Analysis of financial accounts Flashcards
What key analysis are used to assess the financial strengths and weakness a company?
What key analysis are used to assess the financial strengths and weakness a company?
Fundamental analysis
- Economic analysis
- Industry analysis
- Company analysis
Trend Analysis
- Vertical analysis
- Trent analysis
Ratio Analysis
- Profitability
- Efficiency
- Liquidity
- Gearing
- Activity
- Investment performance
What is the purpose of financial analysis?
The purpose of financial analysis is to assess the financial strength and weakness of a company by assessing its efficiency and performance.
The key measures in determining the financial strength of a company are as listed below.
What are the key measures in determining the financial strength of a company?
What are the key measures in determining the financial strength of a company?
- Profitability
- Trend of achievements
- Growth potential of a company
- Comparative position in relation to similar companies or businesses
- Overall financial strength and solvency of a company
What do we mean by:
- Profitability
- Trend of achievements
- Growth potential of a company
- Comparative position in relation to similar companies or businesses
- Overall financial strength and solvency of a company
- Profitability:
the main objective of a company and its management (the agent) is to earn a satisfactory return on the funds invested by the investors or shareholders (the principal). Financial analysis ascertains whether adequate profits are being earned on the capital invested
- Trend of achievements:
analysis can be done through the comparison of financial statements with previous years – especially in relation to trends regarding various expenses, sales/revenue, gross profits and operating profit.
Users can compare the value of assets and liabilities and forecast the future prospects of a company.
- Growth potential of a company:
financial analysis indicates the growth potential of a company.
- Comparative position in relation to similar companies or businesses:
financial analysis help the management to study the competitive position of their company in respect of sales/revenue, expenses, profitability and capital utilisation.
- Overall financial strength and solvency of a company:
analysis helps users make decisions by determining whether funds required for the purchase of new equipment and other assets are provided from internal sources or received from external sources and whether the company has sufficient funds to meet its short-term and long-term liabilities.
What is meant by stewardship accounting?
What is meant by stewardship accounting?
Stewardship refers to the traditional approach of accounting, under which the owners of a company (the shareholders) entrust the management to manage the company on their behalf.
Shareholders entrust the board of directors with the responsibility for managing the resources entrusted to them by giving it direction and providing both control and strategy.
The board employs managers to implement their strategic vision and to help ensure the investments of owners are maximised.
Owners put mechanisms in place to monitor managerial behaviour. For example, the UK Corporate Governance Code (2018) provides guidelines that require directors to conduct business with integrity, responsibility and accountability.
An obligation of stewards or the directors is to provide relevant and reliable financial information, including# analysis of financial statements using various techniques.
Who are the interested parties and how do they benefit from the analysis of financial statements?
Different parties are interested in financial statements and their analysis for various reasons.
These parties include;
investors, management, employees, lenders, suppliers, trade creditors, tax authorities, government and their agencies,
researchers and stock exchanges.
Financial statements are prepared for decision-making purposes, which is driven by effective analysis and interpretation
of financial statements.
Financial analysis indicates the profitability and financial soundness of a business entity for a given period. It determines its financial strengths and weaknesses by assessing the efficiency and performance of an entity.
Key measures include:
- evaluation of profitability
- financial trends of achievements
- growth potential
- comparative position in relation to similar businesses
- assessment of overall financial strength
- assessment of solvency
What does economic analysis look at?
What does economic analysis look at?
It looks a the analysis of:
- GDP
- interest rates
- employment
- foreign exchange
- manufacturing
What does Industry analysis look at?
What does Industry analysis look at?
Analysis of:
- competitors
- state of industry
- Porter’s five - forces for the industry
What does company analysis look at?
What does company analysis look at?
Analysis of:
- the business’s assets
- liabilities
- earnings
What is economic analysis?
The performance of the company mirrors the performance of the economy in which it operates. Different companies and
industries perform differently during the various stages of an economic cycle.
The economic or business cycle is the periodic up-and-down movement in economic activity, measured by fluctuations in
the growth of real GDP and other macroeconomic variables such as employment, interest rates and consumer spending.
According to the UK’s National Bureau of Economic Research (NBER), there are four stages of economic cycle: recovery (expansion), boom (peak), recession (contraction) and depression (trough).
What are the relevant variables of the economy which impact the company and its industry?
- Recovery (expansion)
After reaching bottom, the slow growth starts to kick in under the
expansion phase.
This is characterised by gradual recovery, with increasing
employment, economic growth and upward pressure on prices,
wages, profits, demand and supply of products.
