The Significance Of Financial Statement Analysis Finance Essay
Financial statement analysis involves the assessment of a business’s past, present and future condition. The objective is to identify the weaknesses as well as the strengths of a business. If weaknesses are found, the business can take appropriate steps to correct or overcome them. On the other hand, the business can use its strengths to its advantage. In this way, the business will be able to improve its overall financial situation in the future. As the business owners they are intently interested in how well their business is doing. The most likely way to determine the status of a business is by analyzing the financial data which means crunching the numbers to arise the results.
The basics of financial analysis usually mean calculating different financial ratios and then coming to conclusions about the how the company is financially performing. Financial ratios here refer to principal tools for financial analysis as they can be used to answer numerous questions regarding the business’s financial well being. Financial ratios are applied by three main users. First are managers, who employ ratios as a tool of controlling, analyzing, and thus enhancing firm’s activities. Second is a credit person, such as bond rating analysts or bank loan officers who applied ratios to analyze and assist, as well as determine company’s ability to settle its liability or obligations. Third is stock analyst person, who is interested in a company’s future prospects and the efficiency in managing risk.
Also, the ratios provide useful information to users of financial statements for example investors and analysts to assess and evaluate the operations undertaken as well as being used to analyze its performance and position over time (Al-Ajmi J., 2008). As stated by Al-Ajmi J. (2008), the most important of the users groups to know about financial ratio analysis are investors and creditors because these users interested to refer and depend on the contents stated in financial statements and determine a variety of indicators before they want to make any final decisions for credit and investing decisions. To them, they believe that through analyzing financial statement will provide valuable financial indicators and have predictive power. Financial analysis can be done through assessing the financial statement of company. Financial statement in this case focuses on balance sheet, income statement, cash flow statement and statement of changes in equity.
Financial ratios are generally classified into four main groups’ liquidity ratios, activity ratios, gearing ratios, and profitability ratios. The liquidity ratios can be used to measure whether the firm can repay its debts on time or not. The two famous used liquidity ratios are current ratio and the quick ratio. Next is activity ratios can be used to measure how effectively the firm uses its resources (assets) to generate sales or revenue. This ratio is so called efficiency, turnover or even business asset management ratios. Commonly used to measure activity ratios are inventory turnover ratio, average collection period, accounts receivable turnover ratio, non-current assets turnover ratio and total assets turnover ratio. Third is gearing ratios also called debt management ratios and leverage ratios. This ratio indicate how the firm is utilizing outside funds to finance its assets and whether the firm can pay the interest on the use of these non-owner supplied funds as well as repay the principal or the original amount of the loan. Commonly used to measure gearing ratios are debt ratio, time interest earned ratio and debt to equity ratio. Lastly are profitability ratios which can measure the end results of the firm’s ability to produce profits from its resources as well as to measure the company's use of its assets and control of its expenses to generate an acceptable rate of return. The most commonly used ratio is gross profit margin and net profit margin. Knowing the financial ratios of our business is important because by knowing what these ratios mean and being aware of trends can aid the entrepreneur in better managing a business in future.
In general this paper is reviewing the literature review on the effect of analysis of financial ratios on business financial performance or financial situation in three different types of industries. Focus on the analysis of financial ratio in service industry, financial industry and higher institutional education. Different industry will have different ratio analysis concentrated. It depends on the nature of types of industry to analyze company performance from different perspectives.
2.0 LITERATURE REVIEW
2.1 USEFULNESS OF FINANCIAL RATIOS
Financial ratios are said as the most widely used indicators of company. It play a role to value firms, to distinguish creditworthy companies compare to others, to determine targets of acquisition and to state the progress of organizational in completing or the time needed to complete a task (Al-Ajmi J., 2008).
The financial analysis model known as a quite helpful tool for executives to measure or predict enterprise bankruptcy or enterprise failure provides concerned decision-makers (authorities) with the possibility or hoping to avoid failures. Also it becomes an early warning system to the corporate management. (Karacaer and Kapusuzoğlu, 2008).
As stated by Karacaer and Kapusuzoğlu, (2008), the most highest ratios contribution in the analysis regarding the variables whose effect the financial condition of the sample enterprise are ROE, debt ratio, net working capital, acid test ratio, net profit ratio, cash ratio, and current ratio respectively. Among of them, the liquidity ratios are the main element in these ratios. It is observed that all the variables have differing but significant effects on the corporate financial situation.
Financial ratios can be used as financial indicators which allow for comparisons among companies, industries, also comparison in different time periods for one company, between a single entity firm and its industry average. Apart from that, financial ratios generally hold no meaning unless they are compared against something else, like historic performance or another company and industries. The reason behind that is the ratios of firms in different industries, which face different types of risks, competition and capital requirements are usually difficult to compare if have no other things to compare (Wikipedia).
