Literature review on the use of financial statements

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CHAPTER TWO: LITERATURE REVIEW

2.1 Financial Statement Analysis

In the nineteenth century, there was a lot of improvement in ratio analysis. Firstly, numerous ratios were adopted to make analysis. Secondly, correct ratio criteria were emerged. Current ratio was the most used ratio. Thirdly, to make financial ratio analysis, inter-firm comparison was considered. The need of ratios was important because of the existence of Federal Income Tax Code in 1913 and the Institution of the Federal Reserve System in 1914.

In 1920s, there was a rapid increase in the interest of ratio analysis. Horrigan (1968) said ratio analysis existed a long time ago and it was used in the analysis of the properties ratios in 300 B.C. Nowadays, it is used for analysis of financial statement.

According to Hermanson et al (1992, p. 824), financial statement analysis consists of applying analysis tools and techniques to financial statements and other relevant data to show important relationships and obtain useful information. Therefore, financial statement analysis is very essential for the performance of the business because its aim is to provide useful information of financial position. This information is valuable for internal and external users for decision making. Solvency, profitability and liquidity are the key factors that are taken into consideration. Information should be relevant, reliable, timely and accurate. This information is valuable to internal and external users of accounts.

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However, there are external and internal factors that affect a company’s environment. Those external factors are inflation, interest rates, exchange rates, and government policy whereas the company’s internal factors are new changes in the company by management’s decisions, cutting costs to have a better control on the business, employees need to produce more of the goods and they are less motivated. All these factors have an impact on the financial statements. Through a financial statement, it is easy to evaluate whether a company is successful or failure.

2.2 Users of financial statements

Parties that are interested in financial statement information are internal and external users of accounts. Internal users are those who will run and manage the organization like managers and employees. External users are shareholders, government, lenders and customers who are not directly concerned about the business. But, they use financial statements for different purposes.

(i) Management and employees

They are knowledgeable about the performance of the business before taking a job in the company.

(ii) Shareholders

They need to know the position of the business before and after investing and they should know about the return of their investment.

(iii) Lenders

They should know about the company before giving a loan and if the company is performing well to return the money in the future.

(iv)Government

He will check and estimate the receipt and expenses of the government.

2.3 Financial Ratio as a Tool

Financial ratios are used to calculate a company’s financial statements using information that are found in them. Financial ratios can be used for different purposes like to analyse trends and to compare other companies reports, to evaluate the performance of banks and for investors to decide whether they can invest in a company or not.

Beaver (1966) used financial ratios to predict the failure of corporate firms. By testing 30 ratios from the financial statements, he noticed the cash flow to total assets, net income to total debt were lower for failed firms.

It is important for investors to learn about financial ratios which help them to know about the profitability of the business before investing. Norman (2011) conducted a research on stock exchange in Tanzania for investment decisions. A survey study was carried out in Dar es Salaam including six registered brokers. A sample of 66 people was taken to answer the questionnaires. Primary and secondary data were collected through questionnaires, observation, documentation and interview. The results reveal that most people do not consider financial ratios when investing. However, the brokers who are knowledgeable about ratios, they advise those people in when, how and in which company to invest. Furthermore, big investors know about financial analysis before investing.

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Researchers have used different techniques to measure banks performance. These measures are financial ratios, Data envelopment analysis (DEA) and CAMEL rating. Berger and Humphrey (1997) affirmed the best way to measure bank performance is to separate banks which perform well form those which are doing bad. They further indicated that evaluating the performance of financial institution can inform government policy by assessing the effects of deregulation, mergers and market structure on efficiency (p.175). Bank regulators monitor banks by assessing banks’ liquidity, solvency and profitability to interfere when there are problems (Casu et al, 2006).

Banks improve their performance by comparing other banks performances and evaluating their performance over the years. Tarawneh (2006) studied Oman Commercial banks using financial ratios. The study used financial ratio analysis to measure asset management, effectiveness and bank size of Oman’s banks. The results showed the bank performance was affected by the three factors mentioned above. Moreover, Samad (2004) made an analysis of seven commercial banks in the Gulf from 1994-2001. Financial ratio analysis was used to assess the liquidity, credit worthiness and liquidity performances. The comparison was made between Bahrain banks and the Gulf banks. A student’s t-test was conducted to measure the performance of the banks. It was noted that there was a reduction in profitability and liquidity and an increase in credit quality in Bahrain commercial banks. Zawadi Ally (2013) analyzed the performance of Tanzanian commercial banks from 2006 to 2012. Financial ratios were used to analyze the profitability and liquidity. The results showed the banking sector was profitable and there was an increase in financial performance. In addition, Kumbirai and Webb (2010) made a research on South African Commercial Bank from 2005 to 2009. A student’s t-test was conducted to analyze the difference between the two periods. The results showed a decrease in profitability which was occurred by an increase in operating costs and the emergence of financial crisis. However, the bank’s liquidity and credit quality remain stable.

