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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT
Week 2
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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT
Week 2
Contents
2.1 Financial Statement Analysis Overview……………………………………………………………………………………………. 3
Financial Statements ………………………………………………………………………………………………………………………. 4
2.1 Financial Statement Analysis Concept ………………………………………………………………………………………………. 6
Purpose and intended users ………………………………………………………………………………………………………….. 6
Financial position can be measured through …………………………………………………………………………….. 7
Quality and functionality ……………………………………………………………………………………………………………….. 7
2.2 Financial Statement Interpretation …………………………………………………………………………………………………… 9
Accounting Ratios ………………………………………………………………………………………………………………………….. 10
Profitability ………………………………………………………………………………………………………………………….. 11
Efficiency ………………………………………………………………………………………………………………………………. 12
Financial ratios ……………………………………………………………………………………………………………………. 14
Liquidity ……………………………………………………………………………………………………………………………….. 14
Gearing (Leverage) …………………………………………………………………………………………………………….. 15
Investors’ ratios…………………………………………………………………………………………………………………… 16
Value drivers link towards performance ……………………………………………………………………….. 18
Credit Rating Agencies ………………………………………………………………………………………………………………….. 19
Credit Rating Agency Purpose ………………………………………………………………………………………….. 19
Information and business challenges ……………………………………………………………………………… 21
References ……………………………………………………………………………………………………………………………………….. 22
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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT
Week 2
2.1 Financial Statement Analysis Overview
There is a need for stakeholders and mostly shareholders, to monitor business performance. The tool of doing so is through the assessment of the financial statements preparation by an external auditor.
Due to recent regulation changes it is important to disclose relevant information so as to satisfy all stakeholders and reduce the conflicts of interest. Business is imposed with additional costs by targeting at the same time to produce the appropriate benefits.
Based upon United States law, corporate regulation was provided through various Securities Acts, 1933 and 1934, and Sarbanes-Oxley Act in 2002. The Sarbanes-Oxley Act section 404 took effect November 2004.
It required the business annual report to be assessed by an internal control structure and financial reporting. Auditor has to evaluate and attest to management assessment upon these issues.
The Act involved the creation of Public Companies Accounting Oversight Board.
Aim was to establish new audit guidelines and ethical standards, requires audit committees, requires independent non executive directors to oversee annual audits and disclose whether committees employ a financial expert.
The Act requires the business officers to review and sign its annual reports. Specifically, it is declared that annual report does not contain any false statements or material omissions that financial statements represent fairly the financial results and that signatories are responsible for all the internal controls. In addition, annual report includes a list of internal controls deficiencies.
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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT
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Financial Statements
Contents
• Profit & Loss, or, Income Statement, or, Statement of Profit or Loss and other comprehensive Income
• Balance Sheet, or, Statement of financial position
• Statement of Cash Flows
• Statement of Changes in Equity
Further relevant and detailed information is disclosed as notes to the financial statements set. The financial statements are prepared upon book values and where needed and upon the discretion of the business accountants to choose upon schemes especially for new business, for instance assets’ depreciation method.
Common accounting rules, techniques and practices may vary in different jurisdictions. This is where IASB, the International Accounting Standards Board, develops the IFRSs, international financial reporting standards, so as to intervene and attempt to minimize the gap.
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These have been adopted or plan to be adopted by more than 7000 listed corporation in European Union and over 150 countries worldwide
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2.1 Financial Statement Analysis Concept
Purpose and intended users
Any business stakeholders need to monitor business financial performance so as to safeguard their individual interests. As mentioned in “overview” section, stakeholders are the shareholders, bankers, customers, suppliers, employees, management, competitors, local authorities, investors and so on. Why?
Shareholders and potential investors need to evaluate business performance define business financial strength and solvency.
Employees need to know whether their employer can still offer them employment and possible any salary increase. Maybe are interested to know senior management’s salaries and benefits enjoyed.
Banks, existing or potential lenders are interested to safeguard the resources provided or possibly to be further provided as loan to the business. Business financial strengths and weaknesses, liquidity and going concern are important issues to address.
Customers are interested upon business continuity, especially where specialized items are involved.
Suppliers are interested upon business continuity so as to continue supplying further the business.
Management and competitors base their financial decisions upon financial statements information. And management is reluctant in providing any information that would aid industry competitors.