As mentioned by Salmi, Timo & Roy Dahlstedt & Martti Luoma & Arto Laakkonen (1988), financial ratios are commonly used for comparison of financial position intra-industry. Also, in financial statement analysis a firm's performance and financial status are frequently evaluated in relation to other firms in the same branch of industry or in relation to industry averages.
2.2 STEPS TO EFFECTIVELY FINANCIAL RATIOS
As stated by Darrel Hulsey, the basics of financial analysis usually mean calculating different financial ratios and then coming to conclusions and clarification regarding on how the company is financially performing in business activities. There are certain things that must be considered before too many conclusions are drawn.
Firstly, understand what comprise different financial ratios before start analyzing company’s data. Must take into consideration all financial ratios numbers derived from financial statement comprise of balance sheet and income statement. Balance sheets represent a reflection for a particular point in time. Income statements present a cumulative time summary of performance. For example, year-end financial statements should include a balance sheet that presents how various company accounts look on that particular day at the end of the year, whereas the income statement shows how company’s performance over the period
Second is evaluating external influencing factors. As with all companies, the financial statements can be influenced by various factors like management or owner decisions and discretionary spending, seasonal effects, legal structure choice, type of industry, customer mix, or a number of other issues. These factors can influence the financial statements and will, in turn, influence the financial ratios analysis.
Third is look at internal trends. Always keep in mind is that one ratio alone tells one very little. A clear picture starts developing when one looks at ratios over different time increments. By comparing financial results against prior performance one gets a better idea of what is occurring within the company. Trends will start to develop and can give insight into areas that may need corrective attention or to areas that may need to be reinforced. Internal trend analysis is most likely most beneficial because one is comparing similar business situations over various periods of time.
Fourth is compare results to the industry. Comparing your business performance to other similar businesses is a common way to judge how well the business is doing. Even though this is very common, there are limitations to doing so. First realize these comparative ratios represent an average. Averages are simply that and most likely your business will vary somewhat. Next be sure you are comparing your business to other businesses similar in asset size and sales volume. In some cases there may be no suitable comparisons. Try to insure you are comparing “apples to apples.” There are several sources to get comparative financial data including private companies such as Risk Management Association (RMA) and trade associations that collect data from their members. Knowing what is the average for your industry is important. The averages can serve as a general benchmark for your business. Additionally, these averages are often times used to compare your business performance when you are seeking capital from outside sources such as a bank. Being different may not be a deal killer, but not being able to explain why you are different may indeed be a deal killer.
2.3 THE EFFECT OF ANALYSIS OF FINANCIAL RATIOS ON BUSINESS FINANCIAL SITUATION IN DIFFERENT INDUSTRIES
2.3.1 SERVICE INDUSTRY
In measuring the performance of service firms, the most strongest and consistent ratios used are activity and profitability ratios. Obviously, the profitability ratios indicate that small service firms have higher returns to sales than large firms. Specifically, service firms have less liquidity, greater activity, and higher profitability. Interestingly, the small and medium size service firms had higher total debt levels. The short-term debt findings show that service firms used significantly smaller amounts of short term funding. Means that service industry more prefer to finance the business activity through long term debt. On top of that in service industry, the most suitable of ratio to measure business profitability is by calculating return on equity. Apart from that, activity ratio was measured by a primary ratio and a secondary ratio. It refers to sales to assets and sales to inventory respectively (Michael D., John X. and Steven J.). The results found by Michael D. et. al. associated with the activity ratios for service firms show a positive and significant relationship an concluded that size of firm very unrelated to productivity of public firms in service sector
The growth in air transportation industry gives a picture that performance evaluation is important for executives’ body to identify and recognize the operating problems arise in market competition. According to Feng C.M. and Wang R.T. (2000), referring to previous study it more concerning airline performance evaluation which only focus merely on operational performance. However, evaluation on financial performance is seems to be ignored. As far as we are concern, to measure the survival prospect of an airline market can be look through the financial performance of the company itself. The absence of financial ratios may lead to biased assessment.
There are three main types of performance indicators used in airline industry. The first one is production efficiency, marketing efficiency and execution efficiency which relate to department of production, marketing and management (Feng C.M. and Wang R.T., 2000).
As stated by Feng C.M. and Wang R.T. (2000), in making analysis of financial statement of airline industry, assets and capital of the owner’s equity are classified as the input of financial factors. Moreover debts and expense are classified as the output of the financial factors and for revenue or otherwise losses categorized as the outcome of financial factors. Due to that, the input financial factors characterized by sunk cost which included flight equipment and interest expense, while it’s output by intangible products. Otherwise its consumption characterized as not-stored services.
