Financial Statement Analysis

Dr. Mahmood Osman Imam Framework for Financial Statement Analysis

Financial Statements are at best, only an approximation of economic reality because of the selective reporting of economic events by the accounting system, compunded by alternative accounting methods and estimates. Financial statements are useful because they help investors and creditors make better decisions. Financial statements tend to lag behind reality, as there is a tendency to delay accounting recognition of some transactions and valuation changes.

Need for Financial Statement Analysis

Economic events and accounting entries do not correspond precisely; rather diverge across the dimensions of timing, recognition, and measurement. Financial analysis become further complicated by the variations in accounting treatment among countries in each of these dimensions. Economic events and accounting recognition of those events frequently take place at different times. (For example, recognition of capital gains and losses only upon disposal in most cases; appreciation of a real estate investment). In addition, many economic events do not receive accounting recognition at all. (For example, most contracts, such as lease, derivatives and hedging activities are not reflected in financial statement when entered into, despite significant effect upon financial condition and operating and financial risk. Financial reports often contain supplementary data that help the financial statement user to interpret the statements or adjust measures of corporate performance to make them more comparable, consistent over time, and more representative of economic reality. (The analytic treatment of off-balance-sheet financing activities is a good example of this process). Information from outside the financial reporting process can be used to make financial data more useful.

Information Useful in Investment and Credit Decisions

Financial reporting should provide information that is useful to present & potential investors and creditors and other users in making rational investment, credit and similar decisions.

Classes of Users Primary users Equity investors and creditors Government, regulatory bodies, tax authorities The general public and special interest groups labor unions and customer groups
Equity investors interested in the long-term earning power of the company, its ability to grow, and ultimately its ability to pay dividends and increase in value. They bear residual risk and hence require comprehensive analysis encompassing techniques employed by all other external users. Short-term creditors emphasize on the immediate liquidity of the business because they seek an early payback of their investment. Long-term investors in bonds, such as insurance companies and pension funds concerned with the long-term asset position and earning power of the company. They seek assurance of the payment of interest and the capability of retiring or refunding the obligation at maturity.

Financial Information and Capital Markets

Research findings, with regard to the interrelationship between accounting information and reporting standards on capital markets, are highly critical of the accounting standard-setting process and of the utility of financial analysis. These findings do not negate the usefulness of financial analysis of individual securities that may be mispriced or for decisions made outside a capital market setting, e.g. credit decisions made by banks or other institutional lenders. Financial data are useful to investors only for prediction of a firms risk characteristics. This reasoning is in line with the financial literature and EMH. The impact of accounting is not so much in its information content itself, but rather in the economic consequences to the firm resulting from contracts that are based on or driven by accounting-determined variables (e.g. management compensation contracts)

OBJECTIVES
Interpretation of financial statements, from an accounting point of view, and from an economic/financial/managerial standpoint. The comparative measurement of risk and return to make investment or credit decisions. How to use financial tools (Ratios, Statement of Cash Flows, Pro-forma Statements ) To understand and evaluate the impact of investment and financing decisions To make the diagnosis of the condition of a business unit

The Financial Reporting Systems Three Basic Financial statements: Balance Sheet (Statement of Financial Position) It shows the financial position of a firm on a given date. (Stock Concept). Income Statement (Statement of Earnings) It shows the accounting flows of Revenues and Expenses during a time period. (Flow Concept). Statement of Cash Flows Cash Flow Statement provides information that enables users to evaluate Changes in net assets Its financial structure Ability to affect amounts Ability to affect timing of cash flow The Balance Sheet (BS) : The balance sheet as of any given date describes the categories and amount of assets employed by the business (i.e. the funds committed) and the offsetting liabilities incurred to lenders and owners (i. e. the funds obtained). Assets reported on the BS are either purchased by the firm or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the firm.

