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Chapter 1.

Introduction to the
analysis of financial statements
Mara Jos Garca Lpez

Contents

1.1 Objectives of the analysis


1.2 Common causes of business problems
1.3 Business analysis and assessment
1.4 Complementary information
1.5 Limitations of the analysis of financial statements
1.6 Summary

1.1 Objectives of the analysis


Financial accounting statement analysis comprises a set of techniques
that are used to assess the performance, position and prospects of a
business, with the aim of making decisions. Business managers can, for
example, use such techniques to make decisions that address potential
problems threatening the businesss future. Financial analysis can also be
used by managers to identify the key strengths of the business. Analysis
techniques are also very useful for people interested in knowing about the
financial situation and future prospects of a business. Listed in figure 1.1 are
the principal categories of financial accounting statement users who are likely
to be interested in financial analysis.

Figure 1.1 Principal users of the analysis of financial statements other


than business managers

Banks and other lenders


Shareholders
Suppliers
Clients
Employees, business agencies and trades unions
Auditors
Advisers
Financial analysts
Government departments
Competitors
Investors and potential investors in the business

1.2 Common causes of business problems


It is common practice to blame poor business performance on the
performance of the economy in which it operates. Business crises are often
explained by reference to external economic factors.

Examples of external factors used to excuse poor business performance:

General economic downturn


Changes in the market
Technological changes
Low demand
Pressure from suppliers
Foreign competition especially in respect of quality and/or cost
High taxes
Poor support by government/ excessive quantities of red tape and
bureaucracy
Delay in payment, especially from public sector customers
Customer insolvency
Inflation
Negative treatment in the news media
Adverse trading environment
Natural disasters
Bad luck

1.2 Common causes of business problems


Although it is clear that negative external factors may have an adverse
effect on business performance, business managers should be able to find
ways of adapting, surviving and prospering within their environment.
However, it is also important to identify the internal problems that can be
solved by the business itself. Not all problems can be explained by external
factors. Figure 1.3 identifies some causes of business failure related to purely
internal factors.
Cause

% of total

Fraud

Negligence

Incompetence

85

Other

Total

100

Figure 1.3

1.2 Common causes of business problems


From 1.3 we can see that the main reason businesses default on payments
or go bankrupt is due to management incompetence. Senior managers are
often blind to structural weaknesses in their business that may seriously
damage performance and even threaten survival. Figure 1.4. lists some
commonly found weaknesses. If problems like these are not detected in
time, and remedial measures are not taken, the business may not be able to
recover.

1.3 Business analysis and assessment

In order to make an effective assessment of the businesss position and


performance all relevant data should be thoroughly analyzed. The analysis
should result in a report that identifies all relevant strengths and
weaknesses. A thorough analysis by management should have the following
characteristics:
It should be based on the analysis of all relevant data.
It should be done on a timely basis
It has to be accurate.
It has to be followed by adequate measures to correct for weaknesses and
exploit identified strengths.

Examples of internal weaknesses

Cost problems
Small margins due to high costs
Costs of distribution, advertisement or excessive promotion
Inadequate control over costs of production
High fixed costs
Losses or small profits
Business units with a history of losses

Organizational problems
Insufficient control over new activities
Inefficient decentralization
Problems in information systems
Inadequate cost and management accounting systems
Inaccurate or slow accounting systems

Examples of internal weaknesses

Financial problems
Insufficient capital provision
High leverage (gearing)
Excess short-term debt
Over-trading
Delay in paying suppliers
Excess investment in current assets
Poorly managed/unproductive assets
Excess dividends to shareholders

Commercial problems
Insufficient sales to cover costs.
Unsuccessful product diversification
Obsolete products
Repeated failure in launching new products
Low prices
Failure to compete in innovation
Lack of awareness of market change

Examples of internal weaknesses


Technological and production problems
Unproductive use of buildings, machinery and facilities
Use of obsolete technology
High incidence of quality problems
Problems in human resources
Low productivity due to lack of training and/or poor motivation
High personnel costs
Conflict of interests among employees

1.3 Business analysis and assessment


Management incompetence is observable in many circumstances. For
example, when managers fail to correctly analyse the position and
performance of the business and therefore fail to detect problems that
require corrective measures
Typical weaknesses of managers and other interested parties include the
following:
Business managers sometimes make decisions about investments, or
financial policies, without firstly undertaking a thorough analysis of their
financial position
Businesses may sell to customers on credit terms without thoroughly
exploring their credit-worthiness
Bank managers and professional analysis may assign insufficient time
to the assessment of their clients financial position
Investors buy shares of companies of without analysing the financial
statements
Employees decide to join a business without first analysing its financial
statements

