Chapter 7 - Analysis And Evaluation Of Financial Statements

Question 1

What are the key financial indicators?

Answer 1

1) Profitability: main objective is to earn a satisfactory return. Financial analysis ascertains if adequate profits are earned on the capital invested. Also used to understand the earning capacity of a business, its wellbeing and its prospects including the ability to pay interest and dividends.
2) Trend of achievements: comparison of FS with previous years (crucial in respect of expenses, purchases, sales, gross and net profits). Users can compare value of assets and liabilities and also forecast the future prospects of the business
3) Growth potential of the business
4) Comparative position in relation to similar businesses: to study competitive position in respect of sales, expenses, profitability and capital utilisation.
5) Overall financial strength and solvency of the entity: helps with decisions on purchase of new equipment and machines etc. and whether funds can be raised from internal sources or external sources and whether it can meet short-term and long-term liabilities.

Question 2

What are the key measures to assess the financial strengths and weaknesses of a business?

Answer 2

1. Fundamental analysis:
   - Economic
   - Industry
   - Company
2. Trend analysis:
   - Vertical
   - Trend or horizontal
3. Ratio analysis:
   - Profitability
   - Efficiency
   - Liquidity
   - Gearing
   - Activity
   - Investment performance

Question 3

What is fundamental analysis?

Answer 3

Systematic approach to evaluation of performance. In-depth study of underlying forces that drive a company’s performance and the overall state of the economy in which it operates.

Considers factors such as interest rates, GDP, employment etc.

Main aim is to generate insights and forecasts about the company’s future performance.

Question 4

What is economic analysis?

Answer 4

Performance of the company mirrors the performance of the economy in which it operates. Different companies and industries perform differently during various stages of an economic/business cycle. The business cycle is measured by fluctuations in the growth of real GDP and other macroeconomic variables such as employment, interest rates and consumer spending and is used to analyse competitors, state of industry and Porter’s five forces for the industry.

There are 4 stages of the economic cycle:

1) Recovery (expansion)
2) Boom (peak)
3) Recession (contraction)
4) Depression (trough)

Question 5

What is industry analysis?

Answer 5

Evaluation of the relative SWOT of particular industries. It facilitates a company’s understanding of its position relative to other companies that produce similar products or services. An industry goes through stages during the course of its lifecycle. Each stage offers a different set of growth prospects and challenges.

Grodinsky’s industry life cycle theory is segregated into four stages:

1) Pioneer stage: first stage of a new industry where products and technology are newly introduced and have not reached a state of perfection e.g. new mobile apps and software. There is an opportunity for rapid growth and profit but high risk
2) Expansion stage: second stage for those who have survived the pioneer stage. Companies grow larger and are attractive for investment purposes
3) Stagnation stage: growth stabilises and sales grow at a slower rate than experienced by competitive industries or by the overall economy
4) Decay stage: industry becomes obsolete and ceases to exist with the arrival of new products and new technologies (e.g. KODAK/B+W TV)

It requires the business to take an objective view of the underlying forces, attractiveness and success factors that determine the structure of the industry. Consists of 3 aspects:
1) Underlying forces that drive the industry: Porter’s 5 forces (1) Barriers to entry; (2) Bargaining power of customers; (3) Bargaining power of suppliers; (4) d. Availability of substitute goods; (5) Competitors and nature of competition.

2) Attractiveness of the industry: Porter’s 5 forces shows the existence and non-existence of the industry forces. Overall attractiveness of industry is considered. More barriers to entry will make an industry unattractive.
3) Success factors required for the company’s survival: pre-requisite qualities that determine whether a company is successful or not. Companies need to identify an edge which will provide success in the long-term. Edge = better quality, fair prices, cost advantages etc.

Question 6

What is company analysis?

Answer 6

Evaluates information relating to the company’s profile, products and services as well as profitability and financial position. Investors will consider factors in the company’s history that have contributed to shaping the company. Different companies from the selected industry are evaluated so the most attractive company can be found. Elements include:

1) An overview of the company
2) Analysis of competitive strategies
3) Analysis of FS.

Question 7

What is trend analysis?

Answer 7

Process of analysing financial data to identify any consistent results or trends. Trends can be horizontal or vertical.

