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Financial Statement Analysis

# Financial Statement Analysis

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# Financial Statement Analysis Methods: Horizontal vs.

Vertical Analysis
Introduction Financial statement information is used by both external and internal users, including investors, creditors, managers, and executives. These users must analyze the information in order to make business decisions, so understanding financial statements is of great importance. Several methods of performing financial statement analysis exist. This article discusses two of these methods: horizontal analysis and vertical analysis. Horizontal Analysis Methods of financial statement analysis generally involve comparing certain information. The horizontal analysis compares specific items over a number of accounting periods. For example, accounts payable may be compared over a period of months within a fiscal year, or revenue may be compared over a period of several years. These comparisons are performed in one of two different ways. Absolute Dollars One method of performing a horizontal financial statement analysis compares the absolute dollar amounts of certain items over a period of time. For example, this method would compare the actual dollar amount of operating expenses over a period of several accounting periods. This method is valuable when trying to determine whether a company is conservative or excessive in spending on certain items. This method also aids in determining the effects of outside influences on the company, such as increasing gas prices or a reduction in the cost of materials. Percentage The other method of performing horizontal financial statement analysis compares the percentage difference in certain items over a period of time. The dollar amount of the change is converted to a percentage change. For example, a change in operating expenses from \$1,000 in period one to \$1,050 in period two would be reported as a 5% increase. This method is particularly useful when comparing small companies to large companies. (1050 – 1000)/1000 X 100 = 5%
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Vertical Analysis The vertical analysis compares each separate figure to one specific figure in the financial statement. The comparison is reported as a percentage. This method compares several items to one certain item in the same accounting period. Users often expand upon vertical analysis by comparing the analyses of several periods to one another. This can reveal trends that may be helpful in decision making. An explanation of Vertical analysis of the income statement and vertical analysis of the balance sheet follows. Income Statement Performing vertical analysis of the income statement involves comparing each income statement item to sales. Each item is then reported as a percentage of sales. For example, if sales equals \$10,000 and operating expenses equals \$1,000, then operating expenses would be reported as 10% of sales. 1000/10,000 X 100 = 10% Balance Sheet Performing vertical analysis of the balance sheet involves comparing each balance sheet item to total assets. Each item is then reported as a percentage of total assets. For example, if cash equals \$5,000 and total assets equals \$25,000, then cash would be reported as 20% of total assets. References Edmonds, C., Edmonds, T., Olds, P., & Schneider, N. (2006). "Fundamental Managerial Accounting Concepts." 3rd ed. New York: McGraw-Hill Irwin.

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Session 1: Vertical and Horizontal Analysis Technique Session Learning Outcomes Learners will understand and be appreciative on the use of the horizontal and vertical analysis technique while analyzing the financial statements information, its application and interpretation. Important Learning Terms
• • • •

Financial analysis Horizontal financial statements analysis Vertical financial statements analysis Cross sectional financial statement analysis

Introduction Financial analysis: is a process which involves reclassification and summarization of information through the establishment of ratios and trends. Analysis of financial statement: Refers to the examination of the statements for the purpose of acquiring additional information regarding the activities of the business. The users of the financial information often find analysis desirable for the interpretation of the firm’s activities. Note: The financial statement to be used for the purpose of analysis should be the audited ones. The audited financial statements give the analyst the auditor’s statement as to whether the records represent a fair view of the company’s affairs. The Objectives of Financial Statement Analysis The overall objective of financial statement analysis is the examination of a firm’s financial position and returns in relation to risk. This must be done with a view to forecasting the firm’s future prospective. For the purpose of understanding, the following financial statements will be used.

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A: Horizontal Financial Statement Analysis This technique is also known as comparative analysis. It is conducted by setting consecutive balance sheet, income statement or statement of cash flow side-by-side and reviewing changes in individual categories on a year-to-year or multiyear basis. The most important item revealed by comparative financial statement analysis is trend. A comparison of statements over several years reveals direction, speed and extent of a trend(s). The horizontal financial statements analysis is done by restating amount of each item or group of items as a percentage.
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Such percentages are calculated by selecting a base year and assign a weight of 100 to the amount of each item in the base year statement. Thereafter, the amounts of similar items or groups of items in prior or subsequent financial statements are expressed as a percentage of the base year amount. The resulting figures are called index numbers or trend ratios. From the balance sheet statement in exhibit 1. The following indexed balance sheet can be established.

As basis of Analysis, the analyst may seek variables which seem to improve or deteriorate and bring a challenge to the stakeholders in their various decisions. Example from the previous table one can ask the following questions?
• •

Why is there an increase in the stock of the company? Has the company changed its inventory policy? Why did taxation increase so tremendously? Were there any changes in taxation? Is it reflected by the increase in sales? Profit?

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• •

Why is there an increase in the fixed assets and at the same time decrease in the long-term debt? How were these assets financed? And many more question which can be elaborated by the management or which can be used as the basis for discussions.

Individual Assignment 1: From the Exhibit 1, prepare horizontal analysis for the income statement of TeleTalk (T) Ltd and comment on the relevant changes. Associate the comments from the balance sheet and income statement you have established, what is your general comment on the company undertakings in the past three years of operation. B: Vertical/Cross-Sectional/Common Size Analysis Techniques Vertical/Cross-sectional/Common size statements came from the problems in comparing the financial statements of firms that differ in size.

