Financial statement analysis Flashcards
Financial statement analysis Purpose of financial analysis
In the Corporate Reporting exam, you will be asked to review financial
statements for a particular purpose. This is likely to be one of the
following:
analytical procedures to identify audit risks
advising a current or potential investor/lender
advising on a choice of accounting policies.
The financial analysis will include reviewing the information available in the question
and using it to draw conclusions. This chapter works through the skills required to
answer this type of question.
Financial statement analysis Ratios and relationships 2.1 Using ratios in discussion
Accounting ratios help to summarise and present financial information in a more
understandable form. A ratio will only be meaningful if there is a basis for
comparison. In the exam, you will be provided with two sets of financial data for
comparison together with some background information. The comparative
information may be between:
different accounting periods
different entities
actual results vs industry averages
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.
You will have come across many ratios in your earlier studies. For your reference
these are included in the appendix to this chapter.
Financial statement analysis Ratios and relationships 2.2 Selecting ratios
In the exam you will be expected to calculate relevant ratios, i.e. those which will add
value to your answer and give you meaningful commentary. In making a decision
regarding which ratios to use, both the intended user of the information and the type
of business being analysed should be considered. It would not, for example, be
meaningful to calculate the trade receivables collection period for a business that
makes substantially all sales on cash terms.
If the ratio is not going to lead to useful commentary then there is no
benefit to the calculation. In an exam context, that time can be better
used on other areas.
How do you decide which ratios are the most relevant to calculate? You
need to consider:
who you are reporting to
the reason why you have been asked to analyse the financial
statements
the factors/events relevant to the scenario and how they impact
the financial statements.
In order to do this, you need to read the question in detail.
Financial statement analysis Ratios and relationships 2.3 User focus
It is important that you focus your analysis on what is relevant to the person you are
reporting to.
Different groups of users will look at the analysis for different reasons, and will
therefore focus on different balances and explanations. When preparing your report,
it is important to make sure that you address the concerns of those who will be
relying upon it for their decision making.
Note that in the context of Corporate Reporting, the main standpoints are likely to
be those of the investor (or potential investor) or credit analyst on behalf of a
lender.
Financial statement analysis Creating commentary
When creating commentary about movements (these can be
movements in a ratio or in a figure in the statement itself, such as
revenue) it is useful to think in terms of a series of questions:
WHAT happened?: Revenue has fallen.
WHY did it happen?: This is caused by the loss of a major
customer to a competitor during the period under review.
WHEN did it happen?: The loss happened mid-year, and therefore
the full impact will not be felt until the following year.
SO WHAT?: The company should consider why the customer has
chosen to move to a competitor, and whether this is an isolated
incident or whether other customers are likely to follow.
Analysts can also look at how this movement links through to other
parts of the statements. For example, if this customer is particularly
large, they may have negotiated a special price meaning that these
sales earn a lower margin. An analyst may therefore expect to see an
increase in gross profit margin.
Financial statement analysis Generating ideas for your commentary
To generate a good quality answer you must be able to understand the link between
business events/accounting policy choices, and the impact they have on the financial
statements.
Financial statement analysis Generating ideas for your commentary 4.1 External factors
There are many external factors that may have an impact on the financial
performance and position of a company including:
the general state of the economy
interest rates
foreign exchange rates
government policies
changes in fashions/trends
technological change.
External factors could have a significant impact on the financial performance and
position of any given company. For example, during a recession you would expect
(amongst other things) revenue to fall, margins to be squeezed and potentially more
bad and doubtful debts.
