MIDLANDS STATE UNIVERSITY
FACULTY OF COMMERCE
DEPARTMENT OF ACCOUNTING
Financial Statement Analysis:
Macc 502
By
Kazembe Chitombo Edwin
Chapter I
Introduction
Educational objectives:
By end of unit you should be able to:
Describe the objectives of Financial Statement Analysis
Identify financial statement users and the relevant information to their needs.
Draw up the basic framework of financial statements: Income statement, balance sheet, statement of changes in equity and cash flow statement.
Identify additional information accompanying financial statements
Explain the different stages in financial analysis.
The objective of financial reporting (Correria, Flynn and Xcv :5-1) is to provide financial information needed “…for the purpose of decision-making.”Bernstein and Wild(1998:3) call these financial reports “…past financial performance and current financial position.” The emphasis is that the financial reports contain historical performance and not current performance.
Financial analysis ( http://www.wikipedia.org July 26, 2007 , 14:00hrs) is “…an assessment of the viability, stability and profitability of a business, sub-business or project.” The analysis is usually performed by professionals who prepare reports using financial ratios that “…make use of information taken from financial statements and other reports…(as a) basis in making business decisions.”
Normally, (Chijoriga, ) financial analysis is a process “…which involves reclassification and summarisation …(of) financial reports…the starting point of financial statement analysis.” These statements should be the audited financial statements (www.investopedia.com). The process “…applies analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business decisions.”
Financial statement analysis are :
Ø a screening tool in selecting investment or merger candidates
Ø a forecasting tool of future financial conditions and consequencies
Ø a diagnostic tool in assessing financing, investing, operational activities
Ø an evaluation tool for managerial and other business decisions (Bernsten and Wild,1998:3)
The financial reports comprise the following:
Ø income statement
Ø balance sheet
Ø statement of changes in equity
Ø cash flow statement.
The other reports are:
Ø Chairman’s report
Ø Independent auditor’s report
Ø And social responsibility report. (ACN102-N/1:6 and DZL Holdings 2005 Annual Report.)
These sources of financial information are”…both descriptive and numeric …” in nature with items categorized, grouped in such a manner that anybody with a “…reasonable understanding of accounting…” can use them.(Acn102-N/1:6)
Financial performance is reported by the Income statement whose equation is:
Revenue minus Operational Expenses = Net profit/ (loss).
This performance is measured over a period of time: monthly, quarterly, semi-annually and annually. The information is historical in nature.
Financial position is revealed on a specific date eg 31 December 2005 for DZL Holdings, listing all the assets (non-current and current assets), liabilities ( non-current and current liabilities) following the balance sheet equation:
Assets (nca + ca) = Liabilities (ncl +cl) + Shareholders’ equity
( ordinary share capital + Retained earnings +Reserves). (http://www.investopedia.com)
A balance sheet is a “snap-shot” (Correia:5-4) at a particular point in time.
The cash flow statement “…emphasize the critical nature of cash flow to the operations of the firm.”( Dube et al,2001:19) These cash resources are generated from operations, financing and investing activities of the entity.
The statement of changes in equity presents the profit/loss for the year, dividends received/paid, capital transactions and reserves.(DZL Holdings, 2005:48-9 and ACN102-N/1:9)
Note that the DZL Holdings 2005/6 Annual Report will be used as the case study for these purposes and the financial reports are supplied in Appendices XXX.
The results of financial statement analysis are the decisions by different users of that financial data. Fig.1 below summarises this process:
Fig.1 The process of Financial statement analysis.
Input Processing Output
(Source: Adapted from O’Brien,2004:10)
The financial reports from entities are not restricted to these two above, but are only illustrative.
Users of financial reports.
There are a whole host of financial statement users who perform this analysis and they are given below including what needs they have. Broadly there are two groups/classes of these financial statement users: Internal users and External users.
v Managers
“… (of an entity tasked to make ) operating and strategic decisions” for the entity; they have unlimited, intricate access to the company’s financial information system. Management accounts/reports are generated in such detail, frequency and format tailor made for this class of decision makers…the Chief Executive Officer, Finance Director and other managers.(ACN102-N/1:9)
External users
These form the other class of financial statements users. They are “…individuals not directly involved in the company’s operations.” They rely on the financial information produced by management through financial reports that are more summarized than management reports
(Weil and Noi xxx:238, and Bersten and Wild, 1998:5) itemized these external users:
v Equity investors .These are both the existing and potential shareholders. The former is interested in whether “to hold or sell” the stock, the return on investment, its timing and size including capital gains.
