Chapter 29 · Chapter covers • Improvement of information for shareholders • Published financial statements –their limitations for interpretation purposes • Published financial

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Chapter 29

Analysis of published financial

statements

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Main purpose

The main purpose of this chapter is to review the

analysis of published financial statements where

information is limited to that required by statute.

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Objectives

By the end of this chapter, you should be able to:

• discuss the steps taken to improve information for shareholders;

• critically discuss the limitations of published financial data as a source of useful information for interpretation purposes;

• discuss additional entity-wide cash-based performance measures;

• explain the use of ratios in determining whether a company is shariah-compliant;

• explain the use of ratios in debt covenants;

• critically discuss various scoring systems for predicting corporate failure;

• critically discuss remuneration performance criteria;

• critically discuss the role of credit rating agencies;

• calculate the value of unquoted investments.

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Chapter covers

• Improvement of information for shareholders

• Published financial statements – their limitations

for interpretation purposes

• Published financial statements – additional

entity-wide cash-based performance measures

• Ratio thresholds to be satisfied before investing

• Use of ratios in restrictive loan covenants

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Chapter covers (Continued)

• Investor-specific ratios

• Determining value – EVA

• Total shareholder return approach

• Predicting corporate failure

• Professional risk assessors

• Valuing shares of an unquoted company –

quantitative process

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Making financial information more

understandable and easier to analyse

• Making the information accessible

– The ICAS report in 1999

– Business Reporting: the inevitable change?

• Making the information easier to interpret

– XBRL

• The reliability of current financial information

– Lack of confidence among investors.

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(Continued)

• Audit independence needs to be strengthened

– Schemes have kept liabilities off balance sheet

– Auditors are not seen as protecting shareholders.

• Future business prospects

– Pressure for managers to share their assessment of future business prospects so that investors can make informed investment decisions.

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(Continued)

• Disclosure of strategies

– In 1999, the ICAEW produced a report No Surprises: The Case for Better Risk Reporting.

• Disclosure of risks and focus on relevant ratios

– ICAEW 1998 discussion paper, Financial Reporting of Risk.

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Limitations

• Limitations of ratio analysis

• Lack of detail

• Unaudited information

• Timeliness.

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Limitations of ratio analysis

Ratios are useful flags but there are limitations that

the reader need to bear in mind – these include

limitations.

• relating to the underlying financial statements:

– The reliability of the financial statements that are

themselves made suspect

▪ Window dressing, e.g. dispatching goods at the end

of the period knowing that they are defective, so that

they appear in the current year’s sales, and

accepting that they will be returned later in the next

period.

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Limitations of ratio analysis (Continued)

– The possibility that the accounts are subject to

fundamental uncertainty which could affect the

going concern concept – there might be full

disclosure in the notes but ratios might not be

accurate predictors of earnings and solvency.

– Arising because ratios make use of the statement

of financial position figures.

– The end of year figures are static and might not

be a fair reflection of normal relationships such as

when a business is seasonal.

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▪ E.g. a toy manufacturer might have little inventory after supplying wholesalers in the lead up to Christmas.

▪ Any ratios based on the inventory figure such as inventory turnover could be misleading if calculated at say a 31 December year end.

• Invalidating intercompany comparisons such as

– use of different measurement bases, e.g.

▪ Non-current assets reported at historical cost or revaluation.

▪ Revaluations carried out at different dates.

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– Use of off-balance-sheet finance, e.g.:

▪ Structuring the terms of a lease to ensure that it is

treated as an operating lease and not as a finance

lease.

▪ Special purpose enterprises to keep debts off the

statement of financial position.

– Use of different commercial practices, e.g.:

▪ Factoring accounts receivable so that cash is

increased – a perfectly normal transaction but one

which could cause the comparative ratio of days

credit allowed to be significantly reduced.

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• Invalidating intercompany comparisons, such as

– applying different accounting policies, e.g.

▪ adopting different depreciation methods such as straight line and reducing balance;

▪ adopting different inventory valuation methods such as FIFO and weighted average.

– Assuming different degrees of optimism/pessimism while making judgement-based adjustments to non-current and current assets, e.g.

▪ on the impairment review of intangible and tangible non-current assets;

▪ on writing down inventory and accounts receivable.

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– having different definitions for ratios, e.g.

