Introduction to the Analysis and Interpretation of Accounting Information

Comparative Analysis Evaluating the Performance and Financial Position

Profitability (Keberuntungan) Liquidity (Kecairan) Solvency (Mampu bayar)

Limitations of financial statement analysis

Interpretation and Analysis of Accounting Information Interpretation of financial information: users evaluate and analyse financial information to make judgements/conclusion about financial performance or position Key to any in-depth understanding of an organisations performance.

Interpretation and Analysis of Accounting Information (contd)

Basically, the users evaluate an organisations performance using the information from INCOME STATEMENT and BALANCE SHEET. The value of the analysis depends on the value of the financial statements.

Comparative analysis
Every item in financial reports represents something important. It existed and was material at some time and in some quantity. Its significance can be determined only in relation to something else Single numbers on their own do not provide useful information

Comparative analysis
3 types of useful comparative information: Intra-entity basis Comparisons within a single entity (detects changes in financial relationships and trends) Industry averages Between entities in same industry (determines position relative to others) Inter-entity basis Between other entities (indicates competitive position)

Comparative Analysis Techniques

Horizontal Analysis Vertical Analysis Trend Analysis Ratio Analysis

Horizontal Analysis
Used to evaluate a series of financial statement data over a period of time. Analyses increases or decreases that have occurred from a particular base year. Figures are stated as both dollar amounts and as percentages. Percentages removes the effect of size, so relative magnitude of change is revealed.

Horizontal Analysis
One year is selected as the base year and then increases or decreases are based on the formula:
Change since base year = current yr amt base yr amt Base year amount

Vertical Analysis
It evaluates financial statement by expressing each item in a financial statement as a percent of the base amount (key figure) Key-figure (such as sales in IS and Total assets on BS) are set to 100% Other items are then expressed as percentage of 100

Vertical Analysis (cont..)

Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude. Useful for comparing companies of different sizes. Calculated percentages can also be tracked over time to determine patterns of change.

Trend Analysis

Similar to horizontal analysis, except that the first set of account in the series is given a base of 100

Ratio Analysis
Useful tool for financial analysis Used to evaluate the financial performance and position of a business entity Ratio expresses the relationship among selected items of financial statement data. Absolute accounting figures do give meaningful picture

Ratio Analysis (cont..)

May be used to compare one year with another for the same business (Intracompany comparisons) or one business with another similar business (Inter-entity comparisons)

Ratio analysis (cont..)

Commonly used group of financial ratios: Profitability ratios Liquidity ratios Efficiency ratios Solvency ratios

Profitability Ratios
Profitability ratios measure the profit or operating success of an entity for a given period of time. Size of entitys profit affects its:
Ability to obtain debt and equity financing. Liquidity position. Ability to grow.

Profitability is often regarded as the ultimate test of managements operating effectiveness.

Profitability Ratios
Gross profit Margin indicates entitys ability to maintain an adequate selling price above its costs. Ratio declines as industry becomes more competitive.

Profitability Ratios
Gross profit ratio Gross Profit /Sales

Gross profit margin lower than industry average may indicate low selling price , or high cost of goods sold or both

Profitability Ratios
Profit margin ratio measures percentage of each dollar of sales that results in profit.
High volume firms (e.g. supermarkets) generally experience low profit margins Low volume firms have high profit margins

Profitability ratios
Net profit ratio
Net Profit before tax Sales

May reveal the extent to which the firms expenses are under control

Profitability ratios
Asset turnover Measures how efficiently assets are used to generate sales. Formula:
Net Sales Average Total Assets

Profitability ratios
Return on Assets ratio Measures overall profitability with respect to investment in assets. Affected by:
Degree of leverage (interest expense) Profit margins Asset base

Formula:

Net Profit Average Total Assets

Profitability ratios (cont..)

Relationship between profitability ratios: Return on assets = profit margin x asset turnover = net profit x net sales net sales average total assets

Liquidity Ratios
Liquidity ratios measure the short-term ability of an entity to pay its debts and meet unexpected needs for cash. Important to bankers, suppliers and other short-term creditors.

Liquidity ratios
Current ratio Current Assets / Current Liabilities

Measure the firms ability to meet its short term financial obligations out of its current assets

Quick Ratio
Measure of an entitys immediate short-term liquidity. Often called the acid test ratio. Excludes inventory and prepaid assets which are the least liquid current assets
Formula: Cash + marketable securities + net receivables current liabilities

Liquidity ratios (cont.)

Quick asset /acid test ratio formula:

Current Assets Inventory Prepaid Exp. Current Liabilities

A severe test of liquidity

Liquidity Ratios (cont..)

Inventory turnover Reflects the effectiveness of inventory management. Formula: Cost of Goods Sold Average Inventory

Liquidity Ratios (cont..)

Average days in inventory Converts inventory turnover into a measure of days for inventory to be sold. Formula: 365 days Inventory Turnover

Efficiency Ratios
Inventory turnover ratio
Cost of goods sold/Average Inventory

Inventory holding period

365/ Inventory turnover ratio

Indication of the efficiency with which a business entity manages its inventory

Liquidity Ratios (cont..)

Receivables/ Debtors Turnover Ratio Indicates the effectiveness of credit collection policies. Measures the number of times trade receivables are converted into cash during the period.
Formula: Net credit sales Average net trade receivables

Liquidity ratios (cont..)

Average collection period Converts receivables turnover figure into a measure of days for receivables collection. Formula:

365 days Acc. Receivables turnover

Efficiency Ratios
Debtors Turnover ratio
Net credit sales Average Debtors Control Account

Debtor collection period

356/ Debtors Turnover ratio Measures the average number of days which elapse between making a credit sale and receiving payment from customer

Solvency Ratios
Solvency ratios measure the ability of an entity to survive over a long period of time. Important to long-term creditors and shareholders. 8.

Solvency ratios
Debt to Equity ratio

Total Liabilities/ Total Assets

Indicate the extent to which the firm is financed by debts (the degree of leverage)

Limitations of Financial Statement Analysis

1. Estimates
Financial statements contain many estimates.
e.g. - allowance for doubtful debts - depreciation expense - costs of warranties

If estimates are inaccurate, the financial ratios and percentages will also be inaccurate.

Limitations of Financial Statement Analysis

2. Cost
Many items are carried at historic cost. This does not account for price-level changes.

3. Alternative accounting methods

Differences in accounting policies for the similar financial activities are often allowed.
e.g. methods of depreciation

Limitations of Financial Statement Analysis

4. Atypical data Some end-of-period data may not represent normal business conditions. 5. Diversification Diversification within entities limits usefulness of financial statement analysis. Segment data may provide more relevant and comparable information.

Limitations of Accounting Ratio Analysis

Inflation is ignored Unrepresentative balance sheet figures. Year end data may not reflect the firm position through out the year Difficult to find a firm for meaningful comparison due to different accounting policies Basis of measurement used is historical cost. Financial analysis based on past data