1.3 Business analysis and assessment


Timeliness is of key importance. Although business managers may
undertake financial analysis, their analysis may be inadequate due to lack of
relevant information or because of weaknesses in understanding of analysis
techniques. Other managers may make a correct assessment of the
situation, but too late, when nothing can actually be done about the
problems identified. Accounting practices must be designed to ensure that
financial statements are produced promptly. Typical problems include the
following:
Businesses often fail to keep their accounts up to date
Managers may be unable to rely on the information provided by their
accounting systems
Companies frequently (where a choice is available in law) do not opt for
regular audit

1.3 Business analysis and assessment


Finally, there are managers who succeed in performing thorough, accurate
and timely analyses, but the corrective measures they adopt do not work or
are inappropriate in the circumstances. Typical problems include the
following:
Measures are taken to avoid problems rather than in order to attempt to
solve them
Measures are taken by managers in an attempt to protect themselves
instead of solving the real problems

1.3 Business analysis and assessment


Regular financial analysis of a business by its management will, amongst
other things, help it to achieve its main goals:
Survival: staying alive whilst meeting all liabilities.
Profitability: generating sufficient resources to reward proprietors, and to
provide adequate finance for the businesss investments
Growth: increase sales, market share, profits, an maximise the businesss
value.

1.3 Business analysis and assessment


The assessment needs to be carried out more or less continuously so that
the managers are aware of the businesss current financial status at all
times.

A complete analysis should include the following areas:

Organisational
Financial
Marketing and commercial
Industrial and technological
Human resources

1.3 Business analysis and assessment


The organisational area involves an examination of the business, its
management style, culture, its information systems, administrative cycles,
internal control systems, planning, its relationships with investing
institutions, and so on.
The financial area requires regular analysis of the financial performance
and position (balance sheet, profit and loss account, cash budget and so
on).
Developments in the businesss markets, including an analysis of the
competition, critical appraisal of the businesss marketing plan in relation
to price, product, advertising, distribution and public relations.
Analysis of the businesss industrial and technological position should
examine current and likely future developments in technology, existing
production capacity, productivity, product quality, customer services issues,
the manufacturing process, and so on.
Finally, human resources should also be analysed in detail, examining such
issues as the work environment, health and safety issues, employee
motivation, absenteeism and so on.

1.3 Business analysis and assessment


It should be appreciated at the outset, therefore, that the analysis of
financial statements is just a part of a global analysis that should be
undertaken for every business. This all-encompassing analysis allows
managers to be fully acquainted with the businesss situation at all times.
Likely future developments can be taken into account, allowing managers to
take appropriate corrective measures in an effort to guarantee a viable
future for the business.

1.4 Complementary information


In addition to the financial statements already mentioned, there is a broad
range of complementary information that should be taken into account
when analysing a businesss position and performance. The information
shown in the followings is of great importance to management in running
the business.

Organisational:
Strategic objectives of the business
Management style and business
culture
Planning mechanisms

Management Accountin Information:


Financial situation
Financial results
Costs and margins
Growth
Short and long-term budget

Minimum aspects to be evaluated in the global assessment of a business

Marketing and Commercial


Market conditions
Competition
Price
Product
Marketing and advertising
Distribution
Post-sales service
Business image and public relations

Industrial
Technology
Research
Production capacity
Productivity
Quality
Manufacturing Process
Order book

Minimum aspects to be evaluated in the global assessment of a business

Human Resources
Work environment
Motivation
Absenteeism

1.4 Complementary information


In order to conduct a really thorough analysis we should not only look at
the annual accounts, but also study information such as that as described in
figure 1.6 below. All the additional information about legal aspects,
financial, commercial, technological, and human resources has to be
considered since it can affect the businesss situation quite radically
Analysts drawn from user groups external to the business will find it helpful
where access is obtainable, to visit the business in person and interview key
managers, clients, suppliers, banks and lawyers, to get a complete picture of
the businesss current position. In addition to the wealth of information
generated within the business, there is a great deal of information produced
externally which can be helpful in gaining an understanding of its position
and performance. These source include the following:

General information about the state of the economy


Assuming that the pace of the economy affects the business (which will
generally be the case), it is important to analyse information about the
macroeconomic situation of the country or countries in which it operates.
This data is available in the press, in reports by the OECD, the International
Monetary Fund, World Bank, National Institute of Statistics, Government
Ministries, local government organisations, research agencies acting on
behalf of credit institutions, chambers of commerce, employers
organizations, magazines, the specialist press and so on.