In the balance sheet, for example, the assets as well as the liabilities and equity are each expressed as a 100% and each item in these categories is expressed as a percentage of the respective totals. In the common size income statement, turnover is expressed as 100% and every item in the income statement is expressed as a percentage of turnover (sales).

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From the vertical analysis above, an analyst can compare the percentage mark-up of asset items and how they have been financed. The strategies may include increase/decrease the holding of certain assets. The analyst may as well observe the trend of the increase in the assets and liabilities over several years. Example: It can be observed that there is an increase in the holding of the current assets of the company. The management can seek the reasons of why the holding of these assets is continuing increasing. Exercise 2: From the Exhibit 1, prepare vertical analysis for the income statement of TeleTalk (T) Ltd and comment on the relevant changes. Associate the comments from the balance sheet and income statement you have established, what is your general comment on the company undertakings in the past three years of operation.

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Financial Analysis revised Page 8 of 54 pages. Chapter: 17: Module 3.4: Sensitivity Analysis of ICT Invest... Session 1: Building a Financial Analysis Model for ICT Session Learning Outcome The purpose of this session is to show how the different variables studied in this course and other courses can affect the analysis of a project. In actual undertakings of projects, there are micro and micro variables which affect overall project analysis. Introduction Sensitivity Analysis (SA) is the study of how the variation in the output of a model (numerical or otherwise) can be apportioned, qualitatively or quantitatively, to different sources of variation. Sensitivity Analysis (SA) aims to ascertain how the model depends upon the information fed into it, upon its structure and upon the framing assumptions made to build it. This information can be invaluable, as:
• •

Different level of acceptance (by the decision-makers and stakeholders) may be attached to different types of uncertainty. Different uncertainties impact differently on the reliability, the robustness and the efficiency of the model. Sensitivity analysis is also referred to as “what if analysis”

Building Financial Analysis Model Several activities can be considered in building financial analysis model. In the building of the financial model the following have to be considered:
1. Conservative estimations of the revenues/benefits

This is helpful to ensure that the viability of the proposed project is not easily threatened by unfavorable circumstances. The capital budgeting should be done in a such a way that it has a build in system for conservative estimations. The revenue figures should be justifiable given the capital expenditure proposals. 2. Safety Margin Cost figures A margin of safety for the cost items should be estimated. He margin can be between 10% -30%. For instance, in estimation of installation costs of a wireless telephone system, 10%-30% of the normal installation costs can be added. The management can decide on the percentages in the cost estimation of various items depending on the experience and other firm considerations. 3. Flexible Investment yardsticks Cutting point for the investments can be changed considerably to allow more
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room for seeing beyond the normal cut-off points. Example if the policy of a company is to accept the projects with payback period of less than three years, the use of a prolonged period can be assessed to determine the impact thereto. 4. Calculating the Overall risk index Some projects may call for the calculation of the overall risk index for various project components. These cutoff points may be based on sales, prices, operating cots, etc.

The company may vary all the items by 62% favorable, given the risks index consideration.
5. Judgment on Three point estimation

Telecommunication companies may judge their operations on three point estimation based on the hours of access as follows: o Business (peak) hours E.g. From 0800hrs – 1800hrs o Evening/Morning (off-peak) hours E.g. from 0600hrs – 0800 hrs and from 1800hrs – 2200hrs. o Night Hours E.g 2200hrs-0600hrs Various interconnection and charging rates are considered between three different times as indicated above. Reasons may be due to the fact that the use of bandwidth (which is paid even if not consumed) varies from the three time zones indicated above. Other considerations may be backed on the market responses and returns. The returns for this case may be classified as:
• •

Most pessimistic Most likely

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Session 2: Ratio Analysis Techniques Session Learning Outcome Learners will understand and be appreciative on the use of the time series analysis technique while analysing the financial statements information, its application and interpretation Important Learning Terms
• • • • • • • •

Ratio Types of Ratios Liquidity Ratios Asset management/Activity ratios Financial Leverage/Gearing ratios Profitability ratios Market valuation ratios Ratio limitations

A ratio: Is the mathematical relationship between two quantities in the form of a fraction or percentage. Ratio analysis: is essentially concerned with the calculation of relationships which after proper identification and interpretation may provide information about the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgement. Note: A ratio on its own has little or no meaning at all. Consider a current ratio of 2:1. This means that for every 1 monetary value of current liabilities there are 2 of assets. However each business is different and each has different working capital requirements. From this ratio, we cannot make any comments about the liquidity of the business, whether it carries too much or too little working capital. Significance of Using Ratios The significance of a ratio can only truly be appreciated when:

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1. It is compared with other ratios in the same set of financial

statements. 2. It is compared with the same ratio in previous financial statements (trend analysis). 3. It is compared with a standard of performance (industry average). Such a standard may be either the ratio which represents the typical performance of the trade or industry, or the ratio which represents the target set by management as desirable for the business. Types of Ratios Note that throughout this section, ratios are derived from Exhibit one in Session 1 of this chapter A: Liquidity Ratios
• •

Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due. The main concern of liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. Failure to do this will result in the total failure of the business, as it would be forced into liquidation.

Current Ratio The Current Ratio expresses the relationship between the firm’s current assets and its current liabilities. Current assets normally includes cash, marketable securities, accounts receivable and inventories. Current liabilities consist of accounts payable, short term notes payable, short-term loans, current maturities of long term debt, accrued income taxes and other accrued expenses (wages).

