UNIVERSITY OF NAIROBI SCHOOL OF BUSINESS DEPARTMENT OF ACCOUNTING MBA PROGRAMME DAC 501: FINANCIAL ACCOUNTING Abdullatif Essajee and

d Herick Ondigo ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT

Introduction: Financial statements are essentially historical and static documents. They tell us what has happened during a particular period or series of periods of time. The most valuable information to most users of financial statements or reports, however, concerns what probably will happen in the future. The purpose of financial statement analysis is to assist statement users in predicting the future by means of comparison, evaluation and trend analysis. The first procedure in financial statement analysis is to obtain useful information. The main sources of financial information include, but are not limited to, the following: (i) Published reports Quoted companies normally issue both interim and annual reports, which contain comparative financial statements and notes thereto. Supplementary financial information and management discussion as well as analysis of the comparative years operations and prospects for the future will also be available. These reports are normally made available to the public as well as to the shareholders of the company. (ii) Registrar of companies Public companies are required by law to file annual reports with the registrar of companies. These reports are available for perusal at the registry upon payment of a minimum fee. (iii) Credit and investment advisory agencies Some firms specialize in compiling financial information for investors in annual supplements. Many trade associations also collect and publish financial information for enterprises in various industries. Major stock brokerage firms and investment advisory services compile financial information about public enterprises and make it available to their customers. Some brokerage firms maintain a staff or research analysis department that study business conditions, review published financial statements, meet with chief executives of enterprises to obtain information on new products, industry trends, negative changes and interpret the information for their clients.

(iv) Audit reports When an independent auditor performs an audit, the audit report is usually addressed to the shareholders of the audited enterprise. The audit firms frequently also prepare a management report, which deals with a wide variety of issues encountered in the course of the audit. Such a management report is not a public document, however, it is a useful source of financial information. (v) Government statistics and Market research organizations Objectives of financial statement analysis Financial analysis is the process of critically examining in detail, accounting information given in financial statements and reports. It is a process of evaluating relationships between component parts of financial statements to obtain a better understanding of a firm's performance and financial position. Financial statement analysis involves three basic procedures: 1. Selection This involves the selection from the total information available about an enterprise, the information that is relevant to the decision under consideration. 2. Relation This involves arranging the information in a manner that will bring out a significant relationship(s). 3. Evaluation This involves the study of the relationship and interpretation of the result thereof. The specific objectives of financial statement analysis Financial statements are essentially a record of the past. Business decisions naturally affect the future. Analysts therefore study financial statements as evidence of past performance that may be used in the prediction of future performance. The specific objectives of financial statement analysis are to: (a) assess the past, present and future earnings of an enterprise, (b) assess the operational efficiency of the firm as a whole and its various divisions or departments, (c) asses the short term and long term solvency of the firm, (d) assess the performance of one firm against another or the industry as a whole and the performance of one division against another, (e) assist in the developing of forecasts and preparation of budgets, (f) assess the financial stability of the business under review, and

(g) assist in the understanding of the real meaning and significance of financial information. Usefulness of Analysis The figures in the financial statements are rarely significant or important in themselves. It is their relationships to other quantities, amounts and direction of change from one point in time to another point in time that is of importance. It is only through comparison that one can gain insight into trends and make intelligent judgments as to their significance. Analysis thus involves establishing significant relationships that point to change as well as trends. Techniques of analysis The techniques widely used for analytical purpose are: 1. Trend analysis, 2. Cross sectional analysis, and 3. Ratio analysis Trend analysis This is also known as time series analysis, horizontal analysis or temporal analysis. It involves the comparison of the present performance with the result of previous periods for the same enterprise. Trend analysis is therefore usually employed when financial data is available for three or more periods. It can be carried out by computing percentages for the element of the financial statement that is under observation. Trend percentage analysis states several years' financial data in terms of a base year, which is set to be equal to 100%. In conducting a trend analysis the following need to be taken into account:

(i)
(ii) (iii) (iv) (v)

Accounting principles and policies employed in the preparation of financial statements must be followed consistently for the periods for which an analysis is being made to allow comparability. The base year selected must be normal and a representative year. Trend percentages should be calculated only for these items, which have a logical relationship. To make meaningful comparisons, trend percentage should be adjusted in light of price level changes as compared to the base year. Trend percentages should be carefully studied after considering the absolute figures otherwise they may lead to misleading conclusions.

