Analysis of income statement and balance sheet:

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Financial Statement Analysis-FIN621

Lesson-31

FINANCIAL STATEMENT ANALYSIS

Analysis of income statement and balance sheet:

Financial Statements are like the Instrument panels of a business. There are different needs of different

users of these statements. Users can be outside users and internal users. Identity of user is important, so

as to provide him/her with relevant information.

Financial statement analysis is the process of examining relationships among financial statement

elements and making comparisons with relevant information. It is a valuable tool used by investors and

creditors, financial analysts, and others in their decision-making processes related to stocks, bonds, and

other financial instruments. The goal in analyzing financial statements is to assess past performance and

current financial position and to make predictions about the future performance of a company. Investors

who buy stock are primarily interested in a company's profitability and their prospects for earning a

return on their investment by receiving dividends and/or increasing the market value of their stock

holdings. Creditors and investors who buy debt securities, such as bonds, are more interested in liquidity

and solvency: the company's short-and long-run ability to pay its debts. Financial analysts, who

frequently specialize in following certain industries, routinely assess the profitability, liquidity, and

solvency of companies in order to make recommendations about the purchase or sale of securities, such

as stocks and bonds.

Analysts can obtain useful information by comparing a company's most recent financial statements with

its results in previous years and with the results of other companies in the same industry. Three primary

types of financial statement analysis are commonly known as horizontal analysis, vertical analysis, and

ratio analysis.

Fundamental Analysis

Fundamental analysis at company level involves analyzing basic financial variables in order to estimate

intrinsic value. These variables include sales, profit margins, depreciation, the tax rate, sources of

financing, asset utilization, and other factors. Additional analysis could involve the firm's competitive

position in its industry, labor relations, technological changes, management, foreign competition, and so

on. The end result of fundamental analysis at the company level is an estimate of the two factors that

determine a security's value: cash flow stream and a required rate of return (alternatively, a P/E ratio)

Industry analysis

Industries as well as the market and companies, are analyzed through the study of a wide range of data,

including sales, earnings, dividends, capital structure, product lines, regulations, innovations, and so on.

Such analysis requires considerable expertise and is usually performed by industry analysts employed

by brokerage firms and other institutional investors.

A useful first step is to analyze industries in terms of their stage in the life cycle. The idea is to assess

the industry's general health and current position. A second step is to assess the position of the industry

in relation to the business cycle and macro economic conditions. A third step involves qualitative

analysis of industry characteristics designed to assist investors in assessing the industry's future

prospects.

Uses and limitations of financial analysis

Ratio analysis is used by three main groups: (1) managers, who employ ratios to help analyze, control,

and thus improve their firms' operations; (2) credit analyst, including bank loan officers and bond rating

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analysts, who analyze ratios to help ascertain a company's ability to pay its debts; and (3) stock analyst,

who are interested in a company's efficiency, risk, and growth prospects.

Many large firms operate different divisions in different industries, and for such companies it is

difficult to develop a meaningful set of industry averages. Therefore, ratio analysis is more

useful for small, narrowly focused firms than for large, multidivisional ones.

Most firms want to be better than average, so merely attaining average performance is not

necessarily good. As a target for high-level performance, it is best to focus on the industry

leaders' ratios. Benchmarking helps in this regard.

Inflation may have badly distorted firms' balance sheet- recorded values are often substantially

different from "true" values. Further, because inflation affects both depreciation charges and

inventory costs, profits are also affected. Thus, a ratio analysis for one firm over time, or a

comparative analysis of firms of different ages, must be interpreted with judgment.

Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a

food processor will be radically different if the balance sheet figure used for inventory is the one

just before versus just after the close of the canning season. This problem can be minimized by

using monthly averages for inventory (and receivables) when calculating turnover ratios.

Firms can employ "window dressing" techniques to make their financial statements look

stronger.

Different accounting practices can distort comparisons. As noted earlier, inventory valuation

and depreciation methods can affect financial statements and thus distort comparisons among

firms. Also, if one firm leases a substantial amount of its productive equipment, its assets may

appear low relative to sales because leased assets often do not appear on the balance sheet, at

the same time, the liability associated with the lease obligation may not be shown as a debt.

Therefore leasing can artificially improve both the turnover and the debt ratios. However

accounting professional has taken steps to reduce this problem.

It is difficult to generalize about whether a particular ratio is "good" or "bad". For example, a

high current ratio may indicate a strong liquidity position, which is good or excessive cash,

which is bad (because excess cash in the bank is a non-earning asset). Similarly, a high fixed

assets turnover ratio may denote either that a firm uses its assets efficiently or that is

undercapitalized and can not afford to buy enough assets.

A firm may have some ratios that look "good" and others that look "bad," making it difficult to

tell whether the company is, on balance, stronger or weak. However statistical procedures can

be used to analyze the net effects of a set of ratios. Many banks and other lending organizations

use discriminant analysis, a statistical technique, to analyze firms' financial ratios, and then

classify the firms according to their probability of getting into financial trouble.

Accounting Information

Different Accounting Policies

The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows

valuation of assets to be based on either revalued amount or at depreciated historical cost. The business

may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will

result in lower profit.

