Analytical Procedures

SLAuS 520

M.R.P. Wijesinghe
Lecturer (Prob.)
Department of Finance
University of Kelaniya

Analytical procedures
Means evaluations of financial
information through analysis of plausible
relationships among both financial and
non-financial data
Analytical procedures also encompass
the
investigation
of
identified
fluctuations and relationships that are
inconsistent
with
other
relevant
information or deviate significantly from
predicted amounts

Analytical procedures include the

consideration of comparisons of the
Comparable information for prior periods.
entitys
financial information with, for
Anticipated results of the entity, such as
example

budgets or forecasts, or expectations of the

auditor, such as an estimation of depreciation.
Similar industry information,
Analytical procedures also include

consideration of relationships, for example

Among elements of financial information
that would be expected to conform to a
predictable pattern based on the entitys
experience,
Between financial information and relevant
non financial information,

Requirements
Analytical

procedures must be applied in

the beginning stages of each audit.
Preliminary analytical procedures are
primarily attention directing

Five general types of procedures for

analysis of current year account balance
are as follows:
Compare to balances for one or more
comparable periods.
Compare to anticipated results (budget and
forecasts).
Evaluate relationships to other current-year
balances for conformity with predictable
patterns.
Compare with similar industry information.
Study relationships with relevant non
financial information.

When designing and performing substantive

analytical
procedures,
either
alone
or
in
combination with tests of details, as substantive
procedures in accordance with SLAuS 330, the
auditor shall:
(i) Determine

the suitability of particular substantive

analytical procedures for given assertions

Different types of analytical procedures provide

different levels of Assurance

Example: the prediction of total rental income on a

building divided into apartments, taking the rental rates, the

number of apartments and vacancy rates into consideration,
can provide persuasive evidence and may eliminate the need
for further verification by means of tests of details, provided
the elements are appropriately verified. In contrast,
calculation and comparison of gross margin percentages as a
means of confirming a revenue figure may provide less
persuasive evidence, but may provide useful corroboration if
used in combination with other audit procedures

The
determination
of
the
suitability
of
particular substantive analytical procedures is
influenced by the nature of the assertion and
the auditors assessment of the risk
Example, if controls over sales order processing are
deficient, the auditor may place more reliance on
tests of details rather than on substantive analytical
procedures for assertions related to receivables.

(ii) Evaluate the reliability of data from which

the auditors expectation of recorded
amounts or ratios is developed, taking
account of source, comparability, and nature
and relevance of information available, and
controls over preparation

The reliability of data is influenced by

its source and nature and is dependent
on the circumstances under which it is
obtained. Points to think
Source

of the information available

Comparability of the information available.
Nature and relevance of the information
available.
Controls over the preparation of the
information

(iii) Develop an expectation of recorded

amounts or ratios and evaluate whether the
expectation is sufficiently precise to identify a
misstatement

Matters relevant to the auditors

evaluation
The accuracy with which the expected results
of substantive analytical procedures can be
predicted.
The degree to which information can be
disaggregated
The availability of the information, both
financial and non -financial.

(iv)

Determine the amount of any

difference of recorded amounts from
expected values that is acceptable
without further investigation as required
by paragraph 7

As the assessed risk increases, the

amount
of
difference
considered
acceptable
without
investigation
decreases in order to achieve the
desired level of persuasive evidence.

Analytical Procedures that Assist

When Forming an Overall Conclusion

The auditor shall design and

perform analytical procedures near
the end of the audit that assist the
auditor when forming an overall
conclusion as to whether the
financial statements are consistent
with the auditors understanding of
the entity.

Investigating
Procedures

Results

of

Analytical

If identified fluctuations or relationships that a

re inconsistent with other relevant
information or that differ from expected
values by a significant
amount, the auditor shall investigate such
differences by:
(a)

(b)

Inquiring of management and obtaining

appropriate audit evidence relevant to
managements responses; and
Performing other audit procedures as
necessary in the circumstance

Financial Statement
Analysis
Financial

Statement Analysis is
analyzing the financial statements
using different techniques and
methods and interpreting results
which can be used by the users of
information.

