Unit 2: Financial Statements and Analysis

Introduction

Businesses acquire resources from their environment and use them to produce goods and services. Within the business cycle, they perform three types of activities. These are financing, investing and operating activities. Financial statements represent the results of business activities performed by managers.

The goal of financial statement analysis is to explore the results of these activities and help internal and external users of financial information.

The remainder of the chapter contains three sections after the introduction. First section provides an overview of the basic financial statements. Second section follows with the analytical analysis of the major financial statements. Last section introduces financial ratios and discusses their interpretations and limitations.

Financial Statements

The general purpose of financial statements is to 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 decisions (IAS 1). (International Accounting Standards Board (…)International Accounting Standards...) A complete set of financial statements includes; a statement of financial position (balance sheet), a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows, and notes to financial statements.

Except the statement of cash flows; financial statements are prepared using accrual accounting. Accrual accounting records economic transactions on the basis of their existence instead of the timing of their cash consequences. Accrual accounting is needed to measure business performance on a periodic basis. Financial statements are prepared periodically by closing the books at the end of an arbitrary accounting period which usually corresponds to a calendar year in practice. Cash accounting may not report the full economic outcome of a transaction within an accounting period since cash outcome of a transaction may happen outside of the given accounting period.

Accrual accounting is used to measure the full effects of an economic transaction which takes place within an accounting period regardless of the timing of cash outcomes.

Earnings Management: Managers choose accounting policies, reporting methods and estimates that do not accurately reflect their firms’ underlying economics.

Statement of Financial Position (Balance Sheet)

The main objective of a statement of financial position is to disclose fairly what a company owns and means used to get them at a certain date. It can be thought as a selfie of the company at a point in time. Statement of financial position is made up of assets (what a company has), liabilities (what accompany owes) and owners’ equity (capital) sections reflecting the “accounting equation”.(page:40/Picture 2.2)

Accounting equation reflects the resources available for use of business and how these resources are financed by the business. Similar assets and similar liabilities are grouped together to ease financial analysis. All economic transactions related to business are recorded in the accounting system by keeping the accounting equation in balance. Hence, the same equality is reflected in the statement of financial position.

IAS No.1 requires that the statement of financial position should give the name of the company, the date it is prepared for, the monetary unit, and the level of precision.

Assets

Asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (IASB Framework). In a statement of financial position, assets are classified as current and longterm. This classification helps to analyze if the company has enough assets to pay for long term and short term obligations. The grouping of assets can be seen clearly at Vestel Company’s statement of financial position (Table 2.1)

Current Assets

Current assets are the assets that are expected to be converted into cash within the next year or within the next operating cycle, whichever is longer. Common types of current assets are; cash and cash equivalents, trade receivables, inventories, and prepaid expenses. These items are listed in the order in which they are expected to be converted into cash faster. As seen in Table 2.1 most of Vestel’s current assets consist of inventories and receivables.

Long Term Assets

Long-term assets are the assets that an entity expects to use for longer than one year or the operating cycle. These assets are mainly acquired for the purpose of providing resources for the future operations of the entity. Common types of long term assets are; property, plant and equipment, intangible assets, long term investments, and prepaid expenses.

Liabilities

A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits (IFRS Framework). Similar to asset classification, liabilities are also classified as current and longterm.

Current Liabilities

Current liabilities include obligations which are settled within the next year or operating cycle, resulting in an outflow from the entity either in cash or in kind. Debt to various interest groups such as employees, suppliers, financial institutions should be clearly identified.

Long Term Liabilities

Long-term liabilities are usually debts incurred by the entity for the purpose of financing operations and investments. Unlike current liabilities, longterm liabilities are due after the next accounting period.

Equity

The Shareholders’ Equity section of the statement of financial position includes the amounts invested in the business by the owners or investors, the earnings (losses) that are retained in the business from previous years’ income (losses), and current year income or loss.

