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Financial Analysisby Binam Ghimire

Learning Objectives1. Purpose of financial analysis2. Various techniques of financial analysis 3. Understanding Creative Accounting, and 4. IFRS and auditing

Financial Analysis Financial Analysis as the name suggests is an

analysis of an organisation’s financial position

Why do we undertake financial analysis ? What information do we analyse ? What techniques do we use to undertake

financial analysis ?

Why undertake Financial Analysis ? Investors & Potential Investors - Share/Company valuation

Providers of Finance – Predicting financial distressAssessing creditworthiness

Authorities - Tax legislation Analysts/Investors/Potential Investors -

Forecasting future performance – share valuation/loan decisions

Internally ManagementDesigning profit sharing plansAiding management decisionsManagement performance evaluation

Examples of Documents used for Financial Analysis Published Financial Statements

The Balance Sheet or Statement of Financial Position (Session 4)

The Income Statement (Session 5)The Cash Flow Statement (Session 6)

Business Plans including Cash Forecasts Published Equity data (Session 10) e.g.:

Share PriceEPS; DPS

Analysts Reports

Techniques of Analysis

Common-Size Statements Trend Statements Financial Ratio Analysis including:

Basic Profitability, Liquidity & Gearing RatiosDu-Pont AnalysisCashflow Analysis

Altman “Z”Scores (Distress Analysis) Investment Ratios

These tend to rely on Published Financial Statements but what if they are prepared by Creative Accountants?

Creative Accounting

Creative Accounting is:the practice of showing users what they would

like to see rather than a true and fair value

Reasons for Creative Accounting Possible reasons for creative accounting could

include to:1. reduce taxation by reducing reported profits;2. attract new share capital or loan capital by showing a healthy (and non-volatile) financial position;3. achieve sales or profit targets (especially where performance bonuses are involved);4. report sufficient profit to pay a dividend or to meet investors’ expected level of return.

Methods of Creative Accounting

Overstatement of revenue ‘In-and-out trading’ Manipulation of expenses e.g. Depreciation Capitalization of expenses Concealment of losses or liabilities Revaluation of non-current assets Valuation of current assets e.g. Inventories Auditing 

A Final Word of Caution

the Accounting Standards adopted, which will differ from company to company due to interpretation and country to country due to the standards adopted IAS or US GAPP

Management Bias – desire to show a good position, justify a bonus

The Need/Desire to Meet Lending Conditions Big Bath – in a bad year, why not have a really bad year Mergers & Acquisitions – the desire to avoid, encourage or

take part in, and the method of accounting for M & A Income Smoothing Tax Regime of the country

As a result analysts (you) need to be adversarial when analysing financial statements

The Case of ENRON

The story of Enron and a lesson in Creative Accounting is captured in the Oscar Nominated documentary film, “Enron: The Smartest Guys in the Room”,

An excellent film and well worth a watch.

IFRS and Audits

IFRS and Audits are methods used to ensure Financial Statements are reliable

What are they ?

IFRS

IFRS – International Financial Reporting Standards are:a single set of high quality, understandable

and enforceable global accounting standardsi.e. rules that organisations must follows when

preparing and reporting their financial statements

IFRS are developed and approved by the IASB – International Accounting Standards Board whose objective is…

The Objectives of the IASB (a) to develop, in the public interest, a single set of high

quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world's capital markets and other users make economic decisions;

(b) to promote the use and rigorous application of those standards; and

(c) in fulfilling the objectives associated with (a) and (b), to take account of, as appropriate, the special needs of small and medium-sized entities and emerging economies; and

(d) to bring about convergence of national accounting standards and International Accounting Standards and International Financial Reporting Standards to high quality solutions.

Auditing

An audit is an independent examination of the financial statements and procedures by a professional accountant who then expresses an opinion based on his/her examination.

It should not, merely, be regarded as a public service. Auditors seek to:maximise the revenue of the firm or

department they work forminimise costs maintain quality of financial proceduresminimise risk.

 

External & Internal Auditing Auditors are split into two principal categories –

External – appointed from outside the organisation

Internal – usually employees of the organisation

  Internal ExternalObjectives To advise management on whether the

organisation has sound systems of internal controls to protect the organisation against loss 

To provide an opinion on whether the financial statements provide a “true and fair view”

Legal Basis Generally not a legal requirement. However the latest corporate governance advice recommends that if a listed company does not have an internal audit department, it should regularly assess the need for one. 

Usually a legal requirement for larger limited companies and most public bodies

Scope All areas of the organisation, operational and functional 

Financial focus

Approach Increasingly risk basedAssess risksEvaluate the systems of controlsTest operations of systemsMake recommendations for improvement 

Increasingly risk basedTest underlying transactions that form the basis of the financial statements

Responsibilities 

To advise and make recommendations on internal controls and corporate governance 

To form an opinion on whether the financial statements provide a “true and fair view”

Summary Why do we undertake financial analysis ? What information do we analyse ? What techniques do we use to undertake

financial analysis ? What is Creative Accounting What is the role of IFRS and Auditing ?