Analysis of Financial Statements

Topic Gateway Series

Analysis of Financial Statements

Topic Gateway Series No. 13

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Prepared by Jasmin Harvey and Technical Information Service Last review February 2008

Analysis of Financial Statements

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Topic Gateway Series

About Topic Gateways

Topic Gateways are intended as a refresher or introduction to topics of interest

to CIMA members. They include a basic definition, a brief overview and a fuller

explanation of practical application. Finally they signpost some further resources

for detailed understanding and research.

Topic Gateways are available electronically to CIMA Members only in the CPD

Centre on the CIMA website, along with a number of electronic resources.

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Our information specialists and accounting specialists work closely together to

identify or create authoritative resources to help members resolve their work

related information needs. Additionally, our accounting specialists can help CIMA

members and students with the interpretation of guidance on financial reporting,

financial management and performance management, as defined in the CIMA

Official Terminology 2005 edition.

CIMA members and students should sign into My CIMA to access these services

and resources.

The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom

T. +44 (0)20 8849 2259 F. +44 (0)20 8849 2468 E. tis@cimaglobal.com www.cimaglobal.com

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Definition ‘The objective of financial statements is to provide information… that is useful to

a wide range of users in making economic decisions.’

International Accounting Standards Committee - now the International

Accounting Standards Board

Analysis of financial statement is:

‘The evaluation of a firm’s financial statements in order to assess the firm's worth

and its ability to meet its financial obligations.’

Definitions of each of the ratios described later on this topic gateway can be

found in CIMA Official Terminology, 2005.

Context In the current syllabus, CIMA students will learn and may be examined on this

topic in Paper 8 'Financial Analysis’ and at a strategic level in Paper 9

'Management accounting financial strategy’. Students may be examined if they

take the TOPCIMA case study.

Related concepts The analysis of financial statements is linked to financial analysis and industry or

industrial analysis.

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Overview

The analysis of financial statements relates to the application of analytical tools

and techniques, in particular ratio analysis, to financial statements and other

related company data. The purpose is to derive estimates and to make

interpretations about these to assist in business and economic decision making.

Analysis of financial statements is used to assess past performance or current

position of a business. It can be used to forecast future performance or financial

conditions and risks. It is a helpful screening tool in making merger and other

investment decisions. Analysis of financial statements is also an evaluation tool

for managerial and other business decisions.

In short, it is an important tool in assessing financing, investing and operating

activities. (Bernstein and Wild. 2000).

Analysis of financial statements in practice

Analytical framework

Finance professionals need to use their judgement and experience when they

interpret the results of financial statement analysis. It is not merely about

calculating ratios and applying rules of thumb. The interpretation process is

assisted by adopting an analytical framework, with the following main

components:

• identification of the user of the analysis

• understanding the nature of the business, industry and organisation

• identification of relevant sources of data for analysis

• numerical analysis of available data

• interpretation of the results of the analysis

• appreciating the limitations of the data and analysis

• communicating and reporting the analysis of the results and

recommendations.

Source: Gowthorpe and Robins (2005).

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Users of financial statement analysis Financial statement analysis is used to understand the current financial position of

a company and its prospects for the future.

There is a wide range of external user groups that may be interested in an

entity’s financial statements, in addition to existing and potential investors. Some

of these include existing or potential lenders, suppliers and other creditors,

employees, customers, governments and the general public.

Although the various user groups will almost always use general purpose

financial reports, their needs will differ. It is important that any analysis and

interpretation exercise is tailored to the needs of the particular user.

Understanding the business and industry In order to interpret the calculations, it is important to understand the

relationship between the data and the underlying economic (and other reasons)

for the company’s current position. For example, the history, operating

characteristics, management composition and attitude to risks of the business will

help to explain its current position and future outlook.

Comparisons of the results of the analysis against the industry can be very useful.

Therefore it is important to identify industry characteristics and to establish

benchmarks against which to compare position and performance.

Identification of data sources The most obvious source of financial and non-financial information is a

company’s annual report. The annual report provides information that is required

by law and by accounting standards. The report also usually provides further

voluntary disclosures that may be helpful. Other sources of information include:

• interim announcements

• analyst/broker reports

• media announcements

• company web page

• specialist and industry groups

• corporate social responsibility reports.