The rule of thumb says that the current ratio should be at least 2, that is the current assets should meet current liabilities at least twice. What does the calculated ratio tells us? In 2000, the company only had 85 cents worth of current assets for every dollar of liabilities. This grew to 92 cents in 2002 indicating increasing trend on liquidity, however the company is still unable to support its short-term debt from its currents assets.
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Quick Ratio Measures assets that are quickly converted into cash and they are compared with current liabilities. This ratio realizes that some of current assets are not easily convertible to cash e.g. inventories. The quick ratio, also referred to as acid test ratio, examines the ability of the business to cover its short-term obligations from its “quick” assets only (i.e. it ignores stock). The quick ratio is calculated as follows insert Clearly this ratio will be lower than the current ratio, but the difference between the two (the gap) will indicate the extent to which current assets consist of stock. B: Asset Management/Activity Ratios If a business does not use its assets effectively, investors in the business would rather take their money and place it somewhere else. In order for the assets to be used effectively, the business needs a high turnover. Unless the business continues to generate high turnover, assets will be idle as it is impossible to buy and sell fixed assets continuously as turnover changes. Activity ratios are therefore used to assess how active various assets are in the business. Note: Increased turnover can be just as dangerous as reduced turnover if the business does not have the working capital to support the turnover increase. As turnover increases more working capital and cash is required and if not, overtrading occurs. Asset Management ratios are discussed next. Average Collection Period The average collection period measures the quality of debtors since it indicates the speed of their collection.

• • •

The shorter the average collection period, the better the quality of debtors, as a short collection period implies the prompt payment by debtors. The average collection period should be compared against the firm’s credit terms and policy to judge its credit and collection efficiency. An excessively long collection period implies a very liberal and inefficient credit and collection performance. The delay in collection of cash impairs the firm’s liquidity. On the other hand, too low a collection period is not necessarily favourable, rather it
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may indicate a very restrictive credit and collection policy which may curtail sales and hence adversely affect profit.

Inventory Turnover This ratio measures the stock in relation to turnover in order to determine how often the stock turns over in the business. It indicates the efficiency of the firm in selling its product. It is calculated by dividing he cost of goods sold by the average inventory.

The ratio shows a relatively high stock turnover which would seem to suggest that the business deals in fast moving consumer goods.
• • •

The company turned over stock every 24 days in 2000 and every 28 days in 2002. The trend shows a marginal increase in days which indicates a slow down of stock turnover. The high stock turnover ratio would also tend to indicate that there was little chance of the firm holding damaged or obsolete stock.

Total Assets Turnover Asset turnover is the relationship between sales and assets

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• • •

The firm should manage its assets efficiently to maximise sales. The total asset turnover indicates the efficiency with which the firm uses all its assets to generate sales. It is calculated by dividing the firm’s sales by its total assets.

Generally, the higher the firm’s total asset turnover, the more efficiently its assets have been utilised.

Fixed Asset Turnover The fixed assets turnover ratio measures the efficiency with which the firm has been using its fixed assets to generate sales. It is calculated by dividing the firm’s sales by its net fixed assets as follows:

Generally, high fixed assets turnovers are preferred since they indicate a better efficiency in fixed assets utilisation.

From the above calculations:
• •

It appears that the activity of the business is relatively constant, with a slight upward trend. The ratio also confirms that the business places a much greater reliance on working capital than it does on the fixed assets as the fixed assets (2001 and 2002) turned over more quicker than stock turnover.

C: Financial Leverage (Gearing) Ratios
• • •

The ratios indicate the degree to which the activities of a firm are supported by creditors’ funds as opposed to owners. The relationship of owner’s equity to borrowed funds is an important indicator of financial strength. The debt requires fixed interest payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the
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appointed time. A relatively high proportion of funds contributed by the owners indicates a cushion (surplus) which shields creditors against possible losses from default in payment. Note: The greater the proportion of equity funds, the greater the degree of financial strength. Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is greater than the rate payable on borrowed funds. The following ratios can be used to identify the financial strength and risk of the business. Equity Ratio The equity ratio is calculated as follows:

This indicates that only 32.1% of the total assets in 2002 is supplied by the ordinary stockholders and this has shown a slight decrease from 32.8% in 2000.

A high equity ratio reflects a strong financial structure of the company. A relatively low equity ratio reflects a more speculative situation because of the effect of high leverage and the greater possibility of financial difficulty arising from excessive debt burden.

Debt Ratio This is the measure of financial strength that reflects the proportion of capital which has been funded by debt, including preference shares. This ratio is calculated as follows:

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With higher debt ratio (low equity ratio), a very small cushion has developed thus not giving creditors the security they require. The company would therefore find it relatively difficult to raise additional financial support from external sources if it wished to take that route. The higher the debt ratio the more difficult it becomes for the firm to raise debt. Debt to Equity ratio This ratio indicates the extent to which debt is covered by shareholders’ funds. It reflects the relative position of the equity holders and the lenders and indicates the company’s policy on the mix of capital funds. The debt to equity ratio is calculated as follows:

The debt to equity ratio shows that for every 1 dollar of shareholders funds in 2002 there was 2.12 dollars of debt. This compares to 2.05 dollars in 2000. This ratio is extremely high and indicates the financial weakness of the business.

Times Interest Earned Ratio This ratio measure the extent to which earnings can decline without causing financial losses to the firm and creating an inability to meet the interest cost.
• •

The times interest earned shows how many times the business can pay its interest bills from profit earned. Present and prospective loan creditors such as bondholders, are vitally interested to know how adequate the interest payments on their loans are covered by the earnings available for such payments. Owners, managers and directors are also interested in the ability of the business to service the fixed interest charges on outstanding debt.

