Comparability of Financial Statements.
1.0 Financial Statements and its Significance.
In recent times, we have witnessed tremendous policy reforms and recommendations being made to tackle and control the manner in which businesses carry out their accounting work. Numerous accounting mismanagement and malpractices have only added to the urgency to bring regulations that seek to keep a check on accounting procedures followed by the corporate world. The failure of companies such as Enron due to inappropriate accounting tactics stands out as a perfect example.
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Investors in the form of shareholders and stakeholders provide huge sum of capital anticipating higher future returns. Firms are known to tamper with financial data in order to attract prospective investors to finance their capital requirements and debt elimination. Recently, Shell, one of world biggest energy and oil producing companies was accused of overstating oil reserves to attract investments and had eventually admitted to have tampered with its financial data. Therefore, proper scrutiny of financial statements is essentials especially since various individual and business interests are developed citing information provided in these statements. Countries such as the US have come up with regulations such as US GAAP1 to assess financial policies pursued by corporates and the format to be followed in publishing financial statements.
Countries have adopt accounting procedures and guidelines framed under the International Financial Reporting Standards (IFRS) to eliminate discrepancies in financial analysis, improve investment opportunities and to make financial information available. By 2005, all companies registered in the EU have to adhere by new accounting standard. Countries such as UK have come under immense pressure to replace UK GAAP with the new IFRS scheme.
Investors often depend on various financial ratios to determine when and where to invest. Such complexities and the presence of diverse interests groups make it essential to develop financial mechanisms that determine the financial health of a company. Companies have to publish Annual Reports that summarise its financial status and act as a medium of information to its shareholders. An important and significant step in determining the health of a company is to analysis its historical financial statements. These historical data provides a picture of the financial health of a business and a roadmap outlining the direction the business is heading. The financial data are covered under various headings such as the Balance Sheet and Income Statements. Each of these has a particular format and is based on the principles of financial regulation framework such as the GAAP.
We shall look at them briefly in the following chapter and also look at other techniques developed due to the shortcoming some of these financial ratios are known to show.
2.0 Understanding Financial Ratios
Ratio is nothing but the comparison of one figure with another and is normally depicted as a percentage. Financial ratio is an analytical tool used to analyse trends, strength and weakness of a company’s assets and its liabilities. Financial ratios are compared overtime on a year to year basis. The basic source for these ratios comes from the company’s financial statements which contains information on the assets, liabilities, profits and losses and dividends accruing to its shareholders.2 The most common ratios can be classified under the following headings:
Capital Structure Ratios
In the financial world, firms rely on investors to raise funds for its short and long term needs. This is done by floating shares in the stock markets or by issuing debentures or bonds (loans). The funds may come in the form of short term, medium or long term loans. An investor will only invest if he is fully convinced that his investment will gain higher returns/dividends. He may look at the balance sheet to analyse how much the company is worth. Liquidity is an important criterion that influences investor decisions. The company must be able to pay back its loans on time and doing so will only raise its reputation in the capital market for future borrowings. The company that relies heavily on borrowing its expenses will obviously find it difficult to service its liabilities.
Besides, customer’s spending habit has a larger impact on the company’s sales and liquidity. Purchase affects the company’s stock of goods which, in turn, affects its liquidity. Since stocks cannot be sold in short notice, it has a direct impact on the firm’s capability to raise fund to finance short term debt financing. The current liabilities have to be settled in cash within short period of time. The presence of large stocks will artificially inflate the total current assets which may make it appear as if the company has enough resources to meet its short term liabilities.
We shall look at some popular ratios that, though informative, cannot be used as an ideal tool for financial analysis. Let’s see how. The annual report 2004 of The EMI Group suggests that group has current assets (including stocks) worth £1107 million and current liabilities worth £1403.5 million. The resultant current ratio is 0.78:1.3 This figure suggests that the Group does not have enough short term resources to meet its short term requirements. It has only 78 pence to meet a pound of debt. If we deduct the stocks (£36.4 million) from its current assets to see its immediate liquidity, the quick ratio shows an even poor debt financing capability. The quick ratio is 0.76:1.4 This figure suggests that the Group has only 76 pence to meet every 1 pound worth of debt.5
Analysing the results suggest that it would be inappropriate to rely on the current ratio as it does not explain how much the company real assets are readily convertible into cash in short notice. Stocks are not highly liquid and therefore must be excluded in assessing the company’s liquidity in the short period. Therefore, current ratio cannot be used as a reliable means to make investment decisions and that it essential that we look at other ratios and their merits and demerits to determine which of these is appropriate in the capital market.
