Chapter 18 Financial statement analysis Flashcards
1.1 Ratios and relationships
Accounting ratios summarise and present financial information in an understandable form. A ratio is only meaningful if there is a comparison, the comparative information may be between different accounting periods, different entities, actual results vs industry averages and actual results vs budgeted or forecast results.
Ratios divide into the following main areas:
- Performance
- Short-term liquidity
- Long-term solvency
- Efficiency (asset and working capital)
- Investors’ (or stock market) ratios
When selecting a ratio you need to consider:
- Who you are reporting to
- The reason why you have been asked to analyse the financial statements
- Factors/events relevant to the scenario and how they impact the financial statements
2.1 External factors
External factors which may have an impact on the financial performance and position include:
- General state of the economy
- Interest rates
- Foreign exchange rates
- Government policies
- Changes in fashions/trends
- Technological change
2.2 Industry analysis
Industry analysis considers the factors that determine profit of a particular industry. The profitability of an industry depends upon the competitive nature of the industry. The degree of competition in an industry depends upon:
- The degree of rivalry between firms within the industry
- The barriers to entry within an industry
- The substitutability of the industry’s products
- The price elasticity of an industry’s products
- Factors influencing the cost of materials and labour
- Operating gearing
2.3 Competitive analysis
There are two main ways of gaining a competitive advantage. Low cost strategy which can be achieved through economies of scale, economies of scope, efficient organisation and production and lower input costs.
The second way is product differentiation. If a company can differentiate its product, it has an imperfect substitute and is less sensitive to price changes.
4.5 Sources of value
A firm can create value only if its efficiency organised. The organisation of a company is dependent upon the transaction costs incurred in carrying out the organisation’s activities. To see whether an entity has created, consider these tests:
- Are transaction costs within an entity less than within the market?
- Do economies of scale exist which can be used to reduce costs and create value?
- Do mechanisms to reduce agency costs exist?
5.1 Identifying red flags
There are a number of situations that could be red flags to suggest creative accounting, these include:
- Operating cash flows consistently out of line with reported profits
- Reported income consistently out of line with taxable income
- Ratios showing opposite trends
- Accounting policies for risk areas such as: off-balance sheet refinancing, revenue recognition, capitalisation of expenses or significant accounting estimates
- Actual v estimated results are out of line or exactly as forecast
- Incentives such as profit-related pay, management buyout or takeover by another entity.
6.1 Cash flow analysis
If a company has a net cash outflow it could indicate cash flow issues. This does not always indicate this, as the outflow could be for sound reasons such as a significant investment in revenue generating assets.
A healthy business should generate the majority of its cash inflows from its operations (day-to-day trading) as these should be sustainable. Overtrading is indicated by high profits but low cash generation and large increases in inventory, receivables and payables.
A healthy business should generate enough cash from operations to cover the mandatory payments of tax and interest paid. Otherwise this would indicate cash flow issues, which could lead to loans being recalled or fines incurred.
Any excess cash balance after mandatory payments is known as free cash flow.
8.1 Improving the quality of financial information
Distortions of assets/liabilities and equity are usually caused by choices of accounting policy and inadequate or misleading information. When analysing the accounts they should be removed. Examples of adjustments include:
- Restating PPE to FV to remove distortions caused by depreciation policy
- Adding back any liabilities and assets with commercial value
- Adding back assets previously written off
- Standardising the policy for inventory valuation
- Adding back any provisions based on probabilities
- Removing non-operating items from reporting income
- Removing non-recurring items from reporting item
- Time apportion results from previous year if an acquisition has taken place
- Review and revise any accounting estimates to ensure consistency and comparability
9.1 Performance ratios
- Return on capital employed: (PBIT + associates post tax earnings) / capital employed x 100%
- Return on shareholders’ funds: net profit for the period / (share capital + reserves) x 100%
- Gross profit margin: gross profit / revenue x 100%
- Operating profit margin: operating profit / revenue x 100%
- Current ratio: current assets . current liabilities
- Gearing ratios: net debt / (net debt + equity) x 100%
- Interest cover: (PBIT + investment income) / interest payable
- Net asset turnover: revenue / capital employed
- Inventory days: inventory / cost of sales x 365 days
- Dividend yield: dividend per share / current market price per share x 100%
- Net asset value: net assets (equity share capital and reserves) / number of equity shares in issue