The ratio is calculated as follows:

The company’s major forms of credit are non-interest bearing (trade creditors) which results in the business enjoying very healthy interest
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coverage rates. In 2002 the company could pay their interest bill 16.5 times from earnings before interest and tax. However this is a massive drop from 51.5 times in 2001 and 37.7 times in 2000. D: Profitability Ratios Profitability is the ability of a business to earn profit over a period of time. Although the profit figure is the starting point for any calculation of cash flow, as already pointed out, profitable companies can still fail for a lack of cash. Note: Without profit, there is no cash and therefore profitability must be seen as a critical success factors.
• •

A company should earn profits to survive and grow over a long period of time. Profits are essential, but it would be wrong to assume that every action initiated by management of a company should be aimed at maximising profits, irrespective of social consequences.

The ratios examined previously have tendered to measure management efficiency and risk. Profitability is a result of a larger number of policies and decisions. The profitability ratios show the combined effects of liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of a business is the profitability which results from the effective use of its resources. Gross Profit Margin
• •

Normally the gross profit has to rise proportionately with sales. It can also be useful to compare the gross profit margin across similar businesses although there will often be good reasons for any disparity.

The ratio above shows the increasing trend in the gross profit since the ratio has improved from 15.2% in 2000 to 20.3% on 2002. This indicates that the rate in increase in cost of goods sold are less than rate of increase in sales, hence the increased efficiency.
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Net Profit Margin This is a widely used measure of performance and is comparable across companies in similar industries. The fact that a business works on a very low margin need not cause alarm because there are some sectors in the industry that work on a basis of high turnover and low margins, for examples supermarkets and motorcar dealers. What is more important in any trend is the margin and whether it compares well with similar businesses.

The net margin ratio shows that the margin is fairly stable over time with slight improvement to 1.73% in 2001. However, to know how well the firm is performing one has to compare this ratio with the industry average or a firm dealing in a similar business. Return on Investment (ROI) Income is earned by using the assets of a business productively. The more efficient the production, the more profitable the business. The rate of return on total assets indicates the degree of efficiency with which management has used the assets of the enterprise during an accounting period. This is an important ratio for all readers of financial statements. Investors have placed funds with the managers of the business. The managers used the funds to purchase assets which will be used to generate returns. If the return is not better than the investors can achieve elsewhere, they will instruct the managers to sell the assets and they will invest elsewhere. The managers lose their jobs and the business liquidates.

The ratio indicates that there is increase in the ROI from 8.38% in 2000 to 8.95% in 2002.

Return on Equity (ROE) This ratio shows the profit attributable to the amount invested by the owners of the business. It also shows potential investors into the business what they
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might hope to receive as a return. The stockholders’ equity includes share capital, share premium, distributable and non-distributable reserves. The ratio is calculated as follows:

Again, the profitability to ordinary shareholders is strong and showing an upward trend. Note that the return in 2002 as in all the years is after tax and the shareholders should be extremely comfortable with these returns. Earning Per Share (EPS) Whatever income remains in the business after all prior claims, other than owners claims (i.e. ordinary dividends) have been paid, will belong to the ordinary shareholders who can then make a decision as to how much of this income they wish to remove from the business in the form of a dividend, and how much they wish to retain in the business. The shareholders are particularly interested in knowing how much has been earned during the financial year on each of the shares held by them. For this reason, an earning per share figure must be calculated. Clearly then, the earning per share calculation will be:

Exercises 1. Reconsider the ratios which have been calculated for analysis on profitability. In your own words, analyse the trends in these ratios and discuss the linkage between ROI and ROE. 2. How will the gross margin ratio assist you in determining the profitability of a business? 3. In your own words, explain the calculation used for ROI. 4. When calculating EPS, explain how we should deal with preference shares dividends. E: Market Value Ratios These ratios indicate the relationship of the firm’s share price to dividends
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and earnings. Note that when we refer to the share price, we are talking about the Market value and not the Nominal value as indicated by the par value. For this reason, it is difficult to perform these ratios on unlisted companies as the market price for their shares is not freely available. One would first have to value the shares of the business before calculating the ratios. Market value ratios are strong indicators of what investors think of the firm’s past performance and future prospects. Dividend Yield Ratio The dividend yield ratio indicates the return that investors are obtaining on their investment in the form of dividends. This yield is usually fairly low as the investors are also receiving capital growth on their investment in the form of an increased share price. It is interesting to note that there is strong correlation between dividend yields and market prices. Invariably, the higher the dividend, the higher the market value of the share. The dividend yield ratio compares the dividend per share against the price of the share and is calculated as:

Notice a healthy increase in the yield from 2000 to 2002. The main reason for this is that the dividend per share increased while at the same time, the price of a share dropped. This is fairly unusual because share prices usually increase when dividends increase. However there could be number of reasons why this has happened, either due to the economy or to mismanagement, leading to a loss of faith in the stock market or in this particular stock. Normally a very high dividend yield signals potential financial difficulties and possible dividend payout cut. The dividend per share is merely the total dividend divided by the number of shares issued. The price per share is the market price of the share at the end of the financial year.
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Price/Earning Ratio (P/E ratio)
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P/E ratio is a useful indicator of what premium or discount investors are prepared to pay or receive for the investment. The higher the price in relation to earnings, the higher the P/E ratio which indicates the higher the premium an investor is prepared to pay for the share. This occurs because the investor is extremely confident of the potential growth and earnings of the share.