As commented by Zeller T.L., Stanko B.B., Cleverley W.O (1996), from the perspective of hospital industry, ratio analysis categorized as an important role especially in measuring the profitability, liquidity, then make an estimation on future profit will be generated. Besides, ratio analysis plays an important role to make analysis on competitors as well functioning as make prediction on corporate failure or illiquidity. Due to that in study conducted, there are seven financial ratio factors used to measure hospital performance and analyzing financial condition consistently. This arises from the emerging of statistical-based taxonomy of hospital financial ratios where there are seven characteristic measures for hospital sector which are profitability ratio, fixed asset efficiency ratio, capital structure, fixed asset age, working capital efficiency ratio, liquidity ratio plus debt coverage ratio. Based on the result we can comment since the hospital sector provided services to public as a non-profit organization, therefore the profitability ratio is not an important concern in this matter for the purpose of analyzing the performance but it more concern on measuring the liquidity of organization to support the mission of hospital in providing a good services to public.
2.3.2 FINANCIAL INSTITUTIONS
Evaluating the performance and financial condition of the financial service organizations is very critical. The intermediation role of financial institutions in market trading is such that performance in this sector indirectly gives impacts on other sectors of the economy. When performance is good it will contribute a positive effect on the economy but when the financial sector is distressed and got some problems then they will contribute a negative effect on other sectors of the economy (Ibiwoye A., 2010).
In the perspective of banks to achieve their aims for institution development was by growing the components of their assets as an alternative of moving to increase the profitability. All of these require the determination and management of several factors, which play an important role in the profitability of banks in the new environment (Halkos and Salamouris 2004).
In U.S Banks, to increase investors hope and confidence, they adopt Dominion Bond Rating Service (DBRS) which provides bank ratings as a forward-looking measure of a bank’s ability to meet its financial obligations. The DBRS ratio analysis focuses on four interrelated aspects of a bank’s financial health. First is Earnings Power, it refers to the ability to generate consistent profits and grow capital internally. Second is Asset Quality, it refers to the potential for losses that could impair earnings and capital. Third is liquidity where it focuses on cash resources available to meet short-term obligations. And the last one is Capital Adequacy; it refers to the ultimate creditor protection against future losses (Reid, Lister, Schwartz, and Muranyi, 2005)
According to Al-Ajmi J., (2008), the financial indicators that analysts use as basis for decisions are not necessarily all equally useful to them in making any decision. There are no significant differences between credit analysts and financial analysts with respect to 40 of the indicators identified in the study. From the perspectives of 244 credit analysts and financial analysts in Bahrain, they are measured by the ranking of 71 financial indicators and 5 components of corporate governance. Based on the result it shows that credit analysts consider the quick ratio as the most useful ratio, followed by the non-recurrent ratio. For the financial analysts they consider price-earnings as the most useful ratio, followed by the market-to-book ratio.
It is also worth mentioning that the efficiency difference between large and small banks reaches its maximum value in 1999. While doing financial analysis it has a positive relationship between size and performance. Besides, through mergers and acquisitions it leads to a continuous increase of average efficiency of the larger banks while efficiency of the small banks is impaired. It is proved that the higher the size of total assets leads to the higher of the efficiency is. It is evidenced from the significant increase in the sum of the total assets employed in the market as well as the increase in the average level of Banks’ Assets (Halkos and Salamouris, 2004).
2.4.3 HIGHER EDUCATION INSTITUTIONS
As commented by Buddy N.J. (1999), the study found a complete of financial ratios analysis that conclude the financial condition of a higher education institution where the ratios itself assisted the organization to assess the going concern and feasibility of the six higher education institutions in Oklahoma. The study concentrated on the capability and the survival of the institutions to fulfill current and future financial requirements of the institutions. Therefore financial ratio analysis is the most suitable and known as an effective communication from the perspective of users regarding financial situations of public and private higher education institution to internal and external entities. On top of that, financial ratio recognized as useful tools to make the communication and analysis of financial situation analysis easier. Also facilitate any complicated understanding arise about financial condition and provide detailed information of the institutions.
As what have been found in study conducted by Chabotar, (1989); Cirtin & Lightfoot, (1996), they concluded that financial ratio analysis could also serve as a tool to evaluate the efficiency, effectiveness and accountability of higher institution education as what been done by ratio analysis in analyzing business financial condition. In this case Buddy N.J. (1999) said that financial ratio analysis permits for the analysis of past and previous performance as well as allows evaluating of coming planning of institutions. The presentation of financial data analysis going to be more efficient and effective where it shows an overview and provide a better picture of the real financial condition and situation of the institution of higher education through identifying a number of quality financial ratios. The decreasing numbers to a few manageable and easily interpreted ratios will allow the entities either internal or external to make better-informed decisions regarding financial position and condition of higher learning institutions.
