FINANCIAL ANALYSIS AND

ACCOUNTING RECORDS
Robert Hamilton
October 29, 2009
 BACKGROUND
• Financial analysis refers to an assessment of the viability, stability and profitability of a business.
• It is performed by preparing reports using ratios that make use of information taken from
financial statements and other reports. These reports are usually presented to top management
as one of their bases in making business decisions. Based on these reports, management may:
• Continue or discontinue its main operation or part of its business;
• Make or purchase certain materials in the manufacture of its product;
• Acquire or rent/lease certain machineries and equipment in the production of its goods;
• Issue stocks or negotiate for a bank loan to increase its working capital;
• Make decisions regarding investing or lending capital;
• Other decisions that allow management to make an informed selection on various alternatives in
the conduct of its business.
• Or as it relates to regulation, write a strongly worded letter informing the company that some
time in the future if they do not chose at some point to improve the financial strength of the
company, we may or may not take some form of action that could result in the company possibly
facing another letter.
 Financial Analysis and the Regulator
• A regulator typically applies a system of rules called the Uniform System of
Accounts (USOA), which outlines how licensees are to keep and report their
financial records for regulatory purposes. Typical reports include balance sheets,
income statements, cash flow statements, and operating statistics. Having a USOA
decreases opportunities for abuse and helps in overcoming the operators’
information advantage over the regulator.
 OBJECTIVES
• The objectives of accounting regulation are to provide accurate records that clearly identify
assets and asset values, assess operator earnings, benchmarking, monitoring performance on
investment and other license requirements, and transparency for investors. Financial analysts
often assess the firm's:

• Profitability - its ability to earn income and sustain growth in both short-term and long-term.
A company's degree of profitability is usually based on the income statement, which reports
on the company's results of operations;
• Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations;
• Both 2 and 3 are based on the company's balance sheet, which indicates the financial
condition of a business as of a given point in time.
• Stability- the firm's ability to remain in business in the long run, without having to sustain
significant losses in the conduct of its business. Assessing a company's stability requires the
use of both the income statement and the balance sheet, as well as other financial and non-
financial indicators.
 METHODS
Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.)
with:

• Past Performance - Across historical time periods for the same firm (the last 5
years for example),
• Future Performance - Using historical figures and certain mathematical and
statistical techniques, including present and future values, This extrapolation
method is the main source of errors in financial analysis as past statistics can be
poor predictors of future prospects.
• Comparative Performance - Comparison between similar firms.
 FINANCIAL RATIOS
• Financial ratios say little about the firm's prospects in an absolute sense. Their
insights about relative performance require a reference point from other time
periods or similar firms.
• One ratio holds little meaning. As indicators, ratios can be logically interpreted in at
least two ways. One can partially overcome this problem by combining several
related ratios to paint a more comprehensive picture of the firm's performance e.g.
(EWT ratios).
• Seasonal factors may prevent year-end values from being representative. A ratio's
values may be distorted as account balances change from the beginning to the end of
an accounting period. Use average values for such accounts whenever possible.
• Financial ratios are no more objective than the accounting methods employed.
Changes in accounting policies or choices can yield drastically different ratio values.
• They fail to account for exogenous factors like investor behavior that are not based
upon economic fundamentals.
 ANALYSIS
• The FSC tabled a bulletin in December 2008 called the Early Warning Test bulletin
which detailed key ratios in the areas of:
– Capital Adequacy
– Asset Quality
– Earnings Quality
– Profitability
– Liquidity
 ANALYSIS
• The failure of one or more of these ratios can give an analyst, insight as to possible
red flags that can be identified on the company’s Financial Statements. e.g. Balance
Sheet, P&L and Cash Flow.
• This will lead the analyst to request Balance Sheet and Profit & Loss General Ledger
accounts to examine in detail and identify transactions which may be fraudulent or
incorrectly posted.

• Other Red Flags include:

• Significant changes in account balances from one year to the next.
• Significant changes in account balances over a short period of time (year or less)
could indicate an overstatement or understatement of an account balances.
• This over/under statement could be due to a posting error or misclassification of a
transaction.
• This could be an intentional action to cover up fraud or misrepresent a company’s
true financial performance to its stakeholders and the regulator.
 OTHER RED FLAGS
• Negative operating Cash Flow
– A Situation where the cash outflows during a period are higher than the cash
inflows during the same period. Negative cash flow does not necessarily means
loss, and may be due only to a mismatch of expenditure and income. Chronic
mismatch, however, may indicate ineffective credit management, leakage of
funds through fraud, or actual loss. Temporary mismatch is covered usually by
arranging an overdraft facility or taking a loan.
– This is not a sustainable situation and a prolonged period of negative operating
cash flows will cast serious doubt on a company's ability to continue as a going
concern.
– Has management invested client funds into an alternative investment scheme or
some other bad investment which has not been earning interest income or
principal payments, while the company continues to accrue interest expense and
pay out clients in anticipation of receiving payments at a later date?
– Review page 5 of UGIFIL.
 OTHER RED FLAGS
• Sustained period of operating losses
• A sustained period of operating losses casts serious doubt on a company’s
ability to continue as a going concern
• It also calls into question the ability, motives and competence of management.
• Is management safeguarding investor funds and making investing based on
the risk tolerance and appetite of the investor?

• Changes in Account Balances that go against current economic or industrial trends.

E.g. A company having a positive fair value reserve during the period October 2008
to December 2008. This period was the pinnacle of the global financial crisis and
most securities were devalued.
 OTHER RED FLAGS
• Other red flags can be:
– Asset accounts and expense accounts have credit balances when they should
have credit balances. This could be displayed as either negative balance on
the P&L and Balance Sheet or an expense account being classified as a
revenue a/c and an asset a/c being classified as a liability a/c. The converse is
true for Revenue and Liability.

• Late monthly, quarterly and annual findings Filings

• A company that is significantly late in filing required Financial reports usually
indicates a breakdown in the company’s system of recording financial
information. This could be software problem, competence problem or simply
the company trying to hide its true financial condition from the regulator so as
to not receive another LETTER or other sanctions, maybe, possibly, etc.