▪ the numerator of ROCE may be operating profit, profit before interest and tax, profit before interest, profit after tax, etc.

▪ the denominator of ROCE may be total assets, total assets less intangibles, net assets, etc.

– the use of norms can be misleading, e.g.

▪ a current ratio of 2:1 may be totally inappropriate for a company like Tesco, which does not have long inventory turnover periods – as its sales are for cash it would also not produce trade receivable collection period ratios.

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– making appropriate choice of comparator companies for benchmarking – this is a simple idea but more difficult in practice, e.g.

▪ how to find companies with a similar trade?

▪ how to set criteria for selection?

▪ should it be

– the industry average ratios – but these may be based on many companies operating under very different economies of scale or companies with;

– similar amount of capital employed; or

– similar amount of sales; or

– some other criteria.

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Cash-based performance measures

• EBITDA

• EV/EDITDA

• Net debt/EDITDA

• EDITDA/interest

• EBITDAR

• EBITDARM

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• Screens business activities

• Checks that financial ratios do not exceed specified limits.

Shariah compliant investment

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The indices are compiled after:

(i) screening companies to confirm that their business activities are not prohibited or (fall within the 5% threshold);

(ii) calculating three financial ratios based on total assets; and

(iii) calculating a dividend adjustment factor that results in more relevant benchmarks, as they reflect the total return to an Islamic portfolio net of dividend purification.

The MSCI Islamic indices

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Shariah investment principles do not allow

investment in companies that are directly active in,

or derive more than 5% of their revenue

(cumulatively) from the following activities

(‘prohibited activities’):

alcohol, tobacco, pork-related products, conventional

financial services, defence/weapons,

gambling/casino, music, hotels.

Business activity screening

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Shariah investment principles do not allow

investment in companies deriving significant income

from interest or companies that have excessive

leverage. MSCI Barra uses the following three

financial ratios to screen for these companies:

• total debt over total assets

• sum of a company's cash and interest-bearing

securities over total assets

• sum of a company’s accounts receivables and cash

over total assets

None of the financial ratios may exceed 33.33%.

Financial screening

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PE – a measure of market confidence

Market price takes into account macro events:

• Political factors

‒ imposition of trade embargoes or sanctions.

• Economic factors

‒ downturn in manufacturing activity.

• Companyrelated events

‒ possibility of organic or acquired growth

‒ implication of financial indicators for future cash

flow estimates.

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PE ratio – implication of financial indicators

Statement of financial position

• Change in debt/equity ratio in relation to prior

periods.

• New borrowings for finance expansion.

• Debt restructuring following inability to meet

current repayment terms.

• Contingent liabilities that could be damaging if

they crystallise – non-current assets being

increased or not being replaced.

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PE ratio – implication of financial indicators

(Continued)

• Adequacy of working capital.

• Low acid test (quick) ratio in relation to prior

periods indicating possible liquidity difficulties.

• Change in current ratio in relation to prior periods,

i.e. higher indicating a build-up of slow-moving

inventory and lower possible stock-outs.

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PE ratio – implication of financial

indicators – income statement

Income statement:

• Change in sales trend

• Limited product range, products moving out of patent

protection period

• Expanding product range

• Changes in technology beneficial or otherwise to company

• High or low capital expenditure/depreciation ratio

indicating that productive capacity is not being maintained

• Loss of key suppliers/customers, e.g. loss of longstanding

Marks & Spencer contracts

• Change in ratio of R&D to sales.

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Determining value

• EVA

• NOPAT − (R × CE) = EVA

• How to achieve an increase

• Total shareholder return

• Performance-based remuneration.

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Shareholder value analysis

• Growing interest

• Accounting measures (EPS) not related to share

value

• Linkage with executive remuneration.

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Shareholder value analysis – annual reports

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Economic Value Added (EVA)

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Predicting failure – trend analysis

• Multivariate analysis

– Z-scores

– H-scores

– A-scores

• Balanced scorecards


quantitative process


qualitative process.

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Multivariate analysis

• Single-value score

– Benchmark criteria applied to this score

• Combination of ratios, e.g.

– working capital/total assets

– sales/total assets

• Weighted for predictive capability, e.g.