The price-earning ratio is calculated as follows:

1. High P/E generally reflects lower risk and/or higher growth prospects for earnings. 2. The above ratio shows that the shares were traded at a much higher premium in 2000 than were in 2002. In 2000 the price was 26.8 times higher than earnings while in 2002, the price was only 12 times higher. Dividend Cover

This ratio measures the extent of earnings that are being paid out in the form of dividends, i.e. how many times the dividends paid are covered by earnings (similar to times interest earned ratio discussed above). A higher cover would indicate that a larger percentage of earnings are being retained and re-invested in the business while a lower dividend cover would indicate the converse.

Dividend pay-out ratio This ratio looks at the dividend payment in relation to net income and can be calculated as follows:

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Note: Even though the dividend yield has increased, the dividend payout ratio has reduced, showing that a lower proportion of earnings was paid out as dividend. The ratio has only reduced slightly, however, from 50.7% in 2000 to 49.4% in 2002. Generally, the low growth companies have higher dividends payouts and high growth companies have lower dividend payouts. Exercise: 1. In your own words, comment on the market value ratios in our example. In your answer, assume the following industry average for 2002 Dividend yield: 3.2% P/E Ratio: 12.8 times. 2. What is the purpose of calculating the market value ratio? 3. What actions can directors take to ensure a stable dividend yield growth over time? 4. The P/E ratio indicates the premium an investor is prepared to pay for a share. Discuss? 5. Explain what activities can cause the dividend payout ratio to change. Relationship Among Ratios

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Session 3: Time-Series Techniques/Trend Analysis Session Learning Outcomes Learners will understand and be appreciative on the use of the time series analysis technique while analysing the financial statements information, its application and interpretation Trend analysis: Is the type of analysis in which the information for a single company is compared over time. Over the course of the business cycle, sales and profitability may expand and contract, so the ratio analysis for one year may not present an accurate picture of the firm. Therefore we look at trend analysis of performance over a number of years. However without industry comparisons even trend analysis may not present a complete picture.

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By looking at the company profit margin over time in relation to the industrial average it can be observed that a company was showing the decreasing trend up to 1995 after that the company shows an increasing trend. However the company was performing above the average up to 1989 then below the industry average up to 1995. Trend analysis can be used to compare various other items in the industry/sector such as:
• • • • •

Number of subscribers Investment in fixed assets Investment in total assets Sales Charging rates

Trend analysis can be established by comparing items in the regional area such as:
• •

Number of telephone operators in Tanzania and average number of operators per country in Sub Saharan Africa Charge rates of Botswana mobile subscribers and the average charge rates in the Sub Saharan region over years

Trend analysis can help telecommunication operators enhance their policy making decisions by comparing themselves to other countries and providers in the region. At the same time may seek expertise in the areas which the sector wants to improve if there is a country of comparative benefits as compared to others. Module 1.4: Learning Activity for Financial Statement Analysis and Interpretation
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The following are extracts from the financial statements of a telephone company.

The eight per cent debentures are redeemable in instalments and the final instalment is due to be paid in 2003. The regulatory authority is concerned about the poor liquidity of the company and has asked you to report on the company’s recent performance. After calculating appropriate ratios, comment on the performance and financial health of the company.

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Session 4: Indicators and Souces of Financial Distress Learning Objectives At the end of this session, students should be able to:
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Determine the costs of financial distress Explain the factors influencing the risk of financial distress

Important Learning Terms
• • •

Financial distress Costs of financial distress Indicators for financial distress

In the real world companies do not, generally raise their debt-to-equity ratios to very high levels. This suggests that there are other important influences on capital structure besides lower costs of debt and tax relief on debt. The basic additional factors which have a bearing on the gearing level are: financial distress (bankruptcy costs); agency costs; borrowing capacity; managerial preference; pecking order; financial slack; signalling; control; and industry group gearing. Financial Distress Financial distress is defined as a condition where obligations are not met or are met with difficulty. A major disadvantage for a firm taking on higher levels of debt is that it increases the risk of financial distress, and ultimately liquidation. This may have detrimental effect on both the equity and debt holders. Effects of Financial Distress

The risk of incurring the costs of financial distress has a negative effect on a firm's value which offsets the value of tax relief of increasing debt levels. These costs become considerable with very high gearing. Even if a firm manages to avoid liquidation its relationships with suppliers, customers, employees and creditors may be seriously damaged. Suppliers providing goods and services on credit are likely to reduce the generosity of their terms, or even stop supplying altogether, if they believe that there is an increased chance of the firm not being in existence in a few months' time.

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Customers may develop close relationships with their suppliers, and plan their own production on the assumption of a continuance of that relationship. If there is any doubt about the longevity of a firm it will not be able to secure high-quality contracts. In the consumer markets customers often need assurance that firms are sufficiently stable to deliver on promises.