Users Information
Needs
Accounting information is using by different
type of users for different purposes. Using

this statements they make decisions. Users

mainly can be divided in to:

Internal Users

External Users

Internal

Users are using financial and

management accounting information for
decision making purposes.

External

users
using
only
financial
accounting information to make there own
decisions.

Context for Financial

Statement Analysis
Size

of the business
Riskiness of the business
Economic, social and political
environment
Industry trends and effects of changes
in technology
Effect of price changes

External Sources of
Information
Government

statistics
Trade journals
Financial press
Databases
Specialist agencies

Internal Sources of
Information
chairmans

statement
directors report
statement of financial position
statement of financial performance
accounting policies statement
notes to the accounts
statement of cash flows
auditors report

Methods and
Financial Statement Analysis can be divided
Techniques
into:
Basic Analyzing Methods
Advance Analyzing Methods

Basic Methods:
Horizontal Analysis
Trend Analysis
Vertical Analysis

Advance Methods:
Ratio Analysis

Horizontal
Analysis
technique used to study
the change in

the amounts reported for the same item

in two or more consecutive financial
statements by presenting the amount in
both amounts and percentages.

Generally

performed as a starting point

for forecasting future performance

Important

and unusual changes should

be investigated to determine if possible:
the cause of change
whether the change was favorable or
unfavorable
any trends likely to continue

Horizontal Analysis

Amount difference =
Current Year Base
Year
% difference =
Amount difference /
Base Year *100

Lincoln Company
Comparative Balance Sheet
December 31, 2003 and 2002
Assets
Current assets
Long-term investments
Fixed assets (net)
Intangible assets
Liabilities
Current liabilities
Long-term liabilities
Stockholders Equity
Preferred stock, $100 par
Common stock, $10 par
Retained earnings

2003

2002

$ 550,000 $ 533,000
95,000
177,500
444,500
470,000
50,000
50,000
$1,139,500 $1,230,500
$ 210,000
100,000
$ 310,000

Increase (Decrease)
Amount Percent
$ 17,000
3.2%
(82,500) (46.5%)
(25,500) (5.4%)

$ (91,000) (7.4%)

$ 243,000 $ (33,000) (13.6%)

200,000
(100,000) (50.0%)
$ 443,000 $(133,000) (30.0%)

$ 150,000 $ 150,000
500,000
500,000
179,500
137,500
$ 829,500 $ 787,500
$1,139,500 $1230,500

$42,000
$42,000
$(91,000)

30.5%
5.3%
(7.4%)

Vertical Analysis
Vertical

analysis is a technique used to determine

the relative importance in each item.

According

to this we need to select most

important factor in our statement and then
compared all other items in the same statement
to selected item.

It

is often referred to as common size

statements since all items are expressed as
percentage of some common base amount.

Vertical

analysis is a common tool for:

comparing past performance of an entity

comparing current performance with other entity
comparison with industry averages

Lincoln Company
Comparative Balance Sheets
Assets
Current assets
Long-term investments
Fixed assets (net)
Intangible assets
Liabilities
Current liabilities
Long-term liabilities
Stockholders Equity
Preferred stock, $100 par
Common stock, $10 par
Retained earnings

December 31, 2003

Amount Percent

December 31, 2002

Amount Percent

$ 550,000
95,000
444,500
50,000
$1,139,500

48.3%
8.3
39.0
4.4
100.0%

$ 533,000
177,500
470,000
50,000
$1,230,500

43.3%
14.4
38.2
4.1
100.0%

$ 210,000
100,000
$ 310,000

18.4%
8.8
27.2%

$ 243,000
200,000
$ 443,000

19.7%
16.3
36.0%

$ 150,000
500,000
179,500
$ 829,500
$1,139,500

13.2%
43.9
15.7
72.8%
100.0%

$ 150,000
500,000
137,500
$ 787,500
$1230,500

12.2%
40.6
11.2
64.0%
100.0%

Trend Analysis
Trend

analysis is used to study the change

in an item over several periods by
expressing the absolute Rupee value as a
percentage of the base year

base year (average year) is selected with

an index of 100 and all subsequent values
are converted to an index value related to
the base year.