Changes can be measured in percentage terms or absolute numbers. Trend analysis is helpful in:
• Analysing revenue patterns across products, geography or customers
• Checking the impact of any unusual one-off expenditure in a period
• Preparing financial projections for the company
• Comparing results from multiple companies in the same industry.

Question 8

What is horizontal analysis?

Answer 8

Compares line items in a company’s financial statements or financial ratios over multiple time periods. Tracks the history and progress of a company’s performance by comparing items or financial ratios over multiple reporting periods. Formula for calculating change in a line item is as follows:

Current period amount – base period amount (prior period amount)

A better trend analysis is provided by the change in percentage, calculated as:

(current period amount – base period amount) ÷ base period amount

Question 9

What is vertical analysis?

Answer 9

Proportional analysis of line items as a percentage of base items (as a percentage of sales for P+L and as a percentage of assets for BS). Provides a greater understanding of how sales revenue is being utilised within the business which will result in investigations where level of activity isn’t as expected. Vertical analysis is always done for a single reporting period rather than over multiple periods.
Useful for seeing changes in line items over a period

Calculated as: item ÷ sales or assets x 100

Question 10

What are the 5 categories of ratio analysis?

Answer 10

1) Profitability ratios – measure effectiveness of capital and asset utilisation. Comprises of margin ratios (ability to convert sales into profits) and return rations (ability to generate returns to shareholders)
2) Asset efficiency or turnover ratios
3) Liquidity or solvency ratios
4) Gearing or debt ratios
5) Investment or market value ratios

Question 11

What is the calc and purpose of Gross Profit Margin?

Answer 11

Measures how much company is earning in relation to the costs to produce goods.

(Gross profit ÷ sales) × 100
Where gross profit = sales – cost of goods sold.

Underlying drivers = selling prices, product mix, purchase costs, production cost and inventory valuations

Question 12

What is the calc and purpose of Operating Profit Margin?

Answer 12

Measures percentage of sales after accounting for operating expenses. Higher operating profit margin = comfortably pay for fixed cost and interest. Drivers = employment policy, depreciation methods, write-off of bad debt, selling and marketing expenses

(Operating profit ÷ sales) × 100
Where operating profit = sales – cost of goods sold – operating expenses

Question 13

What is the calc and purpose of Net Profit Margin?

Answer 13

Measures earnings after tax. Reflects strength of management in achieving profits above operating costs. The higher the ratio, the more favourable it is for the company. Can also use net profit before tax.

(Net profit ÷ sales) × 100
Where net profit = sales – cost of goods sold – operating expenses – non-operating expenses + non-operating income – income tax

Question 14

What is the calc and purpose of Return on Equity?

Answer 14

Measures ability to provide returns to equity holders. Higher the ratio = more favourable for company

Net income ÷ total equity
Where net income = sales – cost of goods sold – operating expenses – non-operating expenses – income tax

Question 15

What is the calc and purpose of Return on Assets?

Answer 15

Measures how effectively assets are used in comparison to the income earned. Economies of scale help in improving this ratio. Higher the ratio = more favourable for company

Net income ÷ total assets
Where net income = sales – cost of goods sold – operating expenses – non-operating expenses – income tax

Question 16

What is the calc and purpose of Return on Capital Employed or Accounting Rate of Return?

Answer 16

Measure of return generated by all sources of capital, including equity and debt providers. Similar to ROE but includes debt holders as well.
Measures income available to all investors and not just to shareholders. Higher the ratio = more favourable to company.

PBIT [operating profit] / (total assets - current liabilities) x 100

(EBIT x (1 - tax rate)) ÷ (total equity + debt)
Where EBIT = sales – cost of goods sold – operating expenses – non-operating expenses excluding interest expenses

Question 17

What is the purpose of Asset Turnover?

Answer 17

Ability of the business to generate revenue from its assets. Low number = assets not utilised efficiency and high number = more investments are needed

Question 18

What is the purpose of non-current asset turnover?

Answer 18

How effective a company is at generating revenue from non-current assets at their disposal. For each £1 of investment in non-current assets, how much revenue is generated. Useful for manufacturing co’s that have significant non-current assets. If revenue falls, efficiency ratios fall. If ratio falls and revenue hasn’t then the assets have been over-invested and not providing sufficient return.

Question 19

What is the purpose of inventory turnover?