In a financial distress situation, employees may become demotivated as they sense increased job insecurity and few prospects for advancement. The best staff will start to move to posts in safer companies. Bankers and other lenders will tend to look upon a request for further finance from a financially distressed company with a prejudiced eye – taking a safety-first approach – and this can continue for many years after the crisis has passed. Management find that much of their time is spent "fire fighting" – dealing with day-to-day liquidity problems – and focusing on short-term cash flow rather than long-term shareholder wealth. The indirect costs associated with financial distress can be much more significant than the more obvious direct costs such as paying for lawyers, accountants and for refinancing programs. Some of these indirect and direct costs are shown in the table below:

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Some Indicators of Financial Distress As the risk of financial distress rises with the gearing ratio shareholders (and lenders) demand an increasing return in compensation. The important issue is at what point does the probability of financial distress so increase the cost of equity and debt that it outweighs the benefit of the tax relief on debt? Financial Analysis may be used to view some of the indicators of the financial distress. Important ratios to be considered include:
• • •

Liquidity ratios Debt management ratios Asset utilization ratios

The ratios provide indicators on whether the firm is facing financial problems in meeting both its current and long term debt obligations. Other indicators are as discussed below.
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Some Factors Influencing the Risk of Financial Distress Costs The susceptibility to financial distress varies from company to company. Here are some influences: 1. The sensitivity of the company's revenues to the general level of economic activity. If a company is highly responsive to the ups and downs in the economy, shareholders and lenders may perceive a greater risk of liquidation and/or distress and demand a higher return in compensation for gearing compared with that demanded for a firm which is less sensitive to economic events. 2. The proportion of fixed to variable costs. A firm which is highly operationally geared, and which also takes on high borrowing, may find that equity and debt holders demand a high return for the increased risk 3. The liquidity and marketability of the firm's assets. Some firms invest in a type of asset which can be easily sold at a reasonably high and certain value should they go into liquidation. This is of benefit to the financial security holders and so they may not demand such a high-risk premium. 4. The cash-generative ability of the business. Some firms produce a high regular flow of cash and so can reasonably accept a higher gearing level than a firm with lumpy and delayed cash inflows. Discussion 6 Post your response in the discussions area. (See the procedure for discussions in Course Info.) Discuss whether there is any rationale to study the financial distress of telecommunication companies:
1. Explain what are the possible costs for the ICT industry given

the financial distress situation? 2. What action will the regulators take if in the market where the firm(s) encountered financial distress? Express your answer based on two nature of economies (monopoly and competitive market) 3. You are given a set of financial statements including the balance sheet and the income statement of S.O.SONEY for the three consecutive years. All data is in million shillings.

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Required 1. Perform a detailed financial statement analysis and evaluate the activity and management effectiveness based on (i) Vertical Analysis
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(ii) Horizontal Analysis (iii) Ratio Analysis 2. What can you conclude as to the financial position of the company?

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Session 1: Users and Suppliers of Financial Statements Information Session Learning Outcome Learners will be able to understand parties that demand and supply financial statements information as well as their objectives for the need of the financial statements information. Also, they will learn the conflicts which may arise among the diverse parties demanding and supplying the financial statements. Important Learning Terms
• • • • •

Demand Supply Financial statements information Internal users of financial statements External users of financial statements

A: Users/Demanders of Financial Statements Information Parties demanding financial statement information include:
• • • • • •

Shareholders, investors and security analysts; Managers; Employees; Lenders and other suppliers; Customers; and Government regulatory agencies

These parties can also be grouped into internal versus external users. Internal users consist of managers and employees while external users consist of the rest in the above list. These parties demand financial statement information:
• • •

To Facilitate decision-making, For Monitoring of management, or To Interpret contracts or agreements that include provisions based on such information.

Shareholders, Investors and Security Analysts These are major recipients of the financial statements of corporations. These parties range from individuals with relatively limited resources to large, wellendowed institutions such as insurance companies and mutual funds.

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The decision made by these parties includes:
• •

Shares to buy, retain, or sell, Timing of the purchase or sale of those shares.

Typically, their decisions have either an investment focus or a stewardship focus; in some cases, both will occur simultaneously. In an investment focus, the emphasis is on choosing a portfolio of securities that is consistent with the preferences of the investor for risk, return, dividend yield, liquidity and so on. The information required for this choice can vary significantly. An Illustration Consider approaches aiming to detect mis-priced securities by a fundamental analysis approach as opposed to a technical analysis approach. The former approach examines firm,-industry-and – economy-related information; financial statements play a major role in this approach. An important aspect is predicting the timing, amounts, and uncertainties of the future cash flows of the firm. In contrast, technical analysis aims to detect mispriced securities by examining trends in security prices, security trading volume, and other related variables; financial statement information typically is not examined When predicting the timing, amounts, and uncertainties of future cash flows of the firm, the past record of management in relation to the resources under its control can be a critical variable. The analysis undertaken for decisions by shareholders and investors can be done by those parties themselves or by intermediaries such as security analysts and investment advisors. Note: These intermediaries can have different rankings for financial statement variables than the investors for whom the information analysis is conducted. Managers One source of the demand for financial statement information by managers arises from contracts that include provisions based on financial statement variables. e.g. Management incentive contracts. When structuring agreements between the firm and other entities, management may include contractual terms based on financial statement variables. Managers also utilize financial statement information in many of their financing, investment, and/or operating decisions. A financial-statement based variable, such as the current debt-to-equity ratio or the interest coverage ratio, is frequently important in deciding how much long-term debt to raise.
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The financial statement of other firms can also be used in management decisions. For instance, when deciding where to re-direct the resources of a firm, the financial statement of other firms can show areas where high profit margins are currently being earned. Employees Employees have several motivations. They have a vested interest in the continued and profitable operations of their firm. Financial statements are an important source of information about current and potential future profitability and solvency. They may also need them to monitor the viability of their pension plans. Lenders and Other Suppliers In the ongoing relationship that exists between suppliers and a firm, financial statements can play several roles. Consider the relationship between a firm and the suppliers of its loan capital, e.g. a bank. In the initial loan-granting stage of the relationship, financial statements typically are an important item. Many banks have standard evaluation procedures that stipulate that information relating to liquidity, leverage, profitability, and so on be considered when determining the amount of the loan, interest rate and the security to be requested. Many bank loans include bond covenants that, if violated, can result in the bank restructuring the existing loan agreement. One effect of incorporating a covenant into a loan agreement is to create a demand by the bank for successive financial statements of the firm. Customers The relationship between a firm and its customers can extend over many years. In some cases, these relationships take the form of legal obligations associated with guarantees, warranties, or deferred benefits. In other cases, the long-term association is based on continued attention to customer service. Government/ Regulatory Agencies The demand by these bodies can arise in a diverse set of areas such as; Revenue raising, e.g. for income tax, sales tax, or value-added tax collection. Government contracting, e.g. for reimbursing suppliers paid on a cost-plus basis or for monitoring whether companies engaged in government business are earning excess profits. Rate determination, e.g. deciding the allowable rate of return that an electric utility can earn. Regulatory intervention, e.g. determining whether to provide a government-backed loan agreement to a financially distressed firm.
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For instance, telecommunication regulators may demand financial statements of the telephone/ICT companies to make decisions on the following issues:
• • • • • •