Income Statement/Comprehensive Income Statement

Income statement is a performance statement for a given period with a bottom line figure of profit or loss. Net Income/Loss of the company indicates the success of a company in utilizing its resources in the previous period. Investors are interested in a company’s past net income because it provides information for predicting future net income. Investors invest in the company stock based on their predictions about a company’s future performance.

Earnings Quality: The extent which the reported income reflects the true financial condition and performance of the company.

Statement Of Cash-Flows

The statement of cash flows reports the cash inflows and outflows from operating, investing, and financing activities during a period, and reconciles the beginning and ending cash balances reported in consecutive statement of financial positions.

A statement of cash flows has three sections; cash-flows from operating, investing, and financing activities.

1. Operating activities include the cash effects of transactions that are related to a firm’s operations.
2. Investing activities include the cash effects of transactions that involve the purchase or disposal of investments and property, plant, and equipment,
3. Financing activities include cash effects of transactions that involve obtaining cash from creditors and stockholders and payment of existing debt dividends.

The operating activities category is considered the most important by analysts. It shows the cash provided by company operations.

Free Cash Flow

In the statement of cash flows, cash provided by operating activities is intended to indicate the cashgenerating capability of the company. Analysts have noted, however, that cash provided by operating activities fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations.

Analytical Analysis

The most important aspect of financial statement information is its reliability. Reliability is secured by the auditing process.

There are two types of analytical analysis employed for inter-company and intra-company comparisons. One of them main analyses used for comparison purposes is the vertical analysis where each item is expressed as percentage of revenues in income statement and as percentage of total assets in the statement of financial position. The other available method is horizontal analysis, in which a base year is selected and the changes over time are expressed as a percentage of the base year figures.

Vertical Analysis (Common Size Anaysis)

In vertical (or common size analysis), the items in the financial statements are expressed as a percentage of total assets or sales. The main advantage of vertical analysis is that such an analysis is not much affected by price fluctuations and that it lets industry-wide comparisons.

Common-size Income Statement

From this analysis we can conclude that there has been an increase in cost of production for the company which was compensated by controlling other operating expenses.(page 49/table 2.4)

Common-size Statement of Financial Position

When the common-size Statement of Financial Position, on the asset side, it can be seen that receivables and inventory constitute most of the assets. in this situation, notes to the financial statements should be reviewed to understand who the related parties are. In Vestel’s case, since the parent company has a strong financial position, the collection risk for the company could be viewed as low.(page:50/table 2.5)

Materiality issue: When financial statements are analyzed, items that have low monetary values can be regarded as immaterial. Especially in horizontal analysis big changes in low value items can be ignored in analysis.

Horizontal Analysis

Horizontal analysis is also known as trend analysis. This analysis performs better for longterm analysis within the same company. However, selection of the base year is crucial. Depending on the base year, some items might be given more weight than the others. Care must also be taken to incorporate any accounting policy changes during the analysis period, because horizontal analysis is affected by changes in accounting methods.

Horizontal Analysis of Income Statement

It can be seen in the horizontal analysis of Vestel that sales increased each year but the increase in the cost of sales has been higher than the increase in revenue. Additionally, the increase in both items is higher from 2016 to 2017 compared to 2015 to 2016 increase leading to an increase in income from operating activities.(page:52/table:2.6) Finally profit has decreased compared to 2016. In the trend analysis, 2016 seems to be a good year for Vestel compared to both 2015 and 2017.

Horizontal Analysis of Statement of Financial Position

In the horizontal analysis of Vestel Statement of Financial Position, the increase in receivables and inventories in 2017 is apparent. As mentioned earlier, since these receivables are from related parties, collection risk is minimized.(page:53/table:2.7) An increase in current liabilities and a decrease in long term liabilities suggest that the company prefers short term financing to long term financing during 2017.

Ratio Analysis

Interpretation of the results of the trend and static (vertical) analyses might be difficult in some cases. For example, a user might want to know whether the assets are used efficiently – in other words, might want to assess the profitability of the firm as measured by the relationship between profits and assets, and profit and sales. Such a relationship can be expressed as a ratio.