Answer 19

Measures how efficiently an entity is converting inventory to revenues.
High ratio = inventory is tightly controlled – co knows how much to order.
Low ratio = relatively large order or prices too high and left with inventory. Procurement – co only orders stock as it’s needed. Reduces risk.

Question 20

Rate of collection of trade receivables

Answer 20

Average time it takes debtors to pay for goods received on credit. Company should have credit controls in place with different strictness depending on industry.

Question 21

Rate of collection of trade payables

Answer 21

Amount of time it takes to pay creditors.

Need to get the balance right, weighing up cash flow requirements and tolerance of creditors.

Question 22

What are the limitations of ratio analysis?

Answer 22

• Only the first step towards analysis. Conclusions cannot be drawn merely on percentages shown by ratios as they may not reflect the holistic picture on the company’s situation.
• Mathematical calculation does not work when the base figure is zero or negative and may not reflect the true picture.
• Company projections based on trend and ratio analysis are not adequate as trend is a reflection of historical actions which may not be acceptable in the future. Ratios are purely based on accounting data and accurate forecasts depend on economic and industry performance, management plans, supply and demand situations, competitor analysis and so on.
• Benchmarking focuses on company-to-company comparisons of how products and services perform against their toughest competitors or those companies recognised in leaders in their industry. Benchmark used for financial ratios may not always be most appropriate
• Time-series analysis that makes use of historical financial information may be distorted with inflation or seasonal factors
• Ratios are meaningless without a comparison against trend data or industry data and without looking at the causation factors
• May be window dressing intended to manipulate FS

Question 23

What are the 2 types of fraud in accounting?

Answer 23

1) Fraudulent financial reporting (intentional misstatement); or
2) Misappropriation of assets (theft).

Question 24

What are errors in accounting?

Answer 24

Unintentional misstatements or lowest level of accounting irregularity. Non-fraudulent discrepancies and corrected by those preparing the next FS. Includes incorrect accounting estimates from oversights/misinterpretation or mistakes in application of accounting principles such as measurement, recognition, classification, presentation or disclosure.

Question 25

What is fraudulent financial reporting?

Answer 25

Most severe involving intentional misstatement or omissions of amounts or disclosures to deceive users. Includes manipulation, falsification or alteration of account records, omission of material information and intentional misapplication of accounting principles.

Question 26

What is misappropriation of assets (theft)?

Answer 26

Involves misstatements due to accounting irregularities such as stealing tangible or intangible assets, embezzling receipts or making payments for the purchase of non-existent goods and services.

Usually supported by false documents to conceal missing assets.

Question 27

List 6 types of creative accounting

Answer 27

1) Off-balance sheet financing: a form of financing in which large CAPEX and the associated liability (such as operating leases and partnerships) are kept out of a company’s BS. It impacts a company’s level of debt and liability and has serious implications.
2) Cut-off manipulation: delay invoicing in order to move revenue into the following year.
3) Revaluation of non-current assets: subject to manipulation and can have a significant impact on a company’s statement of financial position.
4) Window dressing: transactions are passed through the books at the year end to make figures look better, often to be reversed after the year end (e.g. loan repayment)

5) Change of accounting policies: this is done as a last resort because companies which change accounting policies know they will not be able to do so again for some time. The effect in the year of change can be
substantial. Potential areas open for such treatment are depreciation, inventory valuation, changes from current cost to historical cost and foreign currency losses.

6) Manipulation of accruals, prepayments and contingencies: this can be very subjective, particularly in relation to contingencies as a contingent liability (for example, an outcome of a pending lawsuit) is difficult to estimate. In such cases, companies will often only disclose the possibility of such a liability, even though the eventual costs may be substantial.

Question 28

Mitigating factors for creative accounting

Answer 28

IAS 27 ensures consolidation of financial statements of subsidiaries with that of parent entity. Stops exclusion of highly-geared subsidiaries from the consolidation.

IFRS 16 ensures proper disclosure of leased assets, which makes it very difficult to keep liabilities off the BS. Assets could be ‘sold’ under a sale and leaseback agreement – in effect a disguised loan – or leased under an operating lease rather than a finance lease in order to keep the liability off the balance sheet.

IAS 37 aims to ensure proper accounting and disclosure of provisions, contingent liabilities and contingent assets.

External audit.