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Financial position can be measured through
• balance sheet, through assetsi, liabilitiesii and equityiii
• profit and loss, through income and expenses
• cash flow statement, through cash inflow and outflow movement
Financial statements provide all the necessary information needed either quarterly if traded in a CSE, but definitely it must be produced annually on a systematic basis and over a predefined period which is normally a calendar year.
Quality and functionality
There is a need to ensure that financial statements are prepared by using relevant, complete, accurate, comparable and timely financial information and free from error. These are the main quality components that define the quality level of the financial statements.
It must be mentioned that inherent subjectivity over assessments upon particular items of financial information varies. Solvency and going concern issue is an important aspect over the financial statements preparation.
For this purpose an external auditor is hired by the board of directors to audit and express an independent opinion upon the financial statements.
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Whether these do present fairly in all material aspects the business financial position and conforms with generally accepted accounting principles.
In cases where auditors identify irregularities and the board is not willing to accept the suggested changes, then a qualified opinion is given. Such a qualification implies that the board acknowledges that irregularities exist; and qualification is given upon material irregularities. This is an alert indication for business stakeholders and investors and surely undermines their confidence towards the board.
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2.2 Financial Statement Interpretation
Financial statements are actually reporting the performance of the business. But in order to be more understood and clear interpretation means are needed to measure this quantitative performance.
For this purpose various ratios have been developed throughout the years that measure current business performance and compare the current results with previous years’ performance indicators. For information to be comparable the very same indicators need to be used throughout the process.
Different stakeholders need a measuring instrument of find that their interest is satisfied in accordance to their needs. For this purpose different needs are measurable through ratios, also called as indicators.
Depending upon the measurable performance these indicators, called as ratios, have been developed in accordance to the financial purpose that needs to be served.
Either called accounting or financial, and depending upon measurable area they determine profitability, liquidity or solvency, efficiency, financing or gearing and investors’ ratio.
Ratios express the relationship between different accounting data points or aspects of the financial statement reports, income statement, balance sheet and cash flow statement, at a specified point of time. These represent the very same source of information that analysts use themselves.
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The important issue behind calculating the ratio is the ability to interpret business performance and reach into conclusions.
And it should be mentioned that there are certain limitations into making the ratio analysis, such as use of historical information, inclusion of any related party transactions, seasonality in business trading, choice and use of judgement upon accounting policies applied and values calculated do not include or have any future prediction.
Accounting Ratios
To serve the purpose of this module it is considered that accounting ratios provide information to the management about business efficiency and profitability position from short term point of view. Illustrations given serve as guidance to ratios calculation that follows.
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Profitability can be calculated through the following:
• Return on Capital Employed (ROCE)
Calculates % of earnings generated from business operations; must be less than cost of capital
Capital Employed = Total Assets – Current Liabilities, or
Capital Employed -= Shareholders’ funds + Long-term Liabilities
• Return on Equity
Calculates in % the use of funds to generate profits
• Gross Profit Margin
Calculates the mark-up % over inventory or services cost
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• Net Profit Margin
Calculates the business ability to manage its expenses in relation to net revenue in %
Efficiency can be calculated through the following:
• Return on Assets or Asset Turnover ratio
Calculates business efficiency in % to get a return over the assets employed in the business
Average Total Assets =
• Accounts Receivable Collection Period
Calculates business ability to collect accounts receivable expressed in days
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• Inventory Turnover Period
Calculates the inventory turnover and is presented in times
Average Inventory =
• Accounts Payable Payment Period
Calculates business efficiency for vendors’ payment in days; credit facility is based upon ratio results
Total Purchases = Closing Inventory Balance +Cost of Sales – Beginning Inventory Balance
Average Payables =
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Financial ratios
To serve the purpose of this module it is considered that financial ratios provide information regarding liquidity position, business loans and debts with long-term terms duration and having a view from an investors’ position.