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Numerical analysis of data Users are primarily interested in two areas:

1. the company’s performance.

2. the company’s current financial position.

Preparers of financial statement analyses in these area will concentrate on the

following key areas:

• performance: this includes calculating profitability, activity and return on

capital ratios, and studying movements in revenue

• liquidity: this includes calculating short-term liquidity ratios, analysing

working capital and the cash position

• capital structure and long-term solvency: a company’s ability to generate

future revenues and meet long-term obligations. The effectiveness of the

company’s capital structure can also be analysed

• valuations and investor related: this area examines a range of ratios to value

the company at specific dates in time for investment purposes. It looks at

growth potential and the ability to generate future wealth and earnings for

investors

• cash flow: a company’s cash flow is arguably the most important indicator of

the financial health of a company. The three main totals on a cash flow

statement (per IAS 7) can be examined: cash flows from operating activities,

investing activities, and financing activities. In addition, various ratios can also

be calculated.

Bernstein and Wild (2000).

In these areas of analysis, a combination of studying movements in absolute

numbers and the calculation of ratios is used to understand a company’s

performance, its current financial position and prospects for the future. (The

further information section of this topic gateway includes resources where you

can find more detail on using and interpreting ratios).

Interpretation of the results An analysis should include, but not restrict itself, to the following:

• Time series analysis. Determining trends against past years or periods by

examining year on year changes. Numbers should be presented both in

absolute terms and in percentages.

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• Comparing actual versus forecast results can assess the accuracy of forecasts

and assist with future planning and can highlight areas for investigation.

• Industrial or cross sectional analysis. Comparing with other companies within

the same industry in the same year or to industry averages. By benchmarking

a company’s results against its peers, a company can determine if it is above

or below average for its industry. It can then work to address weaknesses or

to exploit strengths.

Consideration should also be given to the company’s accounting policies and

style.

Limitations of analysis A substantial limitation of financial statements is found in paragraph 13 in the

IASB’s Framework for the Preparation of Financial Statements (July 1989):

‘Financial statements do not provide all the information that users may need to

make economic decisions since they largely portray the financial effects of past

events and do not necessarily provide non-financial information.’

Gowthorpe and Robins (2005)

Other limitations

Timeliness

When analysing financial statements, caution should be exercised and additional

information sought regarding post year end events. This is due to the delay

between when financial statements are prepared and received (and therefore

analysed by users).

Comparability

The usefulness and accuracy of comparisons may become impaired over time.

This is due to significant business changes, price inflation and changes in

accounting policy and practices over the longer period. Complex businesses, for

example, those operating in more than one business sector, may find

comparisons with industry averages or with other companies difficult.

International issues

Different tax regimes, legal and regulatory regimes and differences in economic

statistics (such as exchange rates and interest rates) must be considered when

interpreting results.

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Reporting of results

How results are reported will depend on the end user of the information. The

content should be tailored to the individual needs of the end user.

Gowthorpe and Robins (2005)

Communicating the results of the analysis

The final step in the analytical framework for financial statement analysis is

communicating the results and recommendations to decision makers. A concise

and understandable format using simple charts and graphs is an effective way to

summarise and illustrate key messages.

Bibliography Bernstein, L. and Wild, J. (2000). Analysis of financial statements. 5th ed. New

York: McGraw-Hill

Gowthorpe, C. and Robins, P. (2005). Financial analysis study system. London:

CIMA Publishing. This book can be purchased from CIMA Publishing.

www.cimapublishing.com [Accessed 28 May 2009]

Walton, P. (2000). Financial statement analysis: an international perspective.

London: Business Press Thomson Learning

Further information

Articles CIMA members can obtain articles on this topic from the Business Source Corporate database, which can be found in the CIMA Professional Development section of the CIMA website. www.cimaglobal.com/mycima [Accessed 28 May 2009]

Bull, R. Financial ratios. Financial Management, April 2005, pp 34-35

Glasgow, B. Metrics and measures: cash flow-based analysis rules the roost.