- Boom (peak)
Post-recovery, the growth in business activity reaches a peak
(the highest point of the business cycle).
In this phase, the real national output is rising at a faster rate than the average growth rate and the economy is producing at maximum allowable output.
- Recession (contraction)
After reaching a peak, business activity remains stagnant with
a significant decline in economic activity spread across the
economy, lasting more than a few months. It is normally visible in
real GDP, real income, employment, industrial production and retail
sales.
- Depression (trough)
In this phase, business activity is declining with output
reaching its lowest point. The economy has hit bottom, from
which the next phase of expansion and positive sentiments
starts to kick in.
Essentially, this phase is a combination of negative and positive
sentiments.
What is Industry analysis?
What is Industry analysis?
An industry goes through stages during the course of its lifecycle. Each stage offers a different set of growth prospects and challenges. According to Julius Grodinsky’s industry life cycle theory, the life of an industry can be segregated into four stages:
- Pioneer stage:
this is the first stage of a new industry where products and technology are newly introduced and
have not reached a state of perfection – such as new mobile applications and the software industry. There is an
opportunity for rapid growth and profit – and high risk.
- Expansion stage:
this is the second stage of expansion of those that survived the pioneering stage. Companies grow larger and are quite attractive for investment purposes.
- Stagnation stage:
growth stabilises and sales grow at a slower rate than that experienced by competitive industries or by the overall economy.
- Decay stage: the industry becomes obsolete and ceases to exist with the arrival of new products and new technologies (for example, the black-and-white television industry)
What are underlying forces that drive the industry?
Underlying forces that drive the industry
In 1980, Michael Porter proposed a standard approach to industry analysis, known as ‘Porter’s five forces’.
These help to identify the weaknesses and strength of the industry.
According to Porter, the following five forces collectively determine
the long-term profit potential of the industry.
- Barriers to entry for new players to enter the market:
this refers to how difficult or easy it is for a new player to enter the industry.
In an industry with little-to-no barrier to entry, new players have a competitive advantage while existing suppliers constantly face a new set of competitors. Barriers to entry include heavy capital requirement, significant differentiation via technology, regulation challenges and poor distribution channel.
- Bargaining power of customers:
a strong buyer can make an industry more competitive and can push existing businesses to lower their prices or offer additional services in comparison to its competitors. Customers now have more bargaining power as they can switch between suppliers.
- Bargaining power of suppliers:
suppliers in a strong bargaining position can choose to reduce the quantity of the product available. If there are few close substitutes, buyers can switch as and when the switching cost to new suppliers
is too high.
The suppliers hold the power to influence the customers and establish competitive advantage. Suppliers are also in a strong position if the product or service they supply is an essential component of the end product.
- Availability of substitute goods:
product substitution occurs when customers can switch easily between competitors.
If all players are producing similar products with little to no differentiation, pricing is fixed. However, businesses can work against this by adding significant product differentiation with a clear focus on consumer requirements.
- Competitors and nature of competition:
the rivalry among players places significant barriers to the industry.
This rivalry can result in price wars, constant innovation in product offerings and new product launches, leading to lower profits. In the long term, it increases fixed costs for businesses, lowers growth rates for the industry and stagnates company performance.
What is company analysis?
Company analysis
Company analysis evaluates information relating to the company’s profile, products and services as well as its profitability and financial position.
During the process of company analysis, an investor also considers factors that have contributed to shaping the company. Different companies from the selected industry are usually analysed and evaluated so that the most attractive company can be identified.
Elements of a company analysis include the following:
- An overview of the company:
the most important points about the company, like its mission statement, legal structure, goals and values, history, management team and location. Other useful information includes the
company’s service performance, product lifecycle stages, competitive strategy, sales and marketing practice, management track record and its future prospects.
- Analysis of competitive strategies: broadly, the company will either have a low-cost approach or a product/service differentiation approach when combating competition. There may be a hybrid approach in certain situations.
This will help when understanding product positioning.
- Analysis of financial statements:
conducted using trend analysis, financial ratios and other financial statistics.
What are the key objectives of fundamental analysis and its components?
Fundamental analysis is a systematic approach to evaluating company performance based on historical data. The end goal of this analysis is to generate an insight about the company’s future performance and business forecast. It is also used:
- to derive the valuation of the company
- to evaluate the performance of the company management and conduct internal audit of its business decisions
- to determine the intrinsic value of the share or the company’s intrinsic value and its growth prospects
The components of fundamental analysis are:
- economic analysis, including analysis of:
– GDP
– interest rates
– employment
– foreign exchange
– manufacturing