Illustration Assume that the following data is extracted from the books of ABC Ltd. 2005 2004 2003 2002 2001 sh. Million sh. Million sh. Million sh. Million sh. Million Sales 725 700 650 575 500

Net income

99

97.5

93.75

86.25

75

From the above absolute figures, there appears to be a general increase in sales and income over the years. When expressing the above data in terms of percentages with 2001 being the base year, the following trend percentage is observed. 2005 Sales 100% Net Income 132 % 145% 130 % 2004 140% 125 % 2003 130% 115 % 2002 115% 100 % 2001

From the above it can be observed that: (i) Sales and net income have grown over the years but at a decreasing rate, and (ii) Net income has not kept pace with growth in sales. When net income is expressed as a percentage of sales: 2005 Net Income X 100 Sales 13.7% 15% 15% 2004 13.9% 2003 2002 14.4% 2001

It is further observed that net income as a percentage of sales is decreasing over the years and this needs to be investigated. Plotting trend percentages relating to sales and net income on a line graph Graph

150 140 Percentage 130 120 110 100 2001 2002 2003 2004 2005 Years From the line graph, one can observe that the growth rate for sales has decreased. The same applies to net income as shown by the slope of the curves. One may also conclude from the curves that between 2002 and 2001 sales and income have

grown at the same rate. Subsequently, growth in net income failed to keep pace with the growth in sales. Financial statement analysis is not an end by itself rather financial statement analysis raises questions for which management has to look for answers. Problems of Trend analysis i. To ensure comparability of figures, the results of each year will have to be adjusted using consistent accounting policies when the same has not been applied. ii. Comparison overtime becomes difficult when the unit of measurement changes in value due to general inflation. iii. If the enterprises environment changes over time with the result that performance that was considered satisfactory in the past may no longer be considered so, more specific measures rather than general trends may be preferred in such instances. Cross sectional analysis This involves the comparison of the financial performance of a company against other companies within the same industry. It may simply involve comparison of the present performance or a trend of the past performance. The idea under this approach is to use a comparable company as a yard-stick to gauge the performance of a company. Cross sectional analysis may involve the use of ratios for a particular company or the entire industry. Problems of Cross sectional analysis i. It is difficult to find a comparable firm within the same industry. This is because firms may have businesses which are diversified to a greater or lesser extent. ii. Businesses operating in the same industry may be substantially different in that, they may manufacture the same product but one may be using rented equipment while the other uses owned equipment making comparison difficult. iii. Two firms may use accounting policies which are quite different resulting in differences in financial statements. It is usually very difficult for an external user to identify differences in accounting policies yet one must bear them in mind when interpreting two sets of accounts. Ratio analysis A ratio is simply a mathematical expression of an amount or amounts in terms of another or others. A ratio may be expressed as a percentage, a fraction, or a stated comparison between two amounts. The computation of a ratio does not add any information not already existing in the amount or amounts under study. A useful ratio may be computed only when a SIGNIFICANT RELATIONSHIP exists between two amounts. A ratio of two unrelated amounts is meaningless. A ratio by itself is useless, unless compared with the same ratio over a period of time and or similar ratio for a different company and the industry. It is important to

note that ratios focus attention on relationships which are significant but the full interpretation of a ratio usually requires, further investigation of the underlying data. Thus ratios are an aid to analysis and interpretation and not a substitute for sound thinking. Classification of Ratios Ratios may be classified into the following broad categories. 1. Short-term liquidity ratios also known as working capital management ratios, 2. Long-term risks and capital structure ratios also known as leverage or debt management ratios, and 3. Operating efficiency ratios and Profitability ratios 4. Investment ratios