The latter want to select stocks to buy from a range of competing alternatives.
These users are mainly interested in the “…future profitability and/or riskiness of a company.” Merger and acquisition analysts look for economic value and “…assess the financial and operating compatibility of potential merger candidates.”
v Auditors . These use financial statement analysis to identify “…areas warranting special attention…” when auditing financial statements of the entity. Their desire is to establish if the financial statements “…fairly present the position and results of the entity.” (Weil and Noi,xxx:239). The teckniques used to arrive at this opinion include “…an analytical review…” of the company, trend and consistent analysis from year to year. This ensures financial statements’ “…reliability and comparability.” ( ACN102-N/1:6, Weil and Noi Xxx:239, Bernstein and Wild,1998:5)
v Creditors. Normally these are the financiers of the entity who provide debt either as short-term or long-term liabilities. Suppliers of inputs to the production process of the entity are also classed the same. Bankers and suppliers look for evidence concerning the ability of the company repaying advanced loans on maturity plus interest falling due.
v Regulatory agencies. These use financial statements for the purposes of supervision especially the Zimbabwe Stock Exchange and Zimbabwe Revenue Authority. Reporting entities should comply with laws of the country, and price controls in force.
v Customers. These evaluate the “staying power” of the entity to keep supplying them with economic goods and services.
v Employees. This class of external users wants to evaluate the fairness of their wages, working conditions and ultimately, job security.
Discussion: DZL Holdings 2005 Annual Report
In groups of four:
Ø Study the financial statements of DZL Holdings---the Balance sheet, Income statement, cash flow statement and the statement of changes in equity.
Ø Analyse the various segments of each statement.
Ø The financial statements are inter-related. Apply the following links
Fig .2
Financial links for DZL Holdings
31/12/05 (Period of time) 31/12/06
Source: Adapted from Bernstein and Wild, (1998:17)
The whole purpose of financial analysis is to take decisions that relate to the future. Subjectivity is unavoidable here as forecasting future conditions has a lot of uncertainty. One needs to thoroughly “understand past and current events and conditions.”
Typical stages in financial analysis.
When the objective of the analysis has been established, the analytical approach takes the following stages as in Fig 3:
Fig.3 Stages in financial analysis.
Source: Weil and Noi,( XX:240)
Selection: An appropriate technique and line item(s) are chosen to bring out the required objective. The technique should extract the relevant information from that available and the relevant data is selected from the financial statements as input to be processed.
Comparison:
The output of this analysis is a “monetary value, a set of numbers, a ratio or a percentage.” These outcomes are then compared against a selected benchmark or benchmarks to facilitate evaluation. Some benchmarks could be:
· Previous years outcomes. Is there an improvement in results as compared to the previous year? Is there progress in the current situation/outcome?
· Budgets and targets: The financial plan at start of year sets targets to be met. Actual outcome is compared to the budgets and targets. Such a comparison shows up deviations from the financial plan and affords the analyst an “opportunity to assess the reasons for the divergence.”
· Similar entities: Entities in the same industry tend to have similar trends in financial performance and position. The entity therefore would compare its performance against those of other entities in the same industry.
· Industry standards: These are independent and objective. They “reflect the results obtained across the industry during a period” the industry is experiencing similar conditions and economic events. This standard may not apply smartly if the entity is a conglomerate.
Evaluation: The question to be answered is: Does the outcome meet the set standard, target or benchmarks? The answer could either be---favourable, unfavourable or indifferent. Unfavourable outcomes require exhaustive reasons to explain the deficit and profer ways to improve the unfavourable outcome. The analyst requires “insightful and experienced judgement” at this stage.
Prediction: This is more futuristic in outcome than the analysis of the past performance of the entity as outlined above. The analyst predicts future performance basing this projection on the current and other conditions. This process is full of uncertainty. See the DZL Holdings 2006 Annual Report on the conditions affecting the entity and the expectations into the future.
Analysis within the environmental context.