Liquidity can be calculated through the following:
• Current Ratio
Calculates in % business liquidity and ratio compares current assets to current liabilities
• Acid Test (Quick) Ratio
Calculates in % available cash and the ratio compares the available cash towards current liabilities
• Debt Ratio
Calculates in % of the overall business total debt (loan) liabilities over total assets
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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT
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Gearing (Leverage)
• Debt to Equity
Calculates business financial stability % and different benchmark value exists per industry, nevertheless the lower the better
• Interest Cover
Calculates in % the business ability to pay any interest involved
• Equity Ratio
Calculates in % business equity financing levels, the higher the better
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Investors’ ratios can be calculated through the following:
• Earnings per Share (EPS)
Calculates income % available for distribution to common shareholders, the higher the better
Weighted Average in its simplified form=
• Price-Earnings Ratio (PE)
Calculates % of how much an investor should pay for the share based on its current earnings
• Dividends per Share
Calculating % of the dividends paid within a period for each share
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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT
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• Divided Cover
Calculates business capacity % to pay dividends from profits attributable to shareholders
And can be interpreted as well as
• Dividend Yield
Calculating investors’ dividends % earned for each share’s dollar worth in %
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Value drivers link towards performance
Source: Contemporary Strategy Analysis, Robert M. Grant
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Credit Rating Agencies
Probability of default is something that all lenders and vendors want to avoid. This was the reason that credit rating agencies do this research on behalf of individuals or corporations. The biggest two rating agencies Moody’s and Standard & Poor’s, S&P, or less known Fitch, provide businesses for a specified fee depending upon the desired detail and the involved investigations, the probability of default rate.
Credit Rating Agency Purpose
The default rate calculated by the credit rating agencies, is given as requested to the vendor or lender, and is upon their discretion to apply the appropriate compensation for the calculated default risk. For this purpose in order to measure default or deterioration risk, credit scoring systems were developed to measure credit quality.
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The rate produced by the credit scoring, or rating, system takes information from financial statements and attempts to predict which are going to default upon their debts and go bankrupt.
Intended users
Credit rating agencies restrict the principal-agent problems by reducing the amount of risk the agent may take on behalf of the principal. Furthermore, the credit rating agencies provide assistance upon monitoring performance upon dispersed debts through downgrades made, a signal given to take any further action needed.
Recognized credit rating agencies do reduce effectively the burden for any lender or vendor to research creditworthiness for any security, issuer or corporation. Credit ratings offer various tools among which portfolio managers can assist upon any investment decision or lenders to decide upon their credit decisions.
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Information and business challenges
“Faulty credit ratings and flawed rating processes” has been identified as key contributors to the worldwide financial crisis. This was the main reason to produce more intense scrutiny and bring radical reforms.
This approach influences the policy choices especially on ratings reliability or even more producing new alternative mechanisms so as bank institutions perform more effectively the role that had traditionally conferred by credit rating agencies.
It has been identified that the rating provided by the credit rating agencies did not provide guidance upon liquidity and price volatility issues.
Even though each credit rating agency has its own rating methodologies and sometimes different scales, their rating is just an opinion that does not provide recommendations upon any further actions needed to be made. Furthermore, their rating does not constitute financial advice, an issue that prevented direct regulation upon their operations.
“Credit rating agencies have been extensively criticized” upon their role in stimulating the growth of the asset-backed structured finance debt market which was the major catalyst for the global financial crisis. Even more the low market transparency and great complexity urged the heavy reliance upon credit rating agencies. Their rating as easily contributed to market growth subsequently accelerated the market’s collapse.
There were incidents where credit rating agencies were accused to their slow react upon market events, such as Enron or Worldcom. The fact is that these rating indications are volatile and may be susceptible to market manipulation. The overreliance upon few credit rating agencies may reinforce practices that may compromise rating integrity.
Regulatory measures have been imposed by several authorities worldwide so as to respond to the occurred failures. And there is no consensus upon a single reform set to manage conflicts of interest, quality of methodologies used, use transparency and information disclosure, introduce government regulation and supervision.
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References
IASB. (2017). IFRS. Retrieved June 10, 2017, from IFRS: http://www.ifrs.org/use-around-the-world/analysis-of-the-use-of-ifrs-standards-around-the-world/
Richard A.Brealey, S. C. (2011). Principles of corporate finance (10th ed.). McGraw-Hill/Irwin.
Stephen A. Ross, R. W. (2010). Corporate Finance. (10th, Ed.) NY: McGraw-Hill/Irwin.
Thomas l.Wheelen, J. H. (2012). Strategic Management and Business Policy toward global sustainability (13th ed.). New Jersey: Pearson Education Inc.
Welch, I. (2009). Corporate Finance, An introduction. Pearson Education.
World, B. G. (2009, October). Credit Rating Agencies. Retrieved June 2017, from The World Bank Group: http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/282884-1303327122200/Note8.pdf
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i Asset is a resource owned, controlled and used by the business from which future economic benefits are expected to be received
ii Liability is a present obligation of the business arising from past events, which is expected to result an outflow for its settlement
iii Equity is the shareholders funds and is the residual value between all assets and liabilities.

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