The Gross Profit Ratio is the ratio between the Gross Profit and the Sales Revenue. The Gross Profits is arrived at by deducting the Cost of Sales from the Sales Revenue.6 To analyse this ratio we shall look at the Income Statement of The Sandvik Group.7 The Consolidated Income Statement suggests that the group had an Invoiced Sales of £4010.2 million and Cost of Sales equalling £2742 million. The GP ratio between these two figures is 1.46:1 meaning that the group is able to make 46 pence extra from every £1 of sales. It may look appealing but it must be noted that the Cost of Sales does not include other expenses that may significantly reduce the gross profits.8 If we deduct other expenses worth £741.9 million, the operating profits drop to £526.3 million. The Shareholders and the company’s future investment plans and its dividend policies depends on the Net Profits. It is arrived at by deducting the interest payables. The Sandvik’s Net Profits for the year after tax deductions are equivalent to £327million.
We can see that though the Gross Profit ratio is a useful ratio it does not shows the company’s financial position and does not influence any investment decisions. The real true figure that matters is the Net Profits after taxation. The ratio categorised under capital structure ratios are more elaborate and descriptive. However when using ratios such as gearing and interest cover, factor such as market structure, consumer preference and taste, economies of scale, product type have considerable influence. For example, payments from debtors depends of consumer income and preference. These factors have its affect on the current assets (cash) which will in turn affect the company ability to pay its creditors.
The points here is that though some factors cannot be measured and may not have direct consequences (market structure) it cannot be ignored. The ideas highlighted above are very important in performing financial analysis of a company. The accounting professionals have introduced techniques that are more accurate and explicable. We shall look at one such technique in the next chapter.
3.0 Improvement in assessment of financial statement.
We have seen the technical failure of various financial ratios and the difficulty in using them as a tool to make investment decisions. Comparing financial results from different periods has its own drawbacks because there are no independent frameworks to assess whether the company’s current results are good or bad. It is very important that care must be taken when comparing results between two different companies in terms of products, size, market share etc. For example, company A may have a significant market share (turnover) compared to company B’s but smaller net profit due to its bigger operational costs. Such discrepancies can influence wrong investment patterns and decisions.
Another major drawback of ratio analysis is that accountants indulge in creative accounting techniques where ratios calculated from published financial statements show favourable figures. For example, sale and repurchase agreements manipulate liquidity figures and off-balance sheet finance which distorts return on capital employed and thereby influencing company’s gearing.
It is therefore essential that new approach to assessing financial statement must be devised and changed to suit to new market conditions. One such technique was developed by Professor Altman who devised a new technique popularly known as the Z-Score.9 The Z-Score is a statistical model that incorporates the use of five different ratios which serve to predict the health of a firm.10 The Z-Score is used to predict bankruptcy of the business using traditional financial ratios and statistical method known as the Multiple Discriminant Analysis. The Z-score is considered to be 90 % accurate in forecasting business failure one year into the future and 80 percent accurate in forecasting it two years into the future.11
By selecting various financial ratios and applying weight to each ratio it is possible to estimate the financial position of the company. In his study, he analysed over 22 such financial ratios and selected 5 distinctive ratios that focused on the balance sheet and performance ratios. Weights were assigned by establishing appropriate coefficients to show how each of these ratios influenced the dependent Z-Score. Altman Z-Score equation:
Z = X1 (a) + X2 (b) + X3 (c) + X4 (d) + X5 (e)12
X1 – Working Capital/Total Assets.
X2 – Retained Earning/Total Assets.
X3 – EBIT/Total Assets.13
X4 – Market Value Equity/Book Value of Total Debt.
X5 – Sales/Total Assets
a, b, c, d, e are respective coefficient assigned to each ratios (X1,X2¦¦..X5).
Z – Overall Z-Score.
Now, companies expand their reach in the global market by producing goods that belong to different markets. Firms engage in horizontal and vertical integration to expand their market and also to reduce risk by spreading their resources in different activities. It is therefore illogical to do a financial comparison of firms from different industry. Professor Altman overcame the problem of comparing companies that specialised in different industries by altering the above equation by eliminating certain ratios. For example, Ratio X5 for non-manufacturing companies. This is done because sales/total assets ratio greatly varies from industry to industry.
Z = X1 (a) + X2 (b) + X3 (c) + X4 (d)
He modified the equation for a privately held company by implementing book value of equity as a private company’s stocks are not publicly traded. He further devised Z Score table to determine a financial healthy company from a sick company in various industries. The companies in the grey area were considered misclassified.
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1.23 – 2.90
1.81 – 2.99
Non Manufacturing Companies
1.11 – 2.60
The Z Score technique is gaining popularity in the financial world as an efficient and accurate method to predict financial health of a company and also it is less likely to be manipulated as Ratio Analysis are known to be.
In the next chapter I shall focus on the International Financial Reporting standard and look at ways it can be improved to promote comparability and facilitate globalisation and movement of capital.