Chemical Market Reporter, 25 November 2002, Volume 262, Issue 19, p. FR3

Mautz, D. Jr. and Angell, R. Understanding the basics of financial statement

analysis. Commercial Lending Review (Aspen), September 2006, Volume 21,

Issue 5, pp 27-34

Negus, S. Avoiding cell hell on your spreadsheets. CIMA Insight, December 2005

Available from: www.cimaglobal.com/insight [Accessed 28 May 2009]

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Prendergast, P. Financial analysis. Financial Management, May 2006, pp 48-49

Available from: www.cimaglobal.com/financialmanagement [Accessed 28 May 2009]

Ruland, W. Financial ratios and statement analysis. Blackwell Encyclopedic

Dictionary of Accounting, 2005, pp 194-198

Walton, P. International financial statement analysis. Blackwell Encyclopedic

Dictionary of Accounting, 2005, pp 255-260

White, H. Financial statement analysis, forecasting and budgeting: an integrative

teaching approach. Journal of Accounting and Finance Research, Fall II 2004,

Volume 12, Issue 5, pp 49-61

Statements of cash flows and analysis of ratios (chapter 4). Cash Rules, 2003,

pp 49-76

Books Bull, R. (2005). Financial ratios: building a model of success for your business. London: Spiro Press. (Spiro Business Guides)

CIMA Official Terminology, (2005). Chartered Institute of Management

Accountants (CIMA). London: CIMA Publishing. This book can be purchased from

CIMA Publishing. www.cimapublishing.com [Accessed 28 May 2009]

Friedlob, G.T. Essentials of financial analysis. (2002). Chichester: John Wiley and

Sons

Gowthorpe, C. and Robins, P. (2005). Financial analysis study system. London:

CIMA Publishing. This book can be purchased from CIMA Publishing.

www.cimapublishing.com [Accessed 28 May 2009]

Helfert, E. (2001). Financial analysis tools and techniques: a guide for managers. New York: McGraw-Hill Education

Holmes, G. et al. (2002). Interpreting company reports and accounts. 8th ed.

Harlow: FT/Prentice Hall

Ogilvie, J. and Parkinson, C. (2005). Management accounting: financial strategy

study system. London: CIMA Publishing. This book can be purchased from CIMA

Publishing. www.cimapublishing.com [Accessed 28 May 2009]

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Palepu, K.G., Healy, P.M. and Bernard, V.L. (2003). Business analysis and

valuation: using financial statements, text and cases text and cases edition.

South-Western Educational Publishing

Peterson, P.P. and Frabozzi, F.J. (2006). Analysis of financial statements. Hoboken, NJ: John Wiley and Sons

Revsine, L.C., Johnson, D.W. and Bruce, W. (2001). Financial reporting and

analysis edition. Harlow: Prentice Hall

Robinson, T., Muter, P. and Grant, J. (2004). Financial statement analysis: a

global perspective. Harlow: Pearson/Prentice Hall

Stickney, C.P. et al. (2006). Financial reporting, financial statement analysis and

valuation: a strategic perspective. South Western College Publishing

White, G.I. (2003). The analysis and use of financial statements. 3rd ed.

Hoboken, NJ: John Wiley and Sons

Wild, J.J. et al. (2006). Financial statement analysis. New York: McGraw Hill

Higher Education

Websites Biz/ed

This is a website for students and educators in business studies, economics and

accounting. It is funded by the Joint Information Systems Committee (JISC). The

financial ratio analysis section of this website provides a comprehensive guide to

financial ratios. It is illustrated with examples from real business organisations.

Available from: www.bized.co.uk

[Accessed 28 May 2009]

Creditguru

Creditguru features corporate credit and risk management solutions. Browsers

can also download a free financial statement analysis worksheet with formulas

and ratios.

Available from: www.creditguru.com

[Accessed 28 May 2009]

Analysis of Financial Statements

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Investopedia, the Investing Education Site

Owned by Investopedia Inc., Investopedia is the largest financial site on

the internet. The site includes free access to over 1,000 articles, 5,000

dictionary entries, and 500 pages of in-depth tutorials on any aspect of

finance and investing. These include comprehensive information and

learning tools on analysing financial statements.

Available from: www.investopedia.com/university/ratios

[Accessed 28 May 2009]

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Copyright ©CIMA 2006

First published in 2006 by:

The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom

Printed in Great Britain