Although there are several available ratios in the literature, we will illustrate the most commonly used ratios within the following classifications.

• liquidity ratios
• solvency/capital structure ratios
• working capital management ratios
• profitability ratios
• market ratios

Liquidity Ratios

These ratios show how well a company manages its cash inflows and outflows to pay its obligations.

Solvency

These ratios show how the assets of a company are financed (i.e., through debt or equity) and provide information about the long-term liquidity of a company.The most common ratios in this category are:

• debt ratios
• equity measures
• number of times interest charges are covered

Working Capital Management

To analyze the working capital management efficiency of a company, analysts are interested in trade receivables, inventories, and trade payables.

Net Working Capital

Net Working Capital is defined as the difference between the current assets and current liabilities of the same period.

Accounts receivable turnover

Since receivables affect the operating cycle, knowing the collection cycle will help users to determine the efficiency of collecting accounts receivable. The shorter the period to collect credit sales and without losses, the more liquid a firm will be. The accounts receivable turnover gives an indication of the collection efficiency.

Operating Cycle

Operating cycle computes the time it takes for a company to turn finished goods/merchandise inventory into cash received from sales. (Computed using finished goods inventory.)

Cash conversion cycle shows effectiveness of management in managing current assets and liabilities. Shorter cash conversion cycle shows more efficient management.

Profitability

Profitability ratios measure for operating success of a company in regards to its resources.

Financial Leverage: The extent which the company uses debt in financing its assets. As long as the cost of debt financing is lower than equity financing financial leverage is beneficial for the company.

Sustainable Growth Rate

Sustainable growth rate refers to the rate at which a firm can grow if its profitability and financial policies do not change.

Market Ratios

Our last category of ratios ties in closely with the profitability ratios and earnings per share. We will demonstrate the following ratios:

• price earnings ratio
• price to book ratio
• dividend payout
• dividend yield

Interpretation And Limitations Of Ratio Analysis

Ratios are used as the major tools of financial analyses. Studies employing various ratios have been able to predict business failures. The main problem is determining which ratios are informative for a particular business depending on the industry, lifecycle of the company and economic environment in which the company operates.

Interpretation Issues

When using financial ratios, factors that needs to be considered are;

• Comparing ratios for the company’s current year with those of preceding years, e.g., 5 to 10 years;
• Comparing ratios of the company with those of its competitors (These can be obtained from the published financial statements of competitors)
• Comparing the company’s ratios with ratios for the industry in which the company operates. (Industry statistics can be obtained from annual publications of trade associations; for example, TUSIAD publishes such ratios for various industries. For some of the ratios, data can be obtained from weekly stock exchange magazines or internet databases.)

Limitations

• Ratios are representations of average conditions that existed in the past, and are influenced by the selection of accounting methods (e.g., weighted average vs. FIFO cost flow; accelerated vs. straight line depreciation);
• Since financial statements are based on historical data, they do not reflect price level effects and real economic values;
• Computation of ratios are not standardized, and thus are influenced by data selection choices;
• Changes in many ratios are strongly associated with each other; e.g., changes in the current ratio and quick ratio between two different times are often in the same direction, and usually proportional. Therefore, it is not necessary to calculate all ratios, and interrelationships between/ among the ratios should be investigated;
• When ratios for the same company are compared over a period of time, care must betaken to analyzethe changes in operating conditions (e.g., changes in economic conditions, changes in product lines or geographic markets, changes in prices, levels of inflation, etc.); and
• When a specific firm is compared with similar firms, differences between/among the firms should be recognized (e.g., accounting policies, type of financing available, operating characteristics such as product lines, size and geographical location).
• The last, but the most important, consideration for the analysis is to obtain audited financial statements. Although unaudited statements might provide valuable information about a company, conclusions reached with this information are questionable, because its use brings up fair representation issues.