 This fundamental accounting relationship is expressed as the balance sheet equation:

ASSETS (A) LIABILITIES (L) + OWNERS EQUITY (E)

Indicates how those resources were financed Represent the resources owned by the firm Balance sheets are static in that, like a snapshot, they reflect conditions on the date of their preparation. They are also cumulative in that they represent the effects of all decisions and transactions that have taken place and have been accounted for up to the date preparation. Income Statement: The income statement reflects the effect of managements operating decisions on business performance and the resulting profit or loss for the owners of the business over a clearly specified period of time. It matches revenues and expenses for a specified period, including write-offs and allocations. It provides more detail about the elements making up the after-tax net profit and loss that was recorded in arriving at the owners equity on the balance sheet.

Factor affecting Demand for financial statement information

Potential of the Information to reduce uncertainty Level of uncertainty faced by a decision maker and expected gains from reducing uncertainty Role that FSA can play in revising beliefs about uncertainty Availability of Competing Information Sources Higher the availability of competing information sources (such as, company-oriented releases dividend releases & production reports; industry-oriented releases new wage contracts with unions; economy-oriented releases money supply announcements), the lesser the demand for financial statement information.

Financial statements may have an advantage over other competing information sources precisely because, Financial statement information is directly related to the variable of interest on which business contracts are written, and Financial statement information is a more reliable, lower-cost and more timely information source.

Roles of Financial Statement Information Financial statement information can play an important role in revising beliefs about uncertainty in investment and credit decisions. It is to serve as an observable on which contracts are written. General Principle and Measurement Rules

Under accrual accounting, revenues are recognized when goods are delivered or services are performed and expenses are recorded as services are used, rather than when cash is collected or expenditure incurred for these transactions. Financial statements are prepared using a monetary unit to quantify the operations of the firm. Transactions are generally measured at their historical cost, the amount of cash or other resources exchanged for the asset or liability; changes in value subsequent to acquisition are usually ignored. Financial reporting also relies on the going concern assumption, which the firm will continue in operation indefinitely.

Additional Statements: Pro Forma Balance Sheet and Pro Forma Income Statement Remarks: Additional comments to the basic statements very often provide in depth information on the figures in the balance sheet and income statement. For example, Summary of accounting policy, currency exchange rates, details of LT debt, Classes of shareholders equity, footnotes on contingent liabilities and off-balance sheet items.

 BASIC PROBLEMS WITH INTERPRETATION OF FINANCIAL STATEMENTS

BALANCE SHEET AND INCOME STATEMENT

ARE DRAWN UP CONFORM TO ACCOUNTING PRINCIPLE

Possible Deviations from Financial-Economic Reality

BOTH BALANCE SHEET AND INCOME STATEMENT ARE DEALING WITH THE PAST

FUTURE? However, financial statements provide the basis for projecting future earnings and cash flows. Approach to the Analysis Main question in the financial analysis: Is a firm heading for financial problems? Absence of financial problems is basic condition for normal functioning of a company Once preceding condition is met, analysis depends on heavily on the objectives (e.g. Manager Creditor Shareholders financial analyst M & A Specialist ..) and the situation (e.g. industry structure, competitive position of the company in Industry, .). Supply of Financial Statement Information The factors that affect the content or timing of financial statement disclosure include A) Regulatory Forces (SEC, Company Act) B) Market Forces (Capital market, Labor market, corporate control market) C) The costs associated with those disclosure (collection & processing costs, litigation costs, competitive disadvantage costs, political costs)

The voluntary disclosures are more likely the result of market forces rather than regulatory-based forces.

Capital Market Forces Firms compete with each other in the capital market on many dimensions. These dimensions include: The instruments Offered equity securities, bank loans and so on The terms of the instruments offered The distribution of expected returns from each instrument.

Two features of the capital market Uncertainty of the quality of the product There is a cost of being perceived as a lemon (as in the used car market) Akerlof (1970)

Prepared By
Prof. Dr. Mahmood Osman Imam Department of Finance Faculty of Business Studies; DU. Contact: 01713036211

Reformed By
M.K.M Prottoy rd EMBA 23 batch; Department of Finance University of Dhaka Contact: 01716600333 Web: prottoy.yolasite.com