Competition strategy set up of the companies Monitoring interconnection charges Limit entries and incubators in the market Deciding on the coverage Setting the upper pricing limit for the services provided by the operators. For industrial/regional comparisons of the services offered by the companies and the returns of the companies.

Other Parties The set of parties that make demands of the financial statements information of corporations is open-ended. Diverse parties such as academicians, environmental protection organizations, and other special interest lobbying groups approach corporations for details relating to their financial and other affairs. B: Suppliers of Financial Statements Information Business firms are the suppliers of the financial statements information. Limited liability companies are required by the company act to prepare financial statements and disclose the audited financial statements to the public/shareholders. Listed companies are required by the regulations governing the operation of the stock market to disclose audited financial statement information. C: Conflicts among Diverse Parties As explained in part A of this section, users of financial data have diversity of interests. These interests sometimes conflict. Owners/Shareholders The interest of these parties in financial statement information lies in the fact that it is their money that is invested in the firm. They would like to ensure that they are getting a good return on their investment. This is assessed by how much profit the firm is making and whether their investment is increasing in value. For shareholders in companies this means they will get good dividend and the market value of their shares will increase and they can make capital gains if these were sold. Management They are responsible to the owners/shareholders in carrying out policies and directives, and in running the business efficiently and effectively. They
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however, need to be paid well and this increases expenses and thus reduces returns to shareholders. Banks/Loan companies This group is interested not only in the firm's profitability but also in its ability to repay loans. Managers would prefer using loaned funds for a longer period. Employees They are part of the organization and feel that their efforts contributed to the firm's profits. They would therefore prefer to be given bonuses and salary increases. This also increases expenses to the firm. Suppliers Suppliers usually extend credit to the firm for goods supplied and they want to be assured of timely payments of accounts due. Their interest will be similar to that of the banks and loan companies. Prospective Investors/Analysts These are interested in a firm's profitability and potential for growth. Prospective investors rely on financial statements information in making their investment decisions. In giving advice to prospective and existing investors, analysts also make use of financial statements information. Government Various ministries and departments have interest in the firm's payments of taxes. Also see the enactment of laws for the industry and provision of social services to the public. The government may also want to ensure that the firm complies with laws on, for example, wage payments and employee benefits. Discussion 4 Post your response in the discussions area. (See the procedure for discussions in Course Info.) 1. What are the possible conflicts in demanding the financial statement for a telephone operator for the following parties a) Users of the service and the operators b) Competitors and the shareholders c) Shareholders and the users d) Shareholder and the operator 2. Explain why each of the following groups might want financial statements information. What type of financial information would
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each group find most useful? a) The company’s existing shareholders b) Prospective investors c) Financial analysts who follow the company d) Company managers e) Current employees f) Commercial lenders who loaned money to the company g) Current suppliers h) Regulators in the sector like Telecommunication Regulators for the telecommunication industry

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Module 1.2: Preparation of Financial Statements for ICT Firms Chapter Learning Objectives
• •

Understand financial reporting for internal and external users. Appreciate how financial statements are prepared and what policy and regulatory issues affect the type of financial results produced.

Chapter Learning Outcomes At the end of this chapter, the learner will have knowledge on the financial reporting required for the internal and external users and how policy and regulatory issues affect the numbers presented in financial statements. The students will learn how the financial statements are prepared and what constitutes the financial statements. Important things to note in this chapter are that the regulators should have at least a basic knowledge on how the financial statements are prepared by the companies. This is important since financial statements can have different forms depending upon who is using the financial statements. Policy and regulations do affect the results presented in financial statements. Session to be Covered Session 1: Preparation of the Income Statement, Balance sheet and Cash flow statements.

