University of Bristol

Pre-sessional Coures 2010

Title of project :

How analysis of financial statements using the ratio method could be misleading?
Name : Date : Tutor : Group : Pimpida Phattarakumpol 6 September 2010 Paul Ayres PSAM

Pimpida Phattarakumpol

QuickTime and a BMP decompressor are needed to see this picture.

Introduction

The companies are required to report their operating performance and financial health in the financial statement, which consists of 5 reports: the statement of financial position, the statement of comprehensive income, the statement of changes in equity, the statement of cash flow and notes. The 5 different reports display the distinct information of the company such as the revenue, the assets and the liabilities. Financial report is used by investors (risk of investment, the return of investment and decide to buy or sell their shape), employees (the stable of their company and an allowance), lenders and supplier (the return of debt and interest) and government (pay the tax and calculate the national income). The information in financial statement just show in numerical data and in the group of different categories, thus the users can not understand directly. Financial statement analysis is the process of reviewing and interpreting financial information for the purpose of appraising the financial health and operating performance of a company. (Haskins, Ferris and Selling, 1996) There are several different methods to analyze the financial statement, including financial ratio analysis, horizontal analysis, vertical analysis, trend analysis and cash flow analysis. The financial ratio analysis is the most common instrument for analyzing the financial report and it is very convenient to compare the data across firms. However, the ratio analysis has limitations to interpret and it can be misleading. This essay will first 2

Pimpida Phattarakumpol

explain the components of financial reports. Secondly, this essay will show the ratio analysis method. Finally, this essay will evaluate limitation to the use of analysis.

The components of financial statement (Or financial report)

According to The IASBs framework (paragraph 12), which is The International Accounting Standards Board (IASB) take the responsibility for developing and publishing the International Accounting Standards (IAS), The objectives of financial statements provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decision(Alfreson et al., 2009) It has already been mentioned that the financial statement comprises five reports. Let us now look at these in more detail. After the company record the transaction of business and prepare from the trial balance, they report the financial statement, which comprises: The statement of financial position presents the assets, liabilities and shareholders equity, classifying in different function as current or non-current and separating line items. The statement of comprehensive income displays the revenue, expenses and the profit or loss for the period. The statement of changes in equity summarizes the various of shareholders equity and includes the net income for the period. The statement of cash flows illustrates the inflows and outflows of cash and cash equivalents, which are short-term, highly liquid investments that are readily

Pimpida Phattarakumpol

convertible to known amounts of cash and which are subject to an insignificant risk of changes in value (Alfredson et al, 2009) for the period in different categories. Notes indicate the extra information, for example the accounting policy, disclosure of other judgments management, the name of the parent and so on, and expand the account. The five elements of financial statements are analyzed by the users for their financial decision. The information of financial report is used the various different reasons, which depend on the goals and objectives of users. Therefore, financial statement analysis is the instrument of analysts for finding the answer of business decision.

Pimpida Phattarakumpol

Ratio analysis

Financial statement analysis is the instrument to assess the operating performance of company and financial health for making business decision. One of the financial statement analysis method is ratio analysis, which is a powerful method for coping with the volume and complexity of data presented in most financial statements and effectively summarizes multiple financial statement categories into one or a few relative indices of performance and financial position (Haskins, Ferris and Selling, 1996). The ratio divides into four categories, which are arranged into two sectors: Financial Health: 1. Liquidity 2. Solvency Operating performance: 1. Asset management 2. Profitability Liquidity refers to the ability of the company to convert current asset to cash for returning short-term obligation and analyze whether the company manage efficiently their asset as much as they can. In the other word, the current assent can be coverage the current liability, For example: Current ratio = Current assets Current liabilities

Quick ratio = Cash + Marketable securities + Account receivable Current liabilities 5

Pimpida Phattarakumpol

Solvency implies the firm can repay the long-term liabilities and it can display the structure of capital of company, which is the ratio between the capital from shareholders and non-current liabilities. Debt to equity ratio = Debt ratio = Long-term debt Shareholders equity Total liabilities Total Assets

Asset management means the company efficiently organizes their asset earning the income and profit. Total asset turnover ratio = Net sales Average total asset balance

Average receivable collection period ratio = 365 days Receivable turnover ratio Profitability shows the ability of the company to manage low costs and expenses. Similarly, the executive can increase the inflow of cash and retain earning of income. Return on assets ratio = Return on equity ratio = Return on sales ratio = Net income Average total asset Net income Average shareholders equity Net income Net sale

Obviously, the ratio analysis is not complicated to calculate and can find out the information of the company (the operating performance and financial health). However, interpreting the ratio is difficult because not only must the analyst really understand ratio, but also they have to know the extra-information of the company such as the background of firm, the transaction of business and the policy of

Pimpida Phattarakumpol

accounting etc.