Creative accounting

The businesses apply creative accounting in trying to show the better financial performance or position

which can be misleading to the users of financial accounting. Like the IAS 16 mentioned above,

requires that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense

in income statement, but if it results in revaluation surplus the surplus should be credited to revaluation

reserve. So in order to improve on its profitability level the company may select in its revaluation

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programme to revalue only those assets which will result in revaluation surplus leaving those with

revaluation deficits still at depreciated historical cost.

Information problems

Ratios are not definitive measures

Ratios need to be interpreted carefully. They can provide clues to the company's performance or

financial situation. But on their own, they cannot show whether

Performance is good or bad.

Ratios require some quantitative information for an informed analysis to be made.

Outdated information in financial statement

The figures in a set of accounts are likely to be at least several months out of date, and so might not give

a proper indication of the company's current financial position.

Historical costs not suitable for decision making

IASB Conceptual framework recommends businesses to use historical cost of accounting. Where

historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios

based on this information will not be very useful for decision making.

Financial statements certain summarized information

Ratios are based on financial statements which are summaries of the accounting records. Through the

summarization some important information may be left out which could have been of relevance to the

users of accounts. The ratios are based on the summarized year end information which may not be a true

reflection of the overall year's results.

Interpretation of the ratio

It is difficult to generalize about whether a particular ratio is `good' or `bad'. For example a high current

ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly

Non current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is

under capitalized and cannot afford to buy enough assets.

Comparison of performance over time

Price changes

Inflation renders comparisons of results over time misleading as financial figures will not be within the

same levels of purchasing power. Changes in results over time may show as if the enterprise has

improved its performance and position when in fact after adjusting for inflationary changes it will show

the different picture.

Technology changes

When comparing performance over time, there is need to consider the changes in technology. The

movement in performance should be in line with the changes in technology. For ratios to be more

meaningful the enterprise should compare its results with another of the same level of technology as this

will be a good basis measurement of efficiency.

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Changes in Accounting policy

Changes in accounting policy may affect the comparison of results between different accounting years

as misleading. The problem with this situation is that the directors may be able to manipulate the results

through the changes in accounting policy. This would be done to avoid the effects of an old accounting

policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the

business's profits are low.

Changes in Accounting standard

Accounting standards offers standard ways of recognizing, measuring and presenting financial

transactions. Any change in standards will affect the reporting of an enterprise and its comparison of

results over a number of years.

Impact of seasons on trading

As stated above, the financial statements are based on year end results which may not be true reflection

of results year round. Businesses which are affected by seasons can choose the best time to produce

financial statements so as to show better results. For example, a tobacco growing company will be able

to show good results if accounts are produced in the selling season. This time the business will have

good inventory levels, receivables and bank balances will be at its highest. While as in planting seasons

the company will have a lot of liabilities through the purchase of farm inputs, low cash balances and

even nil receivables.

Inter-firm comparison

Different financial and business risk profile

No two companies are the same, even when they are competitors in the same industry or market. Using

ratios to compare one company with another could provide misleading information. Businesses may be

within the same industry but having different financial and business risk. One company may be able to

obtain bank loans at reduced rates and may show high gearing levels while as another may not be

successful in obtaining cheap rates and it may show that it is operating at low gearing level. To un

informed analyst he may feel like company two is better when in fact its low gearing level is because it

can not be able to secure further funding.

Different capital structures and size

Companies may have different capital structures and to make comparison of performance when one is

all equity financed and another is a geared company it may not be a good analysis.

Impact of Government influence

Selective application of government incentives to various companies may also distort intercompany

comparison. One company may be given a tax holiday while the other within the same line of business

not, comparing the performance of these two enterprises may be misleading.

Window dressing

These are techniques applied by an entity in order to show a strong financial position. For example,

ABC Trucking can borrow on a two year basis, K10 Million on 28th December 2006, holding the

proceeds as cash, then pay off the loan ahead of time on 3rd January 2007. This can improve the current

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and quick ratios and make the 2006 balance sheet look good. However the improvement was strictly

window dressing as a week later the balance sheet is at its old position.

Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as

necessary. Ratios analysis conducted in a mechanical, unthinking manner is dangerous, but if used

intelligently and with good judgment, it can provide useful insights into the firm's operations.

Three broad areas of evaluating a business are its solvency, stability and profitability, which are studied

through analysis of financial statements. There are four techniques of Financial Statements Analysis.

ANALYSIS TECHNIQUES

Rupee and percentage changes: figures of Financial Statements from one year to the next i.e.

year-to-year are considered.

Income Statement for the year ending June, 30

2001

2002

2003

Net sales

400

500

600

Cost of Good Sold.

235

300

370

Gross profit.

165

200

230

Other expenses.

115

160

194

Net income.

Percentage change cannot be computed for negative amount or zero amount in base

year. Mere figure of rising sales are not sufficient. We have to look at the volume of sales vis-à-vis sale

price. Quarterly or monthly measurement is also done. It compares results of current quarter or month

with those of the same quarter or month in the previous year in order to take care of distortion by

seasonal fluctuations. Size of base amount has to be reasonable (Example: 90% decline to be followed

by 900% increase just to get back to the starting point). Percentage become misleading when base is

small:

1st year

2nd year

3rd year

Income

100,000

10,000

100,000

(90% decline)

(900% increase)

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