Short-term liquidity ratios Liquidity refers to an enterprises ability to meet its short-term debts as and when they fall due. A firm which cannot meet its short- term obligations may be forced into bankruptcy and therefore fail to be provided with the opportunity to operate in the long-run. Liquidity ratios are used to assess a firms ability in meeting its shortterm obligations as and when they fall due. Short-term liquidity ratios include (i) Working capital ratio This ratio represents current assets that are financed from long term capital resources that do not require repayment in the short-run, implying that the portion that is financed from long term capital resources is still available for repayment of short term debts. It is computed as follows: Working capital=Current assets Current liabilities Example:

Balance sheet extract As at December 31

2005 Sh.000 Current assets 26,400 Current liabilities (13,160) 13,240

2004 Sh.000 15,600 (6,400) 9,200

In the year 2004 Sh.9.2 million of working capital, representing current assets financed by long term capital resources is available to pay short term debts and in 2005 Sh.13.24 million is available of working capital to pay short term obligations. (ii) Current ratio

A current ratio similarly tests short-term debt-paying ability of an enterprise. It measures the amount of liquid and near liquid resources available to meet shortterm debts. A high current ratio is assumed to indicate a strong liquidity position while a low current ratio is assumed to indicate a relatively weak liquidity position. The rule of the thumb is that current assets should be twice current liabilities. The ratio is computed as follows: Current ratio= Current assets Current liabilities Illustration:

Balance sheet extract As at December 31

Current assets Current liabilities The current ratio; 2005 Sh.000 26400 13160 = 2: 1 2004 Sh.000 15600 6400 = 2.4: 1 2005 2004 Sh.000 Sh.000 26,400 15,600 (13,160) (6,400)

Observation The enterprise appears to have a strong liquidity position. There has been, however, a slight drop from year 2004 to year 2005. For every shilling that is owed of current liabilities in 2005, the firm has Sh.2 of current assets to pay the debt and for every shilling owed of current liabilities in 2004, the firm had Sh.2.4 of current assets available to meet the liability. (iii) Quick ratio or Acid test ratio The current ratio has further been refined to Quick Ratio or Acid Test Ratio. This ratio tests the short-term debt paying ability of an enterprise without having to rely on inventory and prepayments. The ratio concentrates on more readily realizable or liquid assets available to meet short-term debts. The rule of the thumb is that for every shilling of current liability owed, the enterprise should have a shilling of current quick assets available to meet it. It is given by; Current assets-inventories-prepayments Current liabilities

(iv)

Average collection period (Age of accounts receivable) ratio

The ratio measures the average number of days taken by an enterprise to collect its trade receivables. The ratio is computed as follows: Average trade receivables X 365 days Credit sales OR 365 days Accounts receivable turnover ratio Where, average trade receivables = Beginning trade receivables + Ending trade receivables 2

(v) Accounts receivable turnover ratio The accounts receivable turnover ratio measures the number of times an enterprise has turned accounts receivable into cash during the year, measuring efficiency of collection. The higher the times the more efficient a company will be assumed to be in collecting its debts. Where, Accounts receivable turnover ratio = Credit sales Average trade receivables

(vi) Average payment period (Age of trade payables) ratio This ratio measures the average number of days taken to pay an accounts payable. It is computed as follows:Average trade payables x 365 days Credit purchases OR

Accounts payable turnover ratio Where, average accounts payable= Beginning accounts payable + Ending accounts payable 2

365 days

(vii) Accounts payable turnover ratio The accounts payable turnover ratio measures the efficiency with which firms pay their trade creditors. The higher the number of times, the more efficient the enterprise is assumed to be in paying its creditors Where accounts payable turnover ratio: Credit purchases

Average trade payable (viii) Average sales period ( Age of inventory) ratio This ratio measures the average number of days taken to sell inventory one time. It is given by; Average inventory x 365 days Cost of sales Where, average inventory = Beginning inventory + Ending inventory 2 (ix) Inventory turnover ratio Inventory turnover ratio measures the frequency with which inventory is turned over during the period. Where, inventory turnover = Cost of sales Average inventory Long-term solvency ratios A firm is said to be leveraged whenever it finances a portion of its assets by debt. Debts commit a firm to payment of interest and repayment of capital. Borrowing increases the risk of default and it is only advantageous to shareholders if the return earned on the funds borrowed is greater than the cost of the funds. Longterm solvency ratios include; (i) Debt to equity ratio This ratio measures the amounts of assets provided by creditors for each shilling of assets provided by the shareholders. It is computed as follows: Total liabilities Total stockholders equity (ii) Proprietory ratio This ratio measures the proportion of assets financed by the owners. It is calculated as follows: Total equity X 100 Total assets

(iii) Debt to total assets ratio This ratio measures the proportion of assets financed by outsiders. It is calculated as follows: Total liabilities X 100 Total assets (iv) The times interest earned ratio

This is also known as the interest cover ratio. This ratio measures the ability of a firm to meet its interest payment out of the current earnings. It reflects the likelihood that creditors will continue to receive their interest payments by calculating the number of times the interest payable is covered by profits available for such payments. It is computed as follows:Profit before interest and tax and extraordinary items Interest expense Profitability ratios and Operating efficiency ratios Profitability analysis consists of tests used to evaluate a firm's earnings performance during the year. These ratios combined with other data can be used to forecast the earning potential of a firm since in the long run, the firm has to operate profitably in order to survive. The ratios are of importance to long term creditors, shareholders, suppliers, employees and their representative groups. All these parties are interested in the financial soundness of an enterprise. The ratios commonly used to measure profitability include:(i) Profit margin (Return on sales ratio) This ratio describes the company's ability to earn income. It is a measure of the proportion of sales that contribute to profit. It is computed as follows:Net Income x 100 Net sales (ii) Total assets turnover This ratio describes the ability of a company to use its assets to generate sales. It is computed as follows:Net sales Average total assets

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(iii)Return on total assets This ratio measures how well management has employed assets. It is given by Net income x 100 Average total assets (iv) Return on common stock holders equity This ratio measures the ability of an enterprise to generate income for its owners. It is computed as follows: Net income preference dividend Average common stock holders equity x 100

Where, Common stockholders equity=Total equity-preference share capital

Investment ratios These ratios help equity shareholders and other investors to assess the value and quality of an investment in the ordinary shares of a company. The value of an investment in ordinary shares in a listed company is its market value, and so investment ratios must have regard not only to information in the companys published accounts, but also to the current price. These include: (i) Earnings per share (EPS) This ratio represents or reflects the amount of shillings or cents earned per ordinary share. It is a requirement of IAS 33 that it be disclosed on the face of the income statement for quoted companies. It is given by Net Income Preference dividends . The number of ordinary Shares outstanding. (ii) Dividend pay-out ratio This ratio reflects a companys dividend policy. It is computed as follows: Dividends per share X 100 Earning per share Where, dividends per share = Ordinary dividends Number of ordinary shares

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(iii) Dividend yield ratio This shows the dividend return being provided by the share. It is given by Dividends per share Market price per share x 100

(iv) Price earnings ratio (The PE ratio) This ratio is used in comparing stock investment opportunity. It is an index of determining whether shares are relatively cheap or relatively expensive. It is given by Market price per share Earnings per share The price earnings ratio reflects the consideration that investors are willing to pay for a stream of a shillings of earnings in the future. The price-earnings ratio is widely used by investors as a general guideline in gauging stock values. The ratio reflects the stock market expectations of the future earnings of the company. Investors increase or decrease the price-earnings ratio that they are willing to accept for a share of stock according to how they view its future prospects. Companies with ample opportunity for growth generally have high price-earnings ratios, with the opposite being true for companies with limited growth.

Limitations They are simply indicators of what to investigate. Therefore, they should not be viewed as an end, but as a starting point from which to identify further questions. 2. They are useless when used in isolation. They have to be compared over time for the same firm or across firms or with the industry's average. 3. Ratios are based on financial statements. Any weakness of the financial statements is also captured within the ratios. 4. Comparing ratios across firms may be difficult because the firms may not be comparable. Data among companies may not provide meaningful comparisons because of factors such as use of different accounting policies and the size of the company. The most common variations due to accounting policies lie in the computation of depreciation and amortization and inventory valuation.

1. Ratios are insufficient in themselves as a basis of judgment about the future.

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