It

is commonly used to assess an entity's

growth prospects with overall objective is
to evaluate the various trends and attempt
to assess whether the trend can be
expected to continue.

1992

1993

1994

1995

1996

Sales

550000 590000 650000 700000 760000

Net
profit

32000

35000

39000

48000

52000

Sales

100

107

118

127

138

Net
profit

100

109

122

150

162

Base Year / Base Year = Index

Subsequent Years / Base Year

Ratio Analysis
Ratio

analysis is an analytical tool

which
is
often
combined
with
horizontal, trend and vertical analysis
to assess an entitys performance. Ratio
analysis requires that ration values be
calculated and then compared with:

past performance with the entity

external industrial standards

similar
industries

entities

in

the

same

Ratio Analysis
Ratios

mainly can be divided into

following categories:

Liquidity Ratios

Efficiency Ratios

Profitability Ratios

Long Term Solvency Ratios

Market Based Ratios

Other Ratios

Liquidity (Solvency) Analysis

Liquidity means having enough money on hand to pay
bills when they are due and to take care of unexpected
needs for cash.
Solvency is the ability of a business to meet its financial
obligations (debts) as they are due.
Solvency analysis focuses on the ability of a business
to pay or otherwise satisfy its current and noncurrent
liabilities.
This ability is normally assessed by examining balance
sheet relationships.
There are two main type of ratios for liquidity.

Current Ratio
Quick (Acid Test) Ratio

 Current

ratio is the ratio of current assets to

current liabilities. The current ratio is closely
related to working capital and is believed by
many bankers and other creditors to be a
good indicator of a company ability to pay its
bills and to repay outstanding loans.

Current Ratio
Low

ratio indicate inability to meet short term

debts in an emergency.

High

ratio is favorable to creditors, but may

indicate excessive investment in working
capital items that may not be producing
profits.

Rule

of Thumb: CURRENT
2:1
ASSETS

CURRENT RATIO =

CURRENT LIABILITY

Quick
(Acid
Test
) than
A more rigorous
measure
of liquidity
current ratio. It exclude inventory and
prepayments from total current assets and
Ratio
keeping only quickly converted items to
cash.

The

higher the ratio the more liquid the

entity is considered. A rule of thumb used by
some analysts is that a 1:1 ratio is adequate.

lower ratio may indicate that, in an

emergency, the entity would be unable to
meet its immediate obligations
QUICK ASSETS
QUICK RATIO = CURRENT LIABILITY

QUICK ASSETS = Current Assets (Inventory + Prepayments)

Efficiency Ratios

Efficiency

ratio measuring management

efficiency of the business entity. This
shows how efficiently management is
working to achieve entities objectives.
Under the efficiency we can measures the
following ratios:

Receivable (Debtors) Turnover

Average collection period (number of
days)

Inventory Turnover

Inventory turnover in days

Receivable (Debtors)
Is a measure of how many times the
Turnover

average
receivable
balance
is
converted into cash during the year.
It is also considered a measure of
the efficiency of credit granting and
collection policies that have been
established.

The

higher the receivable turnover

ratio, the shorter the period of time
between recording a credit sales and
collecting the cash. NET CREDIT SALES

RECEIVABLE TURNOVER =

AVERAGE DEBTORS

Average collection period

This ratio shows

(number
of number
days)of days going to
collect the receivables from credit sales.

This

ratio compared with entities credit

terms and if it is less than the credit term,
that indicate the credit policy is effective
and that the entity probably is not
burdened by excessive amounts of bad
debts that have not been written off.

