Introduction to Financial Statement Analysis

Fundamental Concepts and Introduction to Financial Reporting

Introduction to Financial Statement Analysis

Analysis of financial statement is the systematic numerical calculations of the relationship between one fact with the other to measure the profitability, operational, efficiency, solvency and the growth potential of Business. A major source of information regarding a firms operating performance and its resources is the firms financial statement package. Analyzing a set of financial statements involves using ratios of key financial statement items and other tools to gain insight into the profitability and risk of a firm. Financial statement analysis can help us to better understand the business risk and the financial risk of a firm. Tom Rourke

Purpose of Financial Statements

Financial statements are a structured representation of the financial position (Balance Sheet) and financial performance (Income Statement) of an entity. The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of managements stewardship (Planning & Management) of the resources entrusted to it. To meet this objective, financial statements provide information about an entitys:
P.T.O

Purpose of Financial Statements (Cont.)

(a) assets (b) liabilities (c) equity (d) income and expenses, including gains and losses (e) other changes in equity; and (f) cash flows This information, along with other information in the notes, assists users of financial statements in predicting the entitys future cash flows and, in particular, their timing and certainty.

Component of Financial Statements

A complete set of financial statements comprises: a balance sheet; an income statement; a statement of changes in equity showing either: all changes in equity, or changes in equity other than those arising from transactions with equity holders acting in their capacity as equity holders; a cash flow statement; and notes, comprising a summary of significant accounting policies and other explanatory notes.

Principal Financial Statements

Financial statements are intended to provide information on the operating performance and financial health of a business during a specified period of time. In the US, financial statements are required to stick to GAAP (although GAAP does allow some flexibility).
One goal is to make the financial statements of one firm comparable across time and to the financial statements of other firms. Tom Rourke

Principal Financial Statements, (Cont.)

GAAP requires firms to present balance sheets for the two most recent years and income statements and statements of cash flows for the three most recent years in a set of financial statements. In addition, firms are required to present notes to the financial statements that provide information on the accounting methods used by the firm to construct the financial statements.
Tom Rourke

Users of Financial Statements

Users of statements the financial Interest of the user
(existing and They are interested whether buy, hold or sell the shares in hand and also enable them in payment of dividends. Equity investors potential)

Loan creditors ie, existing and The amount will be paid when due and for potential holders of debentures and continuation of the business. loan stock, and providers of shortterm loans Employees (existing, potential and Interested in stability and profitability for past) employment opportunities, remuneration and retirement benefits. Business contacts including Whether the payment of loan will be made in due customers, trade creditors, dates and enable sustainability of business for future competitors and potential take-over business with the enterprise. bidders Government, including tax Interested in allocation of resources and also to authorities, government departments regulate the activities of an enterprise and and local authorities determining tax policies and as a basis for national income. Public, including tax payers, Trends and recent development in the prosperity of ratepayers and environmental groups the entity and range of its activities.

Financial Statement Analysis Framework

The financial statement analysis framework includes the following steps.
Identify the purpose and objectives of the analysis. Review the financial statements, notes and audit opinion. Determine whether restatements are necessary to enhance the comparability of the statements.

Financial Statement Analysis Framework (Cont. 1)

Determine whether the firm's size, capital structure, and product mix are appropriate to proceed with the ratio calculations. Conduct horizontal and vertical analyses of each financial statement, with special emphasis on the income statement. Calculate the basic liquidity ratios. Calculate profitability ratios based on net income and on cash flow from operating activities. Evaluate trends.

Financial Statement Analysis Framework (Cont. 2)

Evaluate the firm's capital structure with special emphasis on trends in the percentage composition ratios. Examine the firm's market performance using the investor ratios. Examine any inconsistencies in the ratio results, review notes, and recalculate the ratios.

Financial statement analysis:

Tools and approaches
Tools:

Approaches used with each tool:

1. Time-series analysis: the same firm over time (e.g., Wal-Mart in 2008 and 2006) 2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2008). 3. Benchmark comparison: using industry norms or predetermined standards.

Common size statements

Trend statements

Financial ratios (e.g., ROA and ROCE)

Limitations of Financial Statement Analysis

Financial statement analysis is limited due to several items.
GAAP presents some limits. Managers often have the ability to select favorable accounting methods. Many major factors affecting profitability and survival of the firm are not included in the financial statements.
A perfect example is human resources.

Limitations of Financial Statement Analysis (Cont.)

While employees are often a firm's most important asset, a value for employees does not appear on the balance sheet. Financial statement analysis relies on past numbers, and the past may not be a reliable indication of the future.

Basic Assumptions for Preparation of Financial Statements

Over all considerations of preparing and presenting financial statements Business Entity Fair Presentation and Compliance with IFRS Going Concern or Continuity Time Period Monetary Unit Historical Cost Realization Matching Consistency Full Disclosure Materiality and Aggregation Off setting Comparative Information

Basic Assumptions
Business Entity
The concept of Business Entity means that business or entity is a separate and distinct from the owners of the entity for which financial statements are prepared

Fair Presentation and Compliance with IFRS.

