysis of actual movement of cash into and out of an organisation. The flow of cash into the business is called as cash inflow or positive cash flow and the flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between the inflow and outflow of cash is the net cash flow. Cash flow statement is prepared to project the manner in which the cash has been received and has been utilized during an accounting year as it shows the sources of cash receipts and also the purposes for which payments are made. Thus, it summarizes the causes for the changes in cash position of a business enterprise between dates of two balance sheets. FINANCIAL STATEMENT ANALYSIS Classification of financial ratios ? 1. Profitability Ratios Gross profit margin Operating profit margin Net profit margin Return on capital employed (ROCE) Return on assets (ROA) FINANCIAL STATEMENT ANALYSIS 2. Liquidity Ratio Current ratio Quick ratio 3. Working Capital Efficiency Ratios Asset turnover Inventory turnover Receivable days Payable days Working capital cycle FINANCIAL STATEMENT ANALYSIS 4. Investor Performance Ratios Earning per share (EPS) Price/Earning ratio Dividend yield Dividend cover 5. Financial Risk Ratios Capital gearing ratio Debt ratio Interest cover Cash flow ratios FINANCIAL STATEMENT ANALYSIS 1. Profitability ratios Gross profit margin Gross profit X 100 It reflects gross margin made on sales. Operating profit margin Operating profit Net profit margin Net profit (PBT) X 100 Sales revenue It reflects net margin made on sales. Sales revenue X 100 Sales revenue It reflects operating margin made on sales. Return on capital employed Operating profit X 100 Capital employed It reflects relationship between profits earned and size of company (measures overall performance of company) FINANCIAL STATEMENT ANALYSIS Return on assets Operating profit X 100 Current ratio Current assets Total assets Current liabilities It reflects relationship between profits earned and total assets. It measures ability to pay current liabilities from the current assets. Quick ratio 2. Liquidity Ratio Quick assets Current ratio Current liabilities Quick ratio It indicates the ability to pay all current liabilities if they become due for payment immediately FINANCIAL STATEMENT ANALYSIS 3. Working Capital Efficiency Ratios Asset turnover Sales revenue (times p.a) Total assets It shows how much revenue generated by a Tshs1,000 worth of asset. Receivables Inventory turnover Cost of sales (times p.a) Inventory It indicates how many times the inventory is being turned over in a year. X 365 days Credit sales It reflects the number of days it takes for a customer to pay. Receivable days Payable days Payables X 365 days Credit purchase It reflects the number of days it takes for a company to settle its bills. FINANCIAL STATEMENT ANALYSIS Working capital cycle Inventory turnover days + receivable days – payable days Approximate number of days it takes to purchase the inventory, sell the inventory and receive cash. 4. Investor Performance Ratios; Earning per share (EPS) Profit after tax It depicts amount which an entity has earned per share for the given period. Current market price per share Earning per share It helps to assess the relative risk of an investment. . Weighted average number of ordinary shares outstanding Price Earning ratio Dividend yield Dividend per share X 100 Market price per share It measures the return on capital investment as a percentage of market prices FINANCIAL STATEMENT ANALYSIS Dividend Cover It expresses the relationship between a company‘s borrowings and its own funds. Debt ratio Profit after tax Dividend It measures the ability of the company to maintain its existing levels of dividends. Total liabilities 5. Financial Risk Ratios It indicates the percentage of assets financed with debt Capital gearing ratio Total long –term debt Shareholder’s fund X 100 Total assets Interest cover Profit before interest and taxes Interest expenses It indicates the number of times, the profit covers the interest charge Example Example