To be able to successfully predict the future performance of the company, the analyst should consider a variety of factors including variables within the entity itself and those external to it. The DZL Holdings 2006 Annual Reports pages 5-25 are useful for this purpose. Also , Fig.4 below gives the scope of these external variables and how they impact on the predictions by analysts..
Fig.4 External variables
Global
Regional economy
economy
National
economy
Entity Industry
Source: Adapted from Weil and Noi ,(XXX:242)
In groups, summarise the external variables affecting and likely to affect DZL Holdings now and into the future. Use what is published now and other sources of information available.
Is Zimbabwe under sanctions?
Internal variables.
The flexibility of an entity to adapt to changes taking place externally is affected and influenced by the internal variables. For example how has DZL Holdings adapted to the changing operating environment? Can you say it has been a success story? Motivate your answer.
Consider the following among other variables:
ü Flexibility of the company---especially adaptability to changing conditions and to survive
ü Quality of management---poor management is a major contributory factor to business failure.
ü Predictions of future sales
ü Quality of personnel and personnel relations especially their impact on productivity and loyalty (Weil and Noi, XXX:243)
Other reports accompanying financial statements
It is not possible to predict the future performance of an entity based on the quantitative reports. One needs access to other reports from where inferences are made about the direction the organization is taking. See the DZL Holdings 2006 Annual reports on
www.dairibord.co.zw.
Some of these reports are:
§ Chairman’s report or statement
§ Chief executive’s statement
§ Independent Auditor’s report
§ Corporate Social responsibility report.
(DZL Holdings 2005/6 Annual Report)
From these other reports, a lot of insight is gained by the financial analyst. Most of these reports are futuristic in nature but do not paint the whole picture. One needs more information from other sources.
Other sources of information
The information given by an entity is insufficient for the purposes of financial statement analysis. Other sources of information to give a “ comprehensive financial analysis of an entity” are:
Ø Bank publications eg RBZ Quarterly Bulletin
Ø The Registrar of companies on such issues as Memorandum and Articles of Association of the entity.
Ø Investment advisory services and research institutions where researchers and analysts publish their researche findings and opinions with respect to “future trends” for clients and subscribers.
Ø Financial press, especially the Financial gazette and Business Herald which have columns eg Kingdom, Dogs and Diamonds, Bulls and Bears, etc on a weekly basis.
Ø Industry surveys sponsored by a number of institutions, eg, “Top Companies Survey” from Fingaz.
Ø The Zimbabwe Stock Exchange publications where “ statistics of movements in prices of listed company shares and overall indices” and similar information to do with new issues of shares are disclosed. (Wiel and Noi, XXX:244, Bernstein and Wild,1998:18-20).
Limitations of accounting data
The greater part of financial statement analysis is based on the financial statements published by entities on a regular basis. Accounting data is the dominant input although other sources do provide financial information.
Major limitations from financial statements are:
Ø Monetary expression. Accounting data expresses financial information”in terms of monetary value” thereby excluding non-monetary value attribute such as:
Management team, human resources valuation. The DZL Holdings at www.dairibord.co.zw has such information supplied. Some managers have been given the opportunity to further their studies and it is expected that they will apply the new knowledge gained in the “operational and strategic’ decisions DZL will make to power the entity into the future. However, there are no monetary values attached to this investment. It is a limitation of the financial statements since this positive development is only given a qualitative description.
DZL Holdings attained ISO14000 status “ in commitment to conducting business in a manner that is environmentally friendly” but such a valuable investment is not given a monetary value.(DZL Holdings 2005:13) This is in response to global trends in trading partners.
A code of conduct was reviewed to strengthen “sound industrial relations” which are not monitarised yet these industrial relations affect greatly business operations, profitability and future prospects of the entity. The financial analyst can only infer the likely impact of this essential development. If indeed “high ethical standards” are attained, the image of the entity in the public is raised for the good of business.
Other matters that are crucial in the conduct of business not given a monetary value include HIV/Aids policy to minimize the “impact of Hiv and AIDS on productivity for the benefit of the business and employees.” The financial analyst is limited in assessing this huge investment and initiative by DZL management. Just how important is it, is not expressed in numeric terms as if there is no cash outflow that is made in anticipation of a return in one form or another.