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Session 1: Preparation of Income Statement, Balance Sheet and Cash Flow Statements This session provides details on how to prepare financial statements. Most commonly used financial statements are income statement, balance sheet and cash flow statements. Session Learning Outcome Learners will be able to understand and appreciate the process in the preparation of the Income Statement or the Trading and Profit and Loss Account, Balance sheet and Cash Flow statements and their importance. Important Learning Terms
• • • • • • • • •

Financial Statements Income statement Balance sheet statement Cash flow statement Revenue/sales determination Cost of goods sold Manufacturing overheads Sources of funds Uses of funds

Basic Definitions Financial statement A report of basic accounting data that helps investors understand a firm's financial history and activities. Income statement (statement of operations) A statement showing the revenues, expenses, and income (the difference between revenues and expenses) of a corporation over some period of time. Balance sheet Also called the statement of financial condition, it is a summary of a company's assets, liabilities, and owners' equity. The document distributed at the annual meeting to shareholders of record who wish to vote their shares in person. Cash flow statement Statement showing earnings before depreciation, amortization, and noncash charges. Sometimes called cash earnings. Cash flow from operations indicates the ability to pay dividends.

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Preparation of Income Statement The Income Statement normally shows whether the business is earning profits or sustaining losses. It communicates the financial performance of the business. The structure of the income statement differs with the nature of the business. The business can either be a manufacturing, merchandising/trading or service entity. Regardless of the structure, they however, communicate the same information. Factors to be considered in the preparation of income statements are: Revenues/Sales This item carries the revenues/sales generations of the company. Sales consist of Cash Sales (cash is paid at the time of sale) or Credit Sales (Cash paid later). The sales/revenue is made up with the following items:

Note: Other Incomes/Revenues results from the revenues which are not core business of the company. Such revenues are for example, if a company earns interest from banking services, dividends received from investment of other companies or subsidiaries, money awards, etc. For a trading and service entity the same consideration is made for the revenues/income as sown above. The only difference for the service company is the return inwards since in most cases services are consumed when manufactured/prepared with nothing to be left as a return. Cost of Goods Sold This represents the total cost of buying raw materials, and paying for all the factors that go into producing finished goods. The cost of goods should be deducted from the sales revenues.

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Note: For manufacturing firm, the process of manufacturing goods is a continuous process. Hence there might be materials which are in stock or some of the goods may be half processed (work in progress) both at the opening of the financial year or at the closure of the financial year. Hence, calculation of the cost of goods sold should include consideration of all the items shown in the table above. Trading Firms

Service Firms In service companies such as telecommunications, cost of service provided may be expressed as percentage of sales say 60% of the revenues
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generated regarded as cost of services to pay for bandwidth access in a satellite company. Gross Profit This is the difference between Net Sales and the Cost of Goods Sold. Gross profit is the profit obtained from the normal operation of a business firm before incurring operating expenses, tax and other deductions. Expenses These are the expenses the company incurs in the process of generating revenues. The expenses depend on the nature of the business firm.

Profit Before Interest and Tax: This is equal to the Cost of goods sold less expenses

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Note: Dividend is a portion of a company's profit paid to common and preferred shareholders. It is paid to common stock holders only when the company makes profit. In arriving at the income statement as shown above, there should be supporting documents which when totalled brings the figures for the above items. Preparation of the Balance Sheet Statement The Balance Sheet shows the value of assets owned by the business, the amount of its debts and the equity of the owner. In other words, it communicates the financial position of the business.

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Discussion 3 Post your response in the discussions area. (See the procedure for discussions in Course Info.) 1. Review financial statements of communication of the regulatory body of your country. a) Identify the common items in the financial statements. b) Relate the financial statements to three other regulatory bodies in the SADC region. 2. Review financial statements of at least two telecommunication companies in your country. Where possible, one company should be a producer of ICT products and the other should be a service firm. a) Identify the common items in the financial statements. b) Relate the financial statements of these firms to each other. Preparation of Cash flow Statement This statement shows the changes that have taken place in actual cash and the working capital of the firm as well as the sources and use of the working capital during the accounting period. It is a summary of a firm’s changes in financial position from one period to
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another; it is also called the sources and uses of funds statement or a statement of changes in financial position. The flow of cash/funds in a firm may be visualized as a continuous process. For every use of cash/funds, there must be an offsetting source. In a broad sense, the assets of a firm represent the net uses of cash/funds; its liabilities and net worth represent net sources. The fund flow statement is useful to know whether the uses of the funds can be met by the available sources funds or there is a need for external financing sources such as bank overdrafts, etc. Sources and Uses of Funds Statement Tracing Cash and Net Working Capital Sources of Funds Consist of all events that increase cash:
• • • • •

A net decrease in any asset other than cash or fixed assets A gross decrease in fixed assets A net increase in any liability Proceeds from the sale of preferred or common stock Funds provided by operations Note: Funds provided by operations usually are not expressed directly on the income statement. To determine them, one must add back depreciation and any other non-cash item that was deducted and also deduct any non-cash item that was added to the net income.

Uses of Funds Consist of all events that decrease cash and include:
• • • • •

A net increase in any asset other than cash or fixed assets A gross increase in fixed assets A net decrease in any liability A retirement or purchase of stock Cash dividends

Statement of Cash Flows It emphasizes the critical nature of cash flow to the operation of the firm. The primary sections of the statement of cash flows are:
• •

Cash flows from operating activities Cash flows from investing activities
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Cash flow from financing activities

The results from each section are added together to compute the net increase or decrease in cash flow for the firm. The format of the cash flows statement is given below:

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Preparation of Other Financial Related Statements

(ii) Explanatory Notes The explanatory notes communicate additional information regarding items included and excluded from the body of the statement. These normally include:
• • • • • •

Accounting policies Detailed disclosure regarding individual elements Commitments and contingencies Business combinations Transactions with related parties Legal proceedings etc.

These are prepared to justify each accounting figure in the prepared financial statements.

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