However, Almazari (2012) used the DuPont system to evaluate the performance of Jordanian commercial bank from 2000 to 2009. DuPont system analysis is based on return on equity model. The study noticed that banks with high deposit, credit, asset and shareholders’ equity do not have a good profitability. Kiyota (2009) assessed the performance of 29 Sub-Sahara African countries commercial banks for 2000 to 2007. The researcher uses Stochastic Frontier Approach to estimate profit and cost efficiency, financial ratios and Tobit regression to evaluate the performance of banks. The results suggested that overseas banks have the tendency to surpass domestic banks in terms of profit and cost efficiency. Similar research has been done by Kirkpatrick et al (2007) who took a sample of 89 banks from Sub-Sahara African countries for 1992 to 1999. The results demonstrated that banks are 67% profitable and 80% cost efficient.

O’Donell and Van der Westhuizen (2002) evaluated the efficiency of a South African bank at branch level. They were examining branches which were doing well and those performing badly. They noticed that branches were managing on a small size and they could improve their operating costs to a better efficiency. Okeahalam (2006) utilized the Bayesian Stochastic Approach to evaluate the effectiveness of 61 bank branches in nine province of South Africa. The results were that there was an increase in operational scale in every branch. The efficiency could be better if the banks decrease costs by 17%. Oberholzer and Van der Westhuizen (2004) assessed the impact on ten regional banks in South Africa’s larger banks. The article shows the link between the accounting measures with the Data Envelopment Analysis. Their findings confirmed those of Yeh (1996) that Data Envelopment Analysis is an efficient measure which has a connection with profitability and efficiency ratios.

Cronje (2007) studied the entire South African banking sector and used Data Envelopment Analysis. A sample of 13 banks was taken to conduct the research. The results stated that the three largest banks were efficient. The other seven banks were inefficient and the recommendations were to increase profitability in those banks. However, this finding differs from the studies in UK where Drake (2001) and Webb (2003) said larger banks are less efficient. This is because South Africa is different from the UK economy which is a developed country.

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Another research done by Ncube (2009) who applies the Stochastic Frontier Approach to examine the cost and profit efficiency of four large and four small South African banks. The results show that the banks have drastically improved their cost efficiencies between 2000 and 2005 with the well-organized banks also being most profitable. However, the profitability over the same time period was not considerable.

The ratio analysis is used to assess the three important qualities of a company: liquidity, solvency and profitability (Wild 2008, p.549). According to Randall (2000), ratios can be broken down into five main groups of ratios. They are as follows:

  • Liquidity Ratio
  • Efficiency Ratios
  • Gearing Ratios
  • Probability Ratios
  • Investment Ratios

The information used for the first four categories is found from a company’s income statements and balance sheets. Investment ratios relate to stock market information to financial statement items. The financial statements of INNODIS LTD will be used to conduct a financial statement analysis.

2.4 Limitation of Financial Statement Analysis

According to Hermanson at el (1992, p.846), “financial analysis relies heavily on informed judgment. Percentages and ratios are guides to aid comparison and useful in uncovering potential strengths and weaknesses. However, the financial analysis should seek the basic causes behind changes and established trends.” Although, financial statement analysis is important to obtain relevant and reliable information to make decisions and to formulate corporate plans and policies, it provides a number of limitations.

The users of accounts and analysts should understand the limitations before analyzing the company’s financial statements. The limitations are discussed below:

2.4.1 Predictability

Financial statements are based on the past, that is, historical data and historical information which are of little use in predicting the future prospects of a company. Changes in sales are unpredictable due to an increase in marketing and advertising or assess the factors on profitability from new entrance and existing competitors. Thus, past performance is not reliable to assess the performance of the financial statements whether there will always be an increase in sales and profit and for how long it will last.

2.4.2 Reliability

It is not easy to assess the reliability of financial statements. Foot notes are included at the end of the financial statements but they may be ignored by some users. When releasing unaudited financial statements, it becomes more difficult to rely on them as the information is not reliable.

2.4.3 Comparability

Making comparisons of one company’s financial statement with another can easily assess the financial performance of the company. Each company has its own way of operating its business. Thus, even the companies have the same business; this does not mean they can be comparable. Unfortunately, accounting strategies and methods of companies differ. For example, firms use different depreciation methods, inventory valuation, and goodwill treatment. It becomes difficult to compare financial statements.

2.4.4 Inflation

There is no impact of inflation on the financial statements of the company (Hermanson et al, 1992. p.848). For example, if a company had purchased land a long time ago, the value will still be at its original cost. But, its value is not worth what it is on the statement of financial statement, it may be more now. When there is inflation, there is a change in inventory, cost of sales and depreciation and this is not taken into consideration which misleads the results of financial analysis (Lasher, 1997. p.82, 83).

2.4.5 Window Dressing

Some companies purposely try to manipulate their financial statements to make them look better and to have a good result of report when the auditor will come to check their accounts. For example, if a company finds it has a low current ratio, it may try to take a long-term loan from the bank to improve the current ratio and will pay the loan after.

2.4.6 Limited Information

Not all information about the business is presented on the financial statements. Consequently, financial ratios present only the figures and ignore the qualitative information like environment changes, management skills, and employees’ requirement which are all necessary for a business to be successful.

2.4.7 No Universal Standard

There is not a yardstick to make comparisons because it depends on the firm’s size, operation, and management. For example, comparisons cannot be made between a big firm and a small firm. Their inventory holding will not be same. The current ratio measure is 2:1 but this is not true for all businesses.

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