1 Financial Analysis by Binam Ghimire

Learning Objectives 1. Purpose of financial analysis 2. Various techniques of financial analysis 3. Understanding Creative Accounting, and 4. IFRS and auditing

Financial Analysis  Financial Analysis as the name suggests is an analysis of an organisation’s financial position  Why do we undertake financial analysis ?  What information do we analyse ?  What techniques do we use to undertake financial analysis ?

Why undertake Financial Analysis ?  Investors & Potential Investors - Share/Company valuation  Providers of Finance –  Predicting financial distress  Assessing creditworthiness  Authorities - Tax legislation  Analysts/Investors/Potential Investors - Forecasting future performance – share valuation/loan decisions  Internally Management  Designing profit sharing plans  Aiding management decisions  Management performance evaluation

Examples of Documents used for Financial Analysis  Published Financial Statements  The Balance Sheet or Statement of Financial Position (Session 4)  The Income Statement (Session 5)  The Cash Flow Statement (Session 6)  Business Plans including Cash Forecasts  Published Equity data (Session 10) e.g.:  Share Price  EPS; DPS  Analysts Reports

Techniques of Analysis  Common-Size Statements  Trend Statements  Financial Ratio Analysis including:  Basic Profitability, Liquidity & Gearing Ratios  Du-Pont Analysis  Cashflow Analysis  Altman “Z”Scores (Distress Analysis)  Investment Ratios  These tend to rely on Published Financial Statements but what if they are prepared by Creative Accountants?

Creative Accounting  Creative Accounting is:  the practice of showing users what they would like to see rather than a true and fair value

Reasons for Creative Accounting  Possible reasons for creative accounting could include to: 1.reduce taxation by reducing reported profits; 2.attract new share capital or loan capital by showing a healthy (and non-volatile) financial position; 3.achieve sales or profit targets (especially where performance bonuses are involved); 4.report sufficient profit to pay a dividend or to meet investors’ expected level of return.

Methods of Creative Accounting  Overstatement of revenue  ‘In-and-out trading’  Manipulation of expenses e.g. Depreciation  Capitalization of expenses  Concealment of losses or liabilities  Revaluation of non-current assets  Valuation of current assets e.g. Inventories  Auditing

A Final Word of Caution  the Accounting Standards adopted, which will differ from company to company due to interpretation and country to country due to the standards adopted IAS or US GAPP  Management Bias – desire to show a good position, justify a bonus  The Need/Desire to Meet Lending Conditions  Big Bath – in a bad year, why not have a really bad year  Mergers & Acquisitions – the desire to avoid, encourage or take part in, and the method of accounting for M & A  Income Smoothing  Tax Regime of the country As a result analysts (you) need to be adversarial when analysing financial statements

The Case of ENRON  The story of Enron and a lesson in Creative Accounting is captured in the Oscar Nominated documentary film,  “Enron: The Smartest Guys in the Room”,  An excellent film and well worth a watch.

IFRS and Audits  IFRS and Audits are methods used to ensure Financial Statements are reliable  What are they ?

IFRS  IFRS – International Financial Reporting Standards are:  a single set of high quality, understandable and enforceable global accounting standards  i.e. rules that organisations must follows when preparing and reporting their financial statements  IFRS are developed and approved by the IASB – International Accounting Standards Board whose objective is…

The Objectives of the IASB  (a) to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world's capital markets and other users make economic decisions;  (b) to promote the use and rigorous application of those standards; and  (c) in fulfilling the objectives associated with (a) and (b), to take account of, as appropriate, the special needs of small and medium- sized entities and emerging economies; and  (d) to bring about convergence of national accounting standards and International Accounting Standards and International Financial Reporting Standards to high quality solutions.

Auditing  An audit is an independent examination of the financial statements and procedures by a professional accountant who then expresses an opinion based on his/her examination.  It should not, merely, be regarded as a public service. Auditors seek to:  maximise the revenue of the firm or department they work for  minimise costs  maintain quality of financial procedures  minimise risk.

External & Internal Auditing  Auditors are split into two principal categories –  External – appointed from outside the organisation  Internal – usually employees of the organisation

InternalExternal ObjectivesTo advise management on whether the organisation has sound systems of internal controls to protect the organisation against loss To provide an opinion on whether the financial statements provide a “true and fair view” Legal BasisGenerally not a legal requirement. However the latest corporate governance advice recommends that if a listed company does not have an internal audit department, it should regularly assess the need for one. Usually a legal requirement for larger limited companies and most public bodies ScopeAll areas of the organisation, operational and functional Financial focus ApproachIncreasingly risk based Assess risks Evaluate the systems of controls Test operations of systems Make recommendations for improvement Increasingly risk based Test underlying transactions that form the basis of the financial statements Responsibilities To advise and make recommendations on internal controls and corporate governance To form an opinion on whether the financial statements provide a “true and fair view”

Summary  Why do we undertake financial analysis ?  What information do we analyse ?  What techniques do we use to undertake financial analysis ?  What is Creative Accounting  What is the role of IFRS and Auditing ?