– working capital/total assets weight 0.012

– sales/total assets weight 0.999

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Multivariate analysis – types of scores

• Z-scores

• Altman’s Z-scores

• Taffler’s Z-scores

• PAS-scores

• A-scores.

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Altman Z-score – components and

weighting in public domain

Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 +

0.999X5

X1 = working capital/total assets

X2 = retained earnings/total assets

X3 = ebit/total assets

X4 = market capitalisation/book value of debt

X5 = sales/total assets

Score > 3 unlikely to fail; score < 1.8 likely to fail

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Taffler Z-score – weightings are not in

public domain

Components are

PBT/current assets

Current assets/current liabilities

Current liabilities/total assets

Length of time able to finance its operations

without new revenue inflow.

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A-scores

Three-stage review of financial and non-financial

signs of failure

1. Defects – e.g. inadequate accounting systems

2. Mistakes – e.g. excessive leverage

3. Symptoms – e.g. creative accounting.

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Weightings used

Matters to consider within each stage are given as

weighting – e.g. for defects

Defects in operational management: Weight

Chief example is an autocrat 8

CEO is also chairman 4

Passive board 2

Unbalanced board (say all engineers) 2

Poor management in depth 1

If score > 10 indicative of possible failure

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Professional risk assessors

Companies are given a rating that can range from

AAA for companies with a strong capacity to meet

their financial commitments down to D for

companies that have been unable to make

contractual payments or have filed for bankruptcy

with more than 10 ratings in between, e.g. BBB for

companies that have adequate capacity but which

are vulnerable to internal or external economic

changes.

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How ratings are set – internal factors

Internal company factors may include

• an appraisal of the financial reports to determine:

– trading performance, e.g. specific financial targets

such as return on equity and return on assets

earnings volatility; past and projected performance;

how well a company has coped with business

cycles;

– cash flow adequacy, e.g. EBITDA interest cover;

EBIT interest cover; free operating cash flow;

– capital structure, e.g. gearing ratio; debt structure

implications of off-balance-sheet financing.

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How ratings are set – internal factors

(Continued)

• a consideration of the notes to the accounts to determine possible adverse implications, e.g. contingent liabilities, heavy capital investment commitments, which may have an impact on future profitability, liquidity and funding requirements;

• meetings and discussions with management;

• monitoring expectation, e.g. against quarterly reports, company press releases, profit warnings;

• monitoring changes in company strategy, e.g. changes to funding structure with company buyback of shares, new divestment or acquisition plans and implications for any debt covenants.

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How ratings are set – external factors

External factors may include:

• growth prospects, e.g. trends in industry sector;

technology possible changes; peer comparison;

• capital requirements, e.g. whether company is fixed

capital or working capital intensive; future tangible

fixed asset requirements; R&D spending

requirements;

• competitors, e.g. the major domestic and foreign

competitors; product differentiation; what barriers

there are to entry.

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• Keeping a watching brief on macroeconomic

factors, e.g. environmental statutory levies, tax

changes, political changes such as restrictions on

the supply of oil, foreign currency risks.

• Monitoring changes in company strategy, e.g.

implication of a company embarking on a heavy

overseas acquisition programme that changes the

risk profile, e.g. difficulty in management control

and in achieving synergies, increased foreign

exchange exposure.

How ratings are set – external factors

(Continued)

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Criticism of credit rating agencies

• Not independent when rating financial products.

• Self-regulation has not worked.

• Designing products to which they then give an

‘objective’ credit rating.

• Agency staff were free to join a company after

rating its products.

• The companies issuing the products paid their

fees.

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Valuing shares of unquoted

company – quantitative

• Maintainable income

– Extrapolate from past 5 years

• Yields required

– earnings yield – majority holding

– dividend yield – minority holding

• Adjustment for adverse factors

– Lack of marketability

– High gearing

• Calculate economic value and NRV.

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Factors to consider

• Management change

• Revenue investment

• Inflation rate

• Competitive pressures.

Valuing shares of unquoted

company – quantitative (Continued)

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Review questions

4. Discuss the difficulties when attempting to

identify comparator companies for benchmarking

as, for example, when selecting a TSR peer

group.

9. Explain how and why EVA is calculated.

Documents

Chapter 29 · Chapter covers • Improvement of information for shareholders • Published financial statements –their limitations for interpretation purposes • Published financial