Financial statements shall present fairly the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework.

Basic Assumptions Going Concern

The going-concern assumption is that the entity will remain in the business for an indefinite period of time, provides viewpoint on the future of the entity. This assumption deliberately disregards the possibility that the entity will go bankrupt or liquidated. If a particular entity is in fact threatened with bankruptcy or liquidation then going concern assumption should be dropped.

The only accurate way to account for the success or failure of an entity is to accumulate all transactions from the opening of the business until the business eventually liquidates. Accountants needs some standard of measure to bring financial transactions together in a meaningful way. Accountant should specify the unit of measure i.e $ or PKR according to the country in which statements is prepared.

Time Period

Monetary Unit

Basic Assumptions Historical Cost

Historical cost is used in practice because it is objective and determinable. The Assets are recorded in financial statements on historical cost.

Consistency of Presentation
The presentation and classification of items in the financial statements shall be retained from one period to the next unless: it is apparent, following a significant change in the nature of the entitys operations or a review of its financial statements, that another presentation or classification would be more appropriate having regard to the criteria for the selection and application of accounting policies.

Basic Assumptions Matching

Accountants need to recognize the costs associated with the recognized revenue. The basic intent is to determine the revenue first and then match the appropriate costs against this revenue. Cost of inventory can be easily matched with revenue.

Realization
While preparing FS, Accountants need to determine that when it is practical to recognize revenue.

Full Disclosure
The accounting report must disclose all facts that may influence the judgment of an informed reader. Several method of disclosure exit such as footnotes and cross references.

Basic Assumptions
Materiality and Aggregation Each material class of similar items shall be presented separately in the financial statements. Items of a dissimilar nature or function shall be presented separately unless they are immaterial.
Off setting Assets and liabilities, and income and expenses, shall not be offset unless required or permitted by a Standard or an Interpretation. Comparative Information Except when a Standard or an Interpretation permits or requires otherwise, comparative information shall be disclosed in respect of the previous period for all amounts reported in the financial statements. Comparative information shall be included for narrative and descriptive information when it is relevant to an understanding of the current periods financial statements.

Basic Assumptions Transaction Approach

A transaction is any event that affects the financial position of an organization and requires recording. There are two approaches of transaction recording: Accrual Basis of Accounting An entity shall prepare its financial statements, except for cash flow information, using the accrual basis of accounting.
The accrual basis of accounting recognizes revenues and expenses when they occur regardless of when cash is received or disbursed.

Cash Basis of Accounting

The cash basis of accounting recognizes revenue and expense when cash is received and disbursed.

Financial Statements Reporting Framework

The reporting frame work that is applicable in Pakistan while preparing and presenting of financial statements is as follows:
Applicable Laws and Regulations Listed Companies other than, Insurance, NBFCs, Modaraba and Bank Banking Companies Companies Ordinance 1984. International Financial Reporting Framework (IFRS) as applicable in Pakistan Stock Exchange Listing Regulations International Financial Reporting Framework (IFRS) as applicable in Pakistan Companies Ordinance 1984. Stock Exchange Listing Regulations (Particularly Code of Corporate Governance) Banking Ordinance 1962 Prudential Regulations (Corporate, SMEs and Consumers) International Financial Reporting Framework (IFRS) as applicable in Pakistan Companies Ordinance 1984 Stock Exchange Listing Regulations Insurance Ordinance and Rules Regulating Authority Securities and Exchange Commission of Pakistan (SECP) Securities and Exchange Commission of Pakistan and State Bank of Pakistan.

Insurance Companies

Securities and Exchange Commission of Pakistan.

Financial Statements Reporting Framework (Cont.)

Applicable Laws and Regulations Non Banking Finance Companies (Leasing Companies, Investment Companies, International Financial Reporting Framework (IFRS). Companies Ordinance 1984. Stock Exchange Listing Regulations (Particularly Code of Corporate Governance) NBFC Rules. Prudential Regulations for NBFCs Prudential Regulations for Leasing Company International Financial Reporting Framework (IFRS). Companies Ordinance 1984. Stock Exchange Listing Regulations (Particularly Code of Corporate Governance) Modarba Act and Rules Regulating Authority Securities and Exchange Commission of Pakistan.

Modarba

Securities and Exchange Commission of Pakistan and Registrar of Modarba

Tom Rourke

Why

Do

We Audit Statements

Financial

In this section we look at the following: Need for audit Objective of the audit

Need for Audit

Principle provides capital and hires manager to manage it.
Principle (Shareholders)

Information asymmetry and conflict of interest lead to information risk for the principle

Directors

Director is accountable to Principle; provides financial reports.

Auditor gathers evidence to evaluate fairness of manager financial statements. Directors hires auditors to report on the fairness of manager financial statements. Risk information asymmetry of principle reduce.

Auditor

Objective of Audit

The objective of the audit is to express an opinion on the financial statements whether or not the financial statements present fairly.

End