“ effective analysis of a set of financial statement requires an understanding of (1) the economic characteristics and current conditions of a firm’s business; (2 ) the particular strategies the firm selects to compete in each of these businesses; and (3)the accounting principles and procedures underlying the firm’s financial statements.”
Part 2.1: Ratio analysis
There are different principle tools of financial analysis. One of them is ratio analysis, which is based on the externally available financial data from corporations, and used to assess how various line items in a firm’s financial statement related to one another. In ratio analysis, the analyst can compare ratios for a firm over several years (a time-series comparison) examining the effectives of a firm’s strategy over time, compare ratios for the firm and other firms in the industry (cross-sectional comparison) to some absolute benchmark. Because of simple and convenient, it is one of the most popular and widely used tools.
Part 2.2: Interpretation problems in ratio analysis
While computation of a ratio is a simple operation, its interpretation is more complex. The usefulness of ratios depends on our skilful application and interpretation of them, and consequently there are some problems arising from the using of ratio analysis.
Firstly, Ratio might be interpreted in isolation, and might not be considered in the context of the company’s other ratios. Example (1), company A maintains a current ratio (current assets divided y current liabilities) well below 1.00, which if viewed by itself could signify a solvency problem. However, the company’s strong earning power and cash flows provide adequate cash to meet the company’s need. Therefore, to more meaningful, a ratio must refer to an economically important relation.
Secondly, the analysts could ignore the factors can affect the effectiveness of ratios. It must be recognized that a substantial amount of important information is not included in a company's financial statements. These events involving such things as industry changes, management changes, competitors' actions, technological developments, government actions, and union activities are often critical to a company's successful operation, and so on. Without considering these events, the accounting data is unreliable. Consequently, the ratios based on those unreliable data will lack insight. This point is illustrated in MicroStrategy case study in Part 1. So, to successfully predict of corporate performance we must assess the unrecorded events potentially influencing future ratios.
Thirdly, the analysts might choose misleading ratios caused by the difficult problem of achieving comparability among firms in a given industry. Achieving comparability among firms requires that the analyst (1) identifies basic differences existing in their accounting principles and procedures, and (2) adjusts the balances to achieve comparability.
Basic differences in accounting usually involve a variety of areas, which include some such as (1) Inventory valuation (FIFO, LIFO, average cost); (2) Depreciation methods, particularly the use of straight-line versus accelerated depreciation. (3)Capitalization versus expense of certain costs, particularly costs involved in developing natural resources, etc..
The use of these different alternatives can make a significant difference in the ratios computed. For example, in the brewing industry, company B noted that if it had used average cost for inventory valuation instead of LIFO, inventories would have increased. Such an increase would have a substantive impact on the current ratio. Several studies have analyzed the impact of different accounting methods on financial statement analysis. The average investor may find it difficult to grasp all these differences, but investors must be aware of the potential pitfalls if they are to be able to make the proper adjustments.
Part 2.3: Discussion From acontextual to contextualized financial analysis
As we can see from the discussion above, analysis of a ratio can reveal important relations and bases of comparison in uncovering conditions. However, some analysts used it in a narrow acontextual manner. So, even the accounting data is reliable, the explanatory potential of ratio analysis is still severely limited. It can only describe the changes in financial numbers, but it can not explain why the changes happen.
Conversely, with contextualization, explanation of performance and levels of performance are illustrated best. Comparing with acontextual financial analysis in isolation explaining little about the company’s historic performance, contextualized analysis can give a rich explanation of past performance and of focusing analysis on a company’s possible future. Clearly, the key of successful financial analysis is understanding the dynamics of corporate performance.
Part 3: Financial statement analysis in an international setting
In many situations, analysts are concerned with comparing the financial statement of companies from different countries. For example, recently, US investors have had an increasing interest in foreign securities traded on foreign markets. Holding foreign stocks can help reduce invests’ risk by diversifying the investment portfolio included securities of companies from more than one countries.
Mostly, financial information provided by the company is the base of the choice to buy or sell a foreign security for the investors. So, the investors have to challenge of analyzing and interpreting financial statements prepared according to foreign accounting. Since the accounting system in a country is a product of the social, economic, political, and cultural environment, it is difficult to make meaningful comparison across companies in different countries.
An interesting research in this area is from the Choi et al. (1983). Such as, raising capital through equity issuances in Japan is relatively unusual for a number of reasons, one of which is that the local banks and government play a particular role in providing debt capital. Some research also reported Japanese managers are much less concerned with short term profits than U.S managers, and are likely to make investment that maximize long-term profitability. In general, they found Japanese were much higher rate and lower net income. Therefore, understanding the foreign environment in which a foreign company is based will achieve a successful of financial analysis.
Part 4: Conclusion
To sum up, this essay has discussed that accounting data itself alone is invaluable. The lessons from MicroStrategy case have proved this point. Then, the essay has discussed how to make accounting figures more meaningful through analyzing ratio analysis, and found contextualized analysis is a better approach to achieve the goal of financial analysis by comparing with the acontextual analysis. We also have considered the international situation for foreign analysts. Finally, without doubt, contextualized analysing manner is necessary in the international situation.
References:
Barry E and Jamie E, (2002) Financial Accounting and Reporting, 7th edition, Prentice Hall.
Foster G. (1986) Financial Statement Analysis, Prentice Hall, Englewoods Clisffs, NJ.
J Pratt (2003), Financial Accounting in an economic context, 5th edition. Von Hoffmann Press.
John J. Wild, Leopold A. Bernstein, K. R. Subramanyam. (2001) Financial Statement Analysis, 7th edition. McGraw Hill.
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McSweeney, B. ‘Narrative and Numbers: From Acontextual to Contextualized Financial Analysis’, Accounting Forum, 53(3), 2001, 246-263
McSweeney, B. ‘Narrative and Numbers: From Acontextual to Contextualized Financial Analysis’, Accounting Forum, 53(3), 2001, 246-263
J Pratt (2003), Financial Accounting in an economic context, 5th edition. Von Hoffmann Press.p198
Foster G. (1986) Financial Statement Analysis, Prentice Hall, Englewoods Clisffs, NJ.p190
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