Limitation of ratio analysis

Ratio analysis is a powerful instrument for comprehending the operations of the company. However, they are not perfect to tell the story and may be misleading, as they are limit to the use of analysis. Firstly, the information from financial statements are recorded last period and all of the transaction of the firm are occurred in the past, so the users analyzed and interpreted as just forecasting the trend in the future. It does not mean the trend will absolutely occur in the next year because the situation of company depends on a lot of factors, which are variable of the business and impact the companys position in the future, for example, the political situation, new laws, the exchange rate, the interest rate and so on. Secondly, the comparing and contrasting across firms can be difficult to do because companies use different method, policy or period for accounting their transaction. For instance, According to IAS 16 (the International Accounting Standards are the rule for accounting and reporting the financial statement), the depreciation policy, being the allocate cost of asset (building and equipment: computer, machine and automobile etc.) in over useful life to expense in the period (Weygandt, Kieso and Kimmel, 2005), divides into three method: the straight-line method, the diminishingbalance method and the units-of-production method (Haskins, Ferris and Selling, 1996). For example, the company buy the car, which price is 1000, and they have to allocate the cars price to 5 years (the accounting standards prescribe car can use in business 5 years), so it mean the company have to record the depreciation expense 200 each year (use the straight-line method). The firm can choose which method is suitable for them and disclosures in the notes, being the one of five financial

Pimpida Phattarakumpol

statements. Obviously, the three methods provide different the depreciation expenses each year, which have the effect of the net asset in the statement of financial position and the expense in the financial of comprehensive income, therefore, the asset value and the net income of each companies will have different results. As a result of the alternative policy, it is quite difficult to compare inter-company. Thirdly, ratios, which are calculated from the statement of financial position figure, illustrate the trend in the end of the period, so they do not show the whole data of the year. For example, some of companies is a seasonal business such as the agriculture business, which is their inventories depend on when they can harvest their product, and other companies (Toy manufacturing) hold the high value of inventories in the end of the year because it is chrismas and new year day. They can sell a lot of their merchandises in this time and after this, the companies will retain in the normal value. Consequently, it does not show the information of the entire period and the ratio can be misleading when the analysts calculate. (Elliott and Elliott, 2008) Fourthly, the analysts do not know whether the information in financial reports can be reliable. The company makes fraud or mispresentation; for instance, the company performs the accounting fraudulent to hide their debt to show good financial health and have high return (the dividend or the interest), so people are interested in the investment in their firm. Some companies have a large number of subsidiary companies, where the parent company holds the share of subsidiary company exceed 50 per-cent (Haskins, Ferris and Selling, 1996), thus they sell their inventory to subsidiary company and according do not eliminate after the end of period: according to IAS 27 (the International Accounting Standards), the companies must eliminate not only the transaction of income, expense and dividend, but also the assets such as the inventories and the fixed asset have to eliminate between the

Pimpida Phattarakumpol

parent company and the subsidiary company in full (Bonham, 2004). As you can see, the analysts use the data in financial statement, which report by the company. As a result of the risk of analysis gets the fake information, the analyst could be attain the misrepresent data and they might make the wrong decision. Fifthly, the events occur after the end of the period of the financial statements and affect to the economic decision. IAS 10 (the International Accounting Standard) requires the company have to adjust the amount in the financial statements to report the information after the event. However, some of events do not be prescribed to adjust the financial reports, for instance, the building or factory of company was fired, the executive decided to combine the main of business and the commencing major litigation arising solely out of events that occurred after the reporting period(Keith et al, 2009). As a result of non-adjusting events after the end of the year, the figure in the financial statement can not use to analyze and will be make the user misleading. Finally, the fraction in the formula of ratio is the group of assets, liabilities or etc. Even though the outcome of ratio looks good and is more than the average of industrial ratio, it does not mean this company has a high liquidity and a good operating performance. For example, if we compare two companies, the first one has the current ratio of 2 and another company is 1. The results of two companies display obviously that the first company is better than the other. However, the investor is misunderstood by the outcome of the ratio formula because the current ratio is the current assets, consisting of cash, short-term investment unearned revenue, account receivable and inventory, divide the current liabilities. The first company could have the high value of the account receivables or the inventories owing to the lack of good management, the inventory out of date, the less of Allowance for Doubtful (the company must to estimate all of the account receivables, which can not collect the

Pimpida Phattarakumpol

money from selling their product on credit and will be the bad debt) and so on. The analyst cannot believe only the result of the ratio formula but they must interpret with the caution and analyze the fraction in the formula of the ratio.

10

Pimpida Phattarakumpol

Conclusion
The financial statement reports the operating performance and financial health of the company. The financial reports include five different statements. The information in financial report is used by the investor, even though it shows in numerical data, so there are several different methods to analyze financial statement. Particularly, the ratio analysis is the usual and powerful instrument for interpreting the financial report but it can be misleading because it has limitation to use: Forecasting the trend in the future. The alternative of the accounting policy or method The information in the statement of financial position do not show the whole

figure of the year The accounting fraudulent Non-adjusting events after the end of the period The fraction in the formula is just the group In brief, the ratio analysis is strong tool to express the information, helping the investor to decrease their risk when they want to make a decision of financial business. However, the financial statement analysis could be telling lie, if the analyst do not interpret with caution. To sum up, the users must understand the ratio and the detail of business, and it will be extremely useful and indicate the relevant information of decision.

11

Pimpida Phattarakumpol

Bibliography

Alfredson, K., Leo, K., Picker, R., Loftus, J., Clark, K. and Wise, V. (2009). Applying international financial reporting standards. Milton: John Wiley & Sons Australia, Ltd.

Bonham, M., Curtis, M., Davies, M., Dekker, P., Denton, T., Moore, R., Richards, H., Wilkinson-Riddle, G. and Wilson, A. (2004). International GAAP 2005. London: Ernst & Young LLP.

Elliott, B. and Elliott, J. (2008). Financial Accounting and Reporting. Essex: Person Education Limited. Haskins, M.E., Ferris, K.R. and Selling, T.I. (1996). International Financial Reporting and Analysis: a contextual emphasis. Chicago: Timed Mirror Higher Education Group, Inc. company

Palat, R.R. (1989). Understanding Ratios. London: Kogan Page Ltd. Weygandt, J.J., Kieso, D.E. and Kimmel, P.D. (2005). Principles of financial accounting. Canada: John Wiley & Sons, Inc.

12