Industry Information
The business will often be affected by general developments in the industry
in which it operates. For this reason, it is essential to analyse the industry in
general by studying reports in the press, by trades unions, chambers of
commerce, banks and savings entities, business information providers,
national statistical offices, international institutions, magazines, the
specialist press and so on.

1.5 Limitations of the analysis of financial statements


As it is the case with any set of techniques applied in management, the
analysis of financial statements has limitations that need to be taken into
account:
The data used is historical and its information content may, therefore, be
limited in respect of likely future business developments
Data in most businesses is usually aggregated for a period ending on the
same date each year, for example, 31 December or 31 March. For businesses
in which seasonality affects sales, production, expenses, collections and
payments, financial statements drawn up to the year end date does not
always provide a very helpful guide to the its position.
As we shall see in Chapter 2, the financial statements of businesses whose
accounting information is subject to manipulation do not represent reality
accurately.

1.5 Limitations of the analysis of financial statements


Accounting data is often not adjusted for inflation. Therefore in some
financial statements, items such as non-current (fixed) assets, inventory
(stock), capital and reserves and depreciation and amortisation are not
always representative of current economic reality.
It is not always possible to obtain industry data with which the businesss
performance can be validly compared
Any conclusions drawn from the study of a set of financial statements
should be carefully considered for validity in the light of these limitations.

Legal Data
Year the business was founded
Legal framework
Proprietors (shareholders, partners)
Management structures
Involvement with institutional and other investors
Lawsuits
Credit rating and status (In Spain, there is a bad debts register the
Registro de Anotacin Impagadas [RAI] which records those businesses
with a record of failing to meet obligations)
Outstanding business tax, value added tax or social security debts.
General information
Business objectives and culture
History of the business
Directors biographical information, including some assessment of their
moral integrity and professional competence
Contractual obligations, agreements, joint ventures, and so on, with other
businesses
Media profile

Marketing and commercial information


Product age, range and future plans for development
Customers and geographical areas
Commercial policy (price, product, promotion advertisement, distribution)
Effect of seasonal cycles on sales
Competition
Research into internal and external markets nationally and internationally
Financial information
Suppliers of credit with whom the business has a relationship
Credit rating reports on the business
Bank references (covering, for example, entities with which the business
trades, longevity of such business relationships)
Relevant external reports (for example, in Spain, from the Bad Debts
Registry - Registro de Aceptaciones Impagadas [RAI]), from the National
Association of Financing Entities - Asociacin Nacional de Entidades de
Financiacin [ASNEF] and from Central Banks Centre for Financial
Statements - Central del Balance del Banco de Espaa and from the Spanish
Central Banks Risk Centre (Central de Riesgos del Banco de Espaa) where
all operations and amounts are registered, as well as financing operations
and endorsements with all credit institutions in the country.

Financial Information (II)


Terms of payment to suppliers and terms of payment agreed with
customers
Percentage of unpaid debts.
Insurance contracts.
Short and long-term forecasts of the performance and position of the
business
Useful information may also be derived by visiting the business to verify
the conditions of facilities, warehouses and so on, and by inspection of the
fixed assets by an expert (applicable only where access to the business is
granted by management).
Verification of fixed assets by an expert.

Technological and production information


Production process
Research and development policy; technology
Patents
Productivity
Level of mechanisation and the current condition of machinery used in
production
Raw materials used and suppliers
Level of total quality.
Environmental policy

Human resources information


Staff
Work environment
Conflicts
Employment policy.
Training
Incentives and motivation

1.6 Summary
This chapter demonstrates that the analysis of financial statements is of
obvious importance for any business that intends to succeed in the medium
and long term.
Financial analysis of a business is only one part of the total analysis needed
before trying to address and remedy its possible problems.
In undertaking an integral assessment of the business we should
analyse, not only the annual financial statements of the business, but also a
range of information relating to organisational, legal, commercial and
technological issues and to human resources.
The assessment needs to be done periodically as a checking procedure, with
the aim of taking timely corrective measures that will address weaknesses
and take full advantage of the businesss strengths.
There are limitations to the analysis of financial statements, and these
limitations should be taken into consideration when decision making is
based on the analysis.