Financial statement analysis Generating ideas for your commentary 4.2 Accounting policy choice or judgement
You need to understand the impact of an accounting policy choice on the financial
statements. The following is a list of standards that allow choices:
Standard
IAS 16 Property, Plant and Equipment
Choice of policy
Cost vs revaluation mode
Standard
IFRS 16 Leases
Choice of policy
Finance lease vs operating lease (Lessor accounting)
Standard
IAS 40 Investment Property
Choice of policy
Cost vs fair value model
Standard
IFRS 9 Financial Instruments
Choice of policy
Classification of investments in equity
(FVPL or FVOCI)
Hedge accounting is a choice
Standard
IFRS 3 Business Combinations
Choice of policy
NCI valuation method
Standard
IAS 20 Government Grants
Choice of policy
Netting off vs deferred income method for
grants related to assets
It is particularly relevant if you are required to compare two different companies to
each other. For example:
if one company chooses to use the revaluation model for PPE, it is likely to
have higher levels of capital employed (due to the revaluation surplus) in
comparison to the other company which applies the cost model
if one company chooses to use the FV model for investment properties and the
property market has improved, profit levels will spike as the FV gain will go
through the SPL.
Financial statement analysis Generating ideas for your commentary 4.3 Industry analysis
Industry analysis considers the factors that determine the potential profit of a
particular industry.
Profit is the difference between revenue and costs and therefore determined by the
output and input prices. Prices are determined by the competitive nature of the
market.
The profitability of an industry therefore 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 i.e. extent of fixed costs.
Financial statement analysis Generating ideas for your commentary 4.4 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
– lower input costs.
Product differentiation – if a company can differentiate its product, it has an
imperfect substitute and is less sensitive to price changes.
Financial statement analysis Generating ideas for your commentary 4.5 Sources of value
A firm can create value only if it is efficiently 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 value, consider three 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?
Financial statement analysis Additional information requests
When providing analysis it is often appropriate to include details of additional
information that would aid you in further analysis. When including this information, it
is important that you consider two things.
How likely are you to obtain the information? If you are working for
management, it would be relatively easy to obtain further detail from within the
business whereas if you were doing your analysis on behalf of a competitor you
would find it difficult to obtain internal information.
Why are you requesting the information? In real life when you ask for additional
information, someone has to provide it. It is therefore useful to justify what that
information is to be used for.
Financial statement analysis Ethical considerations
Analysing financial information is only useful if the information is
reliable, so there is a need to consider if there has been any creative
accounting.
The preparation of financial statements may be affected by pressure to
manipulate financial performance and/or position. Situations that may
give rise to this pressure include:
management being entitled to performance-related bonuses
the need to meet investors’ expectations (such as EPS)
the risk of breaches of loan covenants
imminent disposal of the business
flotation of the business
tax avoidance.
There are many ways to manipulate the financial statements. For example:
taking advantage of areas that require judgement such as inappropriate
recognition/release of a provision/extension of assets’ useful lives
early recognition of revenue
capitalisation of expenditure to improve profits
not writing off bad debts or recognising allowances for doubtful receivables to
improve liquidity.
Financial statement analysis Ethical considerations 6.1 Identifying red flags
There are a number of situations that could be red flags to suggest creative
accounting. This list is not exhaustive, but a useful reference.
Operating cash flows consistently out of line with reported profits.
Reported income consistently out of line with taxable income, with inadequate
explanation or disclosure.
Ratios such as declining gross profit margins but increased net profit margins,
or inventories/receivables increasing more than sales.
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.
Financial statement analysis Cash flow analysis
The statement of cash flows is a valuable source of information about a company’s
liquidity. It can be interpreted through simple analysis of the face of the statement
and through cash flow ratio analysis.
Financial statement analysis Cash flow analysis 7.1 Net cash movement
The first thing to look at when analysing a statement of cash flows is to consider
whether the company has more cash going out than it has coming in. If it has a net
cash outflow it could indicate cash flow issues.
A net cash outflow during the period may not necessarily mean that the company had
cash flow problems. This outflow may have been for sound reasons such as a
significant investment in revenue generating non-current assets was made.
Financial statement analysis Cash flow analysis 7.2 Cash inflows
Sources of cash inflows include:
cash generated from operations (i.e. day-to-day trading)
dividend and interest income received
proceeds from the disposal of property, plant and equipment
share issues
debt issues.
Financial statement analysis Cash flow analysis 7.3 Cash generated from operations
A healthy business should generate the majority of its cash inflows from its
operations (day-to-day trading) as these cash inflows should generally be
sustainable.