4.0 Financial Reporting and Applications.
The International Financial Reporting Standards also known as the International Accounting Standard are a set of accounting standards companies must follow when formulating financial policies and publication of financial statements. In the EU, new regulations require EU companies to adopt International Accounting Standards by the year 2005. Questions have been raised as to whether we need international standards with massive movement towards free market. As Mr. Andrew Crockett puts in advances in IT and the ascendancy of free market principles have underpinned government-led to market-led financial system¦.the period saw the emergence of financial instability14
Mr. Crockett also stress on the fact that we need to develop, seek global acceptance of, and implement a set of codes or standards that pertain to key elements of financial system infrastructure. It was felt that certain regulations on financial prices, financial statements framework, and accounting principles pertaining to domestic and cross border transactions were hindering market forces. These factors combined with the shift towards greater fiscal and monetary prudence laid the foundation for a system that controlled capital movement across borders and international standards that improved global accounting principles.
The steps taken to achieve efficient financial mechanism must be able to address two factors – firstly, it must be able to identify the most economic way of utilising resources and secondly, it must be able to control the manner in which these resources are utilised. It forms the basis for the allocation of income among various claimants on the company and to bring in financial discipline.
The major advantages of such reporting standards are:-
It helps in poverty reduction by reducing the risk of financial crisis and their impact on the global poor. It achieves significance because the scope of globalisation has reached almost every single country.
It helps in creating investor confidence by improving investment climate, eradication of loopholes affecting direct and indirect investments.
Its helps by eliminating barriers on free movement of market information and sentiments.
It assists local governments to implement taxation regulations and also unwanted barriers to trade.
Despite the advantages of having international standards for financial reporting, it is quite evident that certain factors act as a barrier to accounting standards. For e.g. the UK banking sector has been in the forefront of this conflict between the international standards and the national standards. Let’s very briefly look at two such regulations that will have an impact on the banking sector – the Basel II capital accord and International Financial Reporting Standards (IFRS), which apply to all companies listed in the EU.15 Basel II requires banks to link their capital to risk. It is likely to have consequences on all types of lending to SME’s and large companies.
Despite the advantages in terms of better risk management and accurate pricing of loans, the complexity involved in switching will cause some problems. The eventual replacement of UK GAAP with the IFRS comes with the complexity of changing over, cost involved and bad debt provisions. According to an article published in the Business Money magazine by Mr. Mike Imeson, the HSBC bank incurred $ 400 million in expense to bring regulatory changes in accounting standards world over in 2003. Similar sentiments were expressed by Mr. Stephen Pegge, Lloyd TSB in this article by saying that when a business approaches you for a loan, you won’t know for certain which legislation applies.16
Considering the above statements, it is essential to look at national concern towards the development of an international standard on financial regulation. It is true that it will improve investment opportunities by elimination of unwanted barriers and it is also likely to create expenses that may prove as a hindrance to an already volatile and underdeveloped financial systems in most countries. As Mr. Pegge puts in, it will create confusion in the mind of investors and lenders as to what legislation applies and bureaucratic delays in understanding and applying them.
In the preceding chapters, we have seen the importance of financial analysis in investment choice and decision making. The ratio forms a very important aspect in making financial choices and also acts as a medium for companies to assess their business performance. Financial analysis of these ratios influences the interests of various groups of individuals and organisations such as Individual shareholders, Employees, Managers, Directors, Governments.
Considering these interest groups and affects on each of these entities, the need for an international framework for accounting standard has being increasing felt. It acts as a medium of information for the investors who would assess the basis for making further investments and also to see how well the company is performing. The managers stand to benefit as their remuneration and income are directly linked to the company performance. The government’s policy towards economic development and need for further reforms are based on these financial analysis and financial statements. It forms the basis for taxes on trade and tax benefits and exemptions.
While the importance haves been highlighted, it is also essential to note that drawbacks are not ignored. As Mr. Pegge points out there must be a clear understanding of the legislations and it must work towards reducing costs rather than increasing it.
To conclude, financial reforms and regulations are an essential component in today’s global economy. Financial statements must as an informative source free from manipulations of date and figures.
References and Bibliography
Chartered Institute of Management Accountant (CIMA), (2005 Edition), Financial Accounting Fundamentals Paper C2.
Chartered Institute of Management Accountant (CIMA), (2005 Edition), Management Accounting Fundamentals Paper C1.
Annual Report, 2004, The EMI Group.
Annual Report, 2004, The Sandvik Group.
The EMI Group – www.emigroup.com/financial.html
The Sandvik Group – www3.sandvik.com/pdf/annualreports/sandvik2004_eng_web.pdf
Vercor – The Global Resource for Business, Sales, Merger and Acquisitions www.vercoradvisor.com/articles/companyscore.html
Bank for International Settlement – www.bis.org/speeches/sp020227.htm
BusinessMoney.com – http://www.business-money.com/features_mike_imeson_jan05.html
Ventureline – www.ventureline.com/SampleOneIndustry.asp
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