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Interpretation of Financial Statements.

Extracts from this document...

Introduction

Nottingham University Business School N111223 FINANCIAL ACCOUNTING Lectures 9 and 10 Workshop 6 Interpretation of Financial Statements Weetman - Chapter 13 (Ratio Analysis) Chapter 14 (Analysis of Corporate Performance) There are three main aids to the analysis of financial statements: HORIZONTAL and TREND ANALYSIS VERTICAL ANALYSIS RATIO ANALYSIS HORIZONTAL and TREND ANALYSIS Horizontal analysis involves a line by line comparison of one set of data with another - for example, the current year's accounts with last year's, or with this year's budget. It is based on the fact that isolated figures are seldom of much use by themselves. Trend analysis is horizontal analysis extended over several years, often indexing the data to express the first set of figures as 100 and later periods related to that base. For example, profit is �10,000,000. Is this good or bad? (a) Profit for the previous 4 years was: �6,000,000 �7,000,000 �8,000,000 �9,000,000 (b) Profit for the previous 4 years was: �14,000,000 �13,000,000 �12,000,000 �11,000,000 (c) Profit for the previous 4 years was: �10,000,000 �10,000,000 �10,000,000 �10,000,000 The comparison shows fairly clearly how the company is doing - but even this can be improved upon. One way is to calculate the percentage increase/decrease from year to year: (a) 16.7% 14% 12.5% 11% (b) -7% -7.7% -8.3% -9% (c) 0% 0% 0% 0% Using indexation: (a) 100 117 133 150 167 (b) 100 93 86 79 71 (c) 100 100 100 100 100 VERTICAL ANALYSIS This technique requires all of the profit and loss account and balance sheet to be expressed as a percentage of critical components (generally total sales and total assets respectively). This is also called common sizing. For example, if debtors are �25 m and total assets are �100m, then debtors represents 25% of total assets. If this is compared with last year's figure of, say, 20%, it can be seen that debtors are increasing in relative importance, and may indicate a worsening credit control situation. ...read more.

Middle

By removing stock from the equation, the acid test ratio highlights the immediate liquidity of the company. Again, not too much alarm must be taken of a low figure, as with a cash business, and rapidly turning over stocks, the situation may not be drastic. As with the current ratio, the quick ratio has no 'ideal' or standard answer. Traditionally a ratio of 1:1 would have been considered highly desirable. In other words all current liabilities could be paid at least from the generation of cash from the quick assets. The ratio is influenced by a variety of factors including the type of business and the nature of the firm's debtors and creditors. Nowadays, operating on the premise that all of a company's current liabilities do not normally have to be paid immediately - a figure of 0.7:1 or even 0.6:1 will not normally cause undue alarm. In a predominantly cash-based business this ratio can fall even lower. An important point to remember is that these liquidity ratios vary tremendously between industries, depending on the nature of the business. It is important therefore not just to consider the company in isolation, but to compare it with other companies occupied in similar activities. EFFICIENCY RATIOS Traditional financial statements do not tell us how efficiently the Company has been managed - i.e. how well its resources have been looked after and utilised. While profitability gives some indication, accounting profit is subject to so many arbitrary adjustments that it is somewhat less than reliable. Efficiency ratios primarily examine how productively companies utilise assets but they can also include creditors and other business aspects. Efficiency ratios can be calculated from any financial information relating to the company. But it is crucial to remember that whatever efficiency ratios are calculated, they must be relevant and meaningful. Stock Turnover (cost of sales /average stock) The stock turnover ratio is important in the measuring of the length of time that the firm has, on average, stock in its warehouse. ...read more.

Conclusion

In these circumstances the company would hope that maintaining a dividend of �4m would be sending a positive message about its future prospects. It is important to remember that dividends represent only a part of the shareholders' return. Any profits not distributed (retained in the business) should increase the size of the business and therefore lead to enhanced profits in future years. Another factor to be considered in the dividend decision is the availability of cash. If all the assets of the business are tied up in buildings, stock, debtors, etc. then it may be necessary to borrow in order to find the cash to pay shareholders - another cost. LIMITATIONS OF RATIO ANALYSIS It must be emphasised again that ratios are merely an indication or pointer. They can highlight particularly favourable or adverse figures in a business. By themselves ratios are not definitive or absolute statements. Ratios form a basis for further investigation and research. They must not form the sole foundation or only criteria for decision-making. The ratios must be treated with a considerable degree of caution and apprehension. The user / analyst frequently requires forecast information that has predictive value, but most information obtained from the financial statements is historical in nature. Information from financial statements is often in summarised form and details regarded by the company as confidential will not be published. Furthermore the underlying statistical assumptions applied in ratio analysis may not be valid. Assumptions may be made that ratios are normally distributed for companies within a particular sector or that the ratio is proportional for all sizes of companies and has a zero intercept. The analysis may be particularly prone to error if these assumptions are applied to companies with unusual absolute values applied in ratio analysis; e.g. computing ROCE for a company with a very small total of capital or net assets in its balance sheet. Nevertheless, provided the ratios are used with a discriminate application, they can provide a useful analytical tool and act as a starting point to conduct further investigation into a business. 1 ...read more.

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