In the opinion of Buddy N.J. (1999), a good understanding of the financial situation of institutional education become an important part in view of decision making to respond to any pressures arise. As supported by Chabotar, (1989) financial ratios may have the reverse use, to identify what actually is unique when we talking a higher education institution. Besides, work on financial ratio analysis for higher education institutions have aimed at clarifying the intuitive understanding and making judgments of financial problem to make it become more credible and convincing. Due to that the most cited motivation for financial ratio analysis is about the skill to control on the effects of size difference along the time and across institutions
As mentioned by Buddy N.J. (1999), financial ratio analysis can help both the institutional user and those agencies to make funding decisions. This is due to where the financial ratio analysis could be used to obtain the physical evidence of any deviations of the norms and could also allow management by exception. Also financial ratios recognized as an indicator to whether conditions are getting worse or getting better which may allow management without any excuses and make the institution more conscious to the possibility of future financial problem. Besides, financial ratio analyses have a role to determine how and in what ways the condition is different (Collier & Patrick, 1978).
Lupton, Augenblick, and Heyison (1976) in their study identified the indicators which comprise of enrollment trends, trends in education and general expenditures, institutional control, academic expenditures to education and general expenditures, current fund revenues to expenditures, tuition and fees to student aid revenues as well as freshman full-time equivalents (FTEs) to total undergraduate FTEs. All these indicators determined by using discriminate analysis plus a panel of experts, to identify 16 discriminating indicators of financial situation.
Whereas, Collier and Patrick (1978) done a study based on theory-based research and implemented a set of dimensions that explain financial situation as well as financial condition which comprise of financial risk and financial independence, reserve strength, revenue drawing power plus the stability of income. Same as what being done by Lupton etc., Collier and Patrick also used the same ways to determine the indicators which is experts and discriminate analysis for a purpose to differentiate between stable and weak public institutions also to differentiate between stable and weak private institutions. As agreed by Buddy N.J. (1999) the objective of institutional analysis of comparison is to identify differences and to highlight important matters raised regarding historic and future policies for entities either internal or external. The reason is a lot of higher education institutions totally different from comparative peers for good and acceptable reasons. The argument is a conclusion might be drawn as to what is unique about that institution as compared to others institutions when an understanding is reached for why an institution scores differently from its comparative members.
Referring to study of Buddy N.J. (1999), he found that many of the measures financial ratios used by higher education institutions are based on what expenses related with services are incurred and what sources of financial income are earned. Based on the result it permits entities either internal or external to observe institutional effectiveness and efficiency. There are 15 key financial relationships being used by Miller D.E. (1972) to be used for business and industry as a basis of cause-and-effect financial ratio analysis. The reason is higher education institutions itself will find themselves in a particular financial condition because of some causes arises. The 15 ratios identified have been used and tested as a uniform system in many business situations where it demonstrated that, when we used together it will provide a basic financial knowledge and understanding to the users. The interactions that exist between financial resources require a better examination of the institution's total fund structure. A better understanding of the phenomenon in and the situation of the financial resources is important to the early detection of any institutional financial distress. The differences in resources are symptoms of those factors either internal or external factors might cause financial pressure or development. A higher education institution with enough financial resources can remain adverse phenomenon. Besides, it has the flexibility to institute differences at appropriately timed to reverse the trends. Apart from that the resources only provide the opportunity to be flexible enough through changing economic and experiment where possible without impairing the institution's future prospect.
The significance of financial statement analysis should not be underrated. Understanding format of financial ratios provide almost any users and stakeholder of financial statement to get a fundamental comprehensive of the critical policies of financial institutions and their financial situation.
It is important to analyze trends in ratios as well as their absolute levels. Trend analysis can give a picture as to whether the firm’s financial condition is likely to enhance or to impair. Financial statement analysis focusing more on a study of the relationships between statement of comprehensive income and statement of financial position to determine if there is any changes by looking the trend analysis over time and as a benchmark to compare firm performance with other firms in its industry. In addition, financial statements are used as a prediction the firm’s future incomes distribution to shareholders members in terms of dividend. From an investor’s perspective, financial statement analyses is all about in making future corporate prediction. From management’s view, financial statement analysis is benefited to anticipate future conditions and, also as a beginning phase for planning actions that will influence the future planning. From perspective of creditor, making decision to provide credit terms is depends on the financial statement analysis.
The concentrated of financial ratio analysis is depend on different types of industry because it will depend purely on the nature of business activities. Financial ratio analysis will bring a big impact to those related industry in analyzing and compare the performance of the business with previous years or with other similar business. Apart from that, analysis of ratio may provide a careful evaluation and assessment of business’s financial advantages and disadvantages. Knowing what these ratios mean and being aware of trends can aid the business owner in better managing of their business to enhance the reputation of company and maintain loyalty of their customers as well as enlarge the potential customer comes in.
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