If

the collection period exceeding credit

terms indicates a problem with either
the
365
granting
of credit,
collection
policies, or
AVERAGE
COLLECTION
PERIOD
= RECEIVABLE
both.
TURNOVER RATIO

Inventory Turnover
A

measure of the adequacy of

inventory and how efficiently it
is being managed.

The

ratio is an expression of
the number of times the
average inventory balance was
sold and then replaced during
COST OF GOODS SOLD
the
year
INVENTORY TURNOVER =

AVERAGE INVENTORY

Inventory
Turnover
in
Days

This shows the number of days entity is

holding there stocks before they purchase
the new stocks.

The

increase
turnover
generally
be
considered a favorable trend.A very high
inventory turnover indicates the possibility
that the company is not maintaining a
sufficient amount of good on hand and the
possibility of lost sales.

An

analysis of results needs to take into

account:nature of industry, previous turnover
ratios, and unique aspects of current
operations.
365
INVENTORY TURNOVER IN DAYS= INVENTORY TURNOVER

Long Term Solvency Ratio

Long

term solvency is the ability of an

entity to continue operations in the long
term, to satisfy its long term commitments,
and still have sufficient working capital left
over to operate successfully.

Four

widely used ratios are often

calculated to assess a companys ability to
satisfy its long term creditors.

Debt to Equity Ratio

Debt Ratio

Equity Ratio

Interest Coverage Ratio

Debt to Equity Ratio

This

ratio
measures
the
relationship of the companys
assets provided by its creditors to
the
amount
provided
by
shareholders.

The

lower the debt to equity ratio

is, the smaller the company debt
and therefore the TOTAL
less risk
to is
LIABILITIES
DEBT
TO EQUITYby
RATIO
=
assumed
creditors.
TOTAL SHAREHOLDERS
EQUITY

Debt Ratio

This

ratio measures the margin of safety to

the creditors of the firm in the event
liquidation.

The

greater the percentage of assets

contributed by shareholders, the greater the
protection to the creditors.

Since

this ratio is a measure of the margin

of safety to the creditors of the entity in the
event of liquidation, the lower the ratio, the
greater the asset protection to the creditors.
DEBT RATIO =

TOTAL LIABILITIES
TOTAL ASSETS

Equity
Ratio
ratio is referred

This

proprietorship ratio.

to

as

the

The

equity ratio examines the relationship

between shareholders equity and total
assets. Sometimes this ratio is calculated
by
using
only
ordinary
(common)
shareholders equity in the numeration.

Equity

ratio is the measure of the margin

of safety to creditors in the event of
liquidation.

The

higher the equity ratio, the greater

the asset protection to creditors.

EQUITY RATIO =

TOTAL SHAREHOLDERS EQUITY

TOTAL ASSETS

Interest
Coverage
Ratio
This ratio is an indicator of the entitys

ability to satisfy periodic interest payments

from current profit.

rough rule of thumb is that profits should

be 3 to 4 times the interest requirement.

Interest

expenses and income taxes are

added back to operating profits in the
numerator because the ratio is a measure
of profits available to pay the interest
charges.

INTEREST COVERAGE =

NET PROFIT + INCOME TAX

+ INTEREST EXPENSES
INTEREST EXPENSES

Profitability Analysis

Profitability is the ability of an entity to earn profits.

This ability to earn profits depends on the effectiveness and

efficiency of operations as well as resources available.

Profitability analysis focuses primarily on the relationship

between operating results reported in the income statement
and resources reported in the balance sheet.

Profitability concentrating following ratios:

Gross Profit Margin

Net Profit Margin

Assets Turnover Ratio

Return on Assets

Return on Ordinary shareholders equity

Earning per Share

Profit
Margin
Profit margin is calculated

during a
vertical analysis of the profit and
loss statement. It reflect the portion
of each dollar of sales that
represents gross profit or net profit.

