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Analysis looks behind the numbers.

The usefulness of financial statements for evaluating a company depends upon the user's understanding of the accounting principles and policies followed when preparing them. As a credit manager, looking behind the numbers can enhance your understanding of what goes into the financial statements you rely upon when conducting credit analysis.

Begin with the Basics

Accountants' financial reporting provides information that is useful in making business and economic decisions. The objectives of external financial reporting arise primarily from the needs of external users of financial statements who must rely on information that management communicates to them. Accountants generally follow three major objectives of financial reporting:

* to provide information useful in investment, credit, and other economic decisions;

* to provide information useful in assessing cash flow prospects; and,

* to provide information about an enterprise's resources, claims to those resources, and changes in them.

GAAP Define Accepted Practices

Generally Accepted Accounting Principles (GAAP) is a technical term in financial accounting. GAAP are those accounting principles that have substantial authoritative support. They reflect a consensus as to which accounting standards and procedures define accepted accounting practice at a particular time.

In the United States, GAAP are determined within the private sector rather than the government. Since July 1973, the Financial Accounting Standards Board (FASB) has been the official private sector body charged with the responsibility of establishing GAAP in the U.S. The FASB consists of seven members who serve full time and are fully remunerated.

The Financial Accounting Foundation is an independent entity whose board of trustees oversees the basic structure of the standard-setting process and appoints members to the FASB. Foundation trustees are appointed by a panel of representatives from several national organizations whose members have an interest in corporate financial reporting.

Financial Statements Meet the Needs of Many

Financial statements are the most widely used and comprehensive way of communicating financial information about a business enterprise. General-purpose financial statements are used to meet the needs of a variety of users of financial statements, primarily investors and creditors. Basic financial statements include the following:

* a balance sheet that summarizes the financial position of an accounting entity;

* an income statement that summarizes the results of operations for a given period of time;

* a statement of cash flows that summarizes an enterprise's cash flows from operating, financing, and investing activities;

* a statement of retained earnings that describes the changes in an enterprise's retained earnings; and,

* a statement of stockholders' equity that describes the changes in stockholders' equity.

The information presented in financial statements is primarily financial in nature and is expressed in units of money regardless of changes in purchasing power of the dollar. It pertains to specific business entities or a group of related companies, often reflects estimates and judgments, and reports the impact of transactions and events that have already occurred.

Notes to financial statements are considered an integral part and provide additional information not included in the accounts reported on the financial statements. Notes are usually factual rather than interpretative. The first note to the financial statement or a separate section preceding the first note provides a summary of the more significant accounting principles and practices reflected in the statements. Notes should be carefully read and evaluated when financial statements are being analyzed.

Financial statements are based on the concept of full disclosure. Full disclosure requires that all essential facts about an item or activity be reported in financial statements. Circumstances and events that make a difference to financial statement users must be adequately disclosed.

Auditor's Report Establishes Credibility

The financial statements of a business are accompanied by an independent auditor's report. The independent auditor examines the statements and expresses an opinion that provides a degree of credibility to management's representations. The criteria for judging an auditee's financial statements are GAAP. The typical audit leads to an attestation regarding the fairness and dependability of the financial statements. A fair presentation of financial statements does not mean that the statements are fraud-proof. The independent auditor has the responsibility to search for errors or irregularities within the recognized limitations of the auditing process.

The auditor forms an opinion based on a sample of evidence presumed to be representative of all transactions and events. While management, through collusive acts, may deceive the auditor as case studies and history clearly document, the evidence gathered during the auditing process ordinarily enables the auditor to obtain reasonable assurance about whether financial statements are free of material distortions.

The usual form of audit report is one in which the auditor issues an unqualified opinion, which indicates that the auditor believes that the financial statements have been presented fairly in accordance with GAAP. Auditors may also render qualified opinions, adverse opinions, and disclaimers. A qualified opinion is given when the financial statements are presented fairly with the exception of certain items which the auditor discloses. An adverse opinion is used when the financial statements are not presently fairly in accordance with GAAP. A disclaimer of opinion means that the auditor could not evaluate the fairness of the financial statements and expresses no opinion on them.

Analysis Provides a Clearer Perspective

Financial statement analysis is essentially an examination of past and current financial data for the purpose of evaluating performance and estimating future risks and potentials.

Basic tools of analysis include the use of comparative financial statements, percentage analysis, and ratio analysis. Advanced analytical techniques include time-series analysis, regression analysis, and correlation analysis.

Time-series analysis is used where data classified on the basis of intervals of time represent vital information in the control and operation of a business. The changes that can be isolated in time-series analysis include the identification of secular trend, seasonal variations, cyclical fluctuations, and random or erratic fluctuations.

Correlation analysis focuses on the relationship between a known and an unknown variable to estimate the unknown variable and measures the degree of relationship between two or more variables.

Ratio analysis is a favorite tool of financial statement analysts. If a ratio is to have any utility, the elements which constitute the ratio must express a meaningful relationship.

Ratios, or summary indicators, are usually classified by accountants as follows:

* Liquidity ratios measure the enterprise's short-term ability to pay maturing obligations.

* Activity ratios measure how effectively the enterprise is using the assets employed.

* Profitability ratios measure the success or failure of an enterprise for a given period of time.

* Coverage ratios measure the degree of protection for long-term creditors and investors.

Liquidity ratios include current ratio, quick or acid-test ratio, working capital ratio, and others. Activity ratios include receivable turnover, inventory turnover, and asset turnover. Profitability ratios include profit margin on sales, rate of return on assets, rate of return on equity, earnings per share, price-earnings ratio, and the payout ratio. Coverage ratios include debt to total assets, book value per share, and cash flow per share.

While it can be helpful, ratio analysis does have its limitations. Ratios reflect past conditions, transactions, events, and circumstances. They also reflect book values, not real economic values, market values, or price level effects. The application of accounting principles and policies varies among firms and can affect comparability. Intercompany comparisons can be difficult when companies are diversified or have different risk characteristics.

Segment Reporting Helps Solve Difficulties

Many U.S. companies operate in several different industries or in different geographic areas worldwide. When this occurs, the difficulties related to financial statement analysis are compounded. To deal with such situations, accountants provide segment reporting which offers a disaggregation of a company's regular financial statements and can be very useful when evaluating the company.

A segment of a business is part of an entity whose activities represent a major line of business or class of customer. Segment information that must be disclosed in financial statements includes an enterprise's operations in different industries, foreign operations and export sales, and major customers. Detailed information relating to a segment's revenues, operating profit or loss, and identifiable assets must be disclosed. Segment information discloses a great deal about a company's diversification activities and enables the analyst to make useful industry comparisons.

Development Companies Are Another Special Case

A development stage company is one which devotes substantially all of its efforts to establishing a new business and either its principal operations have or have not begun but revenue produced is insignificant. Activities of such companies usually include financial planning, raising capital, research and development, recruiting and training, and market development. A development stage enterprise must follow GAAP applicable to operating enterprises in the preparation of its financial statements. Notes to the financial statement must identify the company as a development stage enterprise and describe the nature of its activities. Development stage companies are difficult to analyze because they usually do not have an earnings record to evaluate.

Look for Warning Signs

Companies in financial distress also pose difficult analytical problems for analysts. A major problem for the analyst is to identify such companies. Some problems to look for in these companies are:

* Financing problems--difficulties in meeting obligations (liquidity or equity deficiencies; debt default; funds shortage).

* