a framework for financial statement analysis

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Introduction to Financial

Statement Analysis

Fundamental Concepts andIntroduction to FinancialReporting


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Tom Rourke

Introduction to Financial Statement

Analysis

Analysis of financial statement is the systematicnumerical calculations of the relationship betweenone fact with the other to measure theprofitability, operational, efficiency, solvency andthe growth potential of Business.

A major source of information regarding a firmsoperating performance and its resources is thefirms financial statement package.

Analyzing a set of financial statements involves

using ratios of key financial statement items andother tools to gain insight into the profitability andrisk of a firm.

Financial statement analysis can help us to betterunderstand the business risk and the financial riskof a firm.


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Purpose of Financial Statements

Financial statements are a structured

representation of the financial position (BalanceSheet) and financial performance (IncomeStatement) of an entity.

The objective of financial statements is to provideinformation about the financial position, financial

performance and cash flows of an entity that isuseful to a wide range of users in makingeconomic decisions.

Financial statements also show the results of

managements stewardship (Planning &Management) of the resources entrusted to it. Tomeet this objective, financial statements provideinformation about an entitys:

P.T.O


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(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 thenotes, assists users of financial statements in predicting

the entitys future cash flows and, in particular, theirtiming and certainty.

Purpose of Financial Statements (Cont.)


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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 arisingfrom transactions with equity holders

acting in their capacity as equity holders; a cash flow statement; and

notes, comprising a summary of significantaccounting policies and other explanatory

notes.


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Tom Rourke

Principal Financial Statements

Financial statements are intended toprovide information on the operating

performance and financial health of abusiness during a specified period of time.

In the US, financial statements are requiredto 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 thefinancial statements of other firms.


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Principal Financial Statements,

(Cont.)

GAAP requires firms to present balancesheets for the two most recent years andincome statements and statements of cash flows

for the three most recent years in a set offinancial statements.

In addition, firms are required to presentnotes to the financial statements that provideinformation on the accounting methodsused by the firm to construct the financialstatements.


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Users of Financial StatementsUsers of the financial

statements

Interest of the user

Equity investors (existing and

potential)

They are interested whether buy, hold or sell the

shares in hand and also enable them in payment ofdividends.

Loan creditors ie, existing and

potential holders of debentures and

loan stock, and providers of short-

term loans

The amount will be paid when due and for

continuation of the business.

Employees (existing, potential and

past)

Interested in stability and profitability for

employment opportunities, remuneration and

retirement benefits.

Business contacts including

customers, trade creditors,

competitors and potential take-over

bidders

Whether the payment of loan will be made in due

dates and enable sustainability of business for future

business with the enterprise.

Government, including tax

authorities, government departments

and local authorities

Interested in allocation of resources and also to

regulate the activities of an enterprise and

determining tax policies and as a basis for national

income.

Public, including tax payers,

ratepayers and environmental groups

Trends and recent development in the prosperity of

the entity and range ofits activities.


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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, notesand audit opinion.

Determine whether restatements arenecessary to enhance the comparability of

the statements.


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Financial Statement Analysis

Framework (Cont. 1) Determine whether the firm's size, capital

structure, and product mix areappropriate to proceed with the ratio

calculations.

Conduct horizontal and vertical analysesof each financial statement, with special

emphasis on the income statement. Calculate the basic liquidity ratios.

Calculate profitability ratios based on netincome and on cash flow from operating

activities. Evaluate trends.


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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 ratioresults, review notes, and recalculate theratios.


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Financial statement analysis:Tools and approaches

Tools: Approaches used with each tool:

1. Time-series analysis: the same firmover time (e.g., Wal-Mart in 2008 and2006)

Common size statements

Trend statements

Financial ratios

(e.g., ROA and ROCE)

2. Cross-sectional analysis: differentfirms at a single point in time (e.g.,Wal-Mart and Target in 2008).

3. Benchmark comparison: usingindustry norms or predetermined

standards.


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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 profitabilityand survival of the firm are not includedin the financial statements.

A perfect example is human resources.


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Limitations of Financial

Statement Analysis (Cont.)While employees are often a firm's most

important asset, a value for employees doesnot appear on the balance sheet.

Financial statement analysis relies on pastnumbers, and the past may not be a reliableindication of the future.

B i A ti f P ti f


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Basic Assumptions for Preparation of

Financial StatementsOver 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


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Fair Presentation and Compliance withIFRS.

Financial statements shall present fairly the financialposition, financial performance and cash flows of an

entity. Fair presentation requires the faithfulrepresentation of the effects of transactions, other eventsand conditions in accordance with the definitions andrecognition criteria for assets, liabilities, income andexpenses set out in theFramework.

Basic Assumptions

Business Entity

The concept of Business Entity means that business orentity is a separate and distinct from the owners of theentity for which financial statements are prepared

B i A ti


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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. Thisassumption deliberately disregards the possibility that theentity will go bankrupt or liquidated. If a particular entityis in fact threatened with bankruptcy or liquidation then

going concern assumption should be dropped.

Basic Assumptions

Time Period The only accurate way to account for the success or failure

of an entity is to accumulate all transactions from theopening of the business until the business eventually

liquidates.Monetary Unit

Accountants needs some standard of measure to bringfinancial transactions together in a meaningful way.Accountant should specify the unit of measure i.e $ or

PKR according to the country in which statements isprepared.


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Historical Cost

Historical cost is used in practice because it is objectiveand determinable. The Assets are recorded in financialstatements on historical cost.

Basic Assumptions

Consistency of Presentation

The presentation and classification of items in thefinancial statements shall be retained from one period tothe next unless: it is apparent, following a significant change in the

nature of the entitys operations or a review of itsfinancial statements, that another presentation orclassification would be more appropriate havingregard to the criteria for the selection and applicationof accounting policies.

Basic Assumptions


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Matching Accountants need to recognize the costs associated with

the recognized revenue. The basic intent is to determinethe revenue first and then match the appropriate costsagainst this revenue.

Cost of inventory can be easily matched with revenue.

Basic Assumptions

While preparing FS, Accountants need to determine thatwhen it is practical to recognize revenue.

Full Disclosure

The accounting report must disclose all facts that mayinfluence the judgment of an informed reader. Severalmethod of disclosure exit such as footnotes and crossreferences.

Realization


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Basic AssumptionsMateriality and Aggregation

Each material class of similar items shall be presented

separately in the financial statements. Items of a dissimilarnature or function shall be presented separately unless theyare immaterial.

Off setting

Assets and liabilities, and income and expenses, shall notbe offset unless required or permitted by a Standard or anInterpretation.

Comparative Information

Except when a Standard or an Interpretation permits orrequires otherwise, comparative information shall bedisclosed in respect of the previous period for all amountsreported in the financial statements. Comparativeinformation shall be included for narrative and descriptive

information when it is relevant to an understanding of thecurrentperiods financial statements.

Basic Assumptions


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Basic Assumptions

There are two approaches of transaction recording:Accrual Basis of Accounting

An entity shall prepare its financial statements, except forcash flow information, using the accrual basis ofaccounting.

The accrualbasisof accounting recognizes revenues andexpenses when they occur regardless of when cash isreceived or disbursed.

Cash Basis of Accounting

The cash basis of accounting recognizes revenue and

expense when cash is received and disbursed.

Transaction Approach

A transactionis any event that affects thefinancial position of an organization

and requires recording.

Financial Statements Reporting


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Financial Statements

Reporting

FrameworkThe reporting frame work that is applicable in Pakistan while preparing

and presenting of financial statements is as follows:Applicable Laws and Regulations Regulating

Authority

Listed Companies

other than,

Insurance, NBFCs,

Modaraba and Bank

Companies Ordinance 1984.

International Financial Reporting Framework (IFRS)

as applicable in Pakistan

Stock Exchange Listing Regulations

Securities and

Exchange

Commission of

Pakistan (SECP)

Banking Companies International Financial Reporting Framework (IFRS)



Stock Exchange Listing Regulations (Particularly Code

of Corporate Governance)

Banking Ordinance 1962

Prudential Regulations (Corporate, SMEs and

Consumers)

Securities and

Exchange

Commission of

Pakistan and State

Bank of Pakistan.

Insurance

Companies

International Financial Reporting Framework (IFRS)


Companies Ordinance 1984


Insurance Ordinance and Rules

Securities and

Exchange

Commission of

Pakistan.


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Financial Statements Reporting

Framework (Cont.)

Applicable Laws and Regulations Regulating

Authority

Non Banking

Finance Companies

(Leasing

Companies,Investment

Companies,

International Financial Reporting Framework

(IFRS).


Stock Exchange Listing Regulations(Particularly Code of Corporate Governance)

NBFC Rules.

Prudential Regulations for NBFCs

Prudential Regulations for Leasing Company

Securities and

Exchange

Commission of

Pakistan.

Modarba International Financial Reporting Framework

(IFRS).



(Particularly Code of Corporate Governance)

Modarba Act and Rules

Securities and

Exchange

Commission of

Pakistan and

Registrar of

Modarba

Tom Rourke

Wh D W A dit Fi i l


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Why Do We Audit Financial

Statements

In this section we look at the following:

Need for audit

Objective of the audit


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Need for Audit

Principle

(Shareholders)

Directors

Auditor

Information asymmetry

and conflict of interest lead

to information risk for the principle

Principle provides capital

and hires managerto manage it.

Directors hires

auditors to report

on the fairness of

manager financial

statements. Risk

information

asymmetry ofprinciple reduce.

Auditor gathers

evidence to evaluate

fairness of manager

financial statements.

Director is accountable to Principle;provides financial reports.


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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.


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End

a framework for financial statement analysis

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