GROSS PROFIT
GROSS PROFIT MARGIN = NET SALES REVENUE

NET PROFIT MARGIN =

NET PROFIT AFTER TAX

NET SALES REVENUE

Assets
Turnover
Ratioassets
This ratio measure
how efficiently
are used to generate sales revenue.
It

relates net sales to average total assets

to show how many times in a period the
assets were turned over in generating
sales.

This

is a general indicator of long term

stability, an analysis of the entitys ability
to use its assets during a period may be
expressed in the asset turnover ratio.

NET SALES REVENUE

ASSETS TURNOVER RATIO = AVERAGE TOTAL ASSETS

Rate of Return on Total

Assets Ratio
This

ratio shows the overall earning power of

total assets irrespective of capital structure.

This

is an attempt to measure the rate of

return earned by management through
activities and is determined by dividing the
sum of operating profit before tax plus interest
expense by average total assets for the year

This

ratio is useful in measuring management

efficiency in using the entitys assets to
produce operating profits after tax and before
interest.
NET PROFIT + INCOME TAX +
INTEREST EXPENSE
RETURN ON ASSETS =
AVERAGE TOTAL ASSETS

Return on Ordinary
Shareholders Equity
A

measure of how well the firms

resources are being used to
generate profits for the ordinary
shareholder. The ratio will show
how much the company earned
for each dollar invested on
ordinary shareholders
funds.
NET PROFIT

PREFERENCE DIVIDEND
RETURN ON ORDINARY
SHAREHOLDERS EQUITY = AVERAGE ORDINARY
SHAREHOLDERS
EQUITY

Earning per Share

Earning

per share (EPS) on ordinary

shares is a commonly quoted and
widely published ratio calculated from
an entitys financial statements.

As

the term implies, this ratio is the

conversion of the absolute dollar
amount of profit to a per share basis.

EARNING PER SHARE =

NET PROFIT
PREFERENCE DIVIDEND
WEIGHTED AVERAGE
NUMBER OF ORDINARY
SHARES OUTSTANDING

Market Based Ratio

Most

market based ratios are based on a

companys earnings, the current market
price of the shares, or its dividend
distributions. Each ratio establishes a
relevant relationship between two or
more of these figures and often used by
investors, security analysis and other
interested parties.

Major

market based ratios are:

Price Earning Ratio

Earning Yield

Dividend Yield

Price Earning Ratio (P/E)

This ratio indicates how much an investor would have

to pay in the market place for each dollar of earnings.

It enhances a statement users ability to compare the

market value of one ordinary share relative to profits
with that of other entities.

P/E ratio vary widely between industries since they

represent investors expectations for a company.

High P/E ratio are associated with growth companies,

whereas more stable companies have low P/E ratio

MARKET PRICE PER

PRICE EARNING RATIO = ORDINARY SHARE
EARNING PER SHARE

Earnings Yield
The

reciprocal of the P/E ratio is

known as earning yield.

Earning

yield indicates the average

rate of return available to a
prospective
investor
if
an
investment
is
made
in
the
companys shares at the market
EARNING PER SHARE
price.

EARNING YIELD =

MARKET PRICE PER

ORDINARY SHARE

Dividend Yield
This

ratio is normally calculated by an

investor who is acquiring ordinary shares
primarily for dividends rather than for
appreciation in the market price of the
shares.

The

percentage yield indicates a rate of

return on the dollar invested and permits
easier comparison with returns from
alternative investment opportunities.

DIVIDEND PER ORDINARY SHARE

DIVIDEND YIELD =
MARKET PRICE PER SHARE

Limitations of financial statement

Ratios are useful only to the extent that the financial
analysis
information on which they are based is accurate and
reliable.

Caution is needed in comparisons:

formulas must be consistent when applied
differences between entities must be considered
seasonal influences must be considered
industry averages may not be efficient

Caution is needed in interpretations:

no ration should be judged in isolation
ratio give indications rather than explanation

Limitations of historic cost accounting are reflected in

ratios:
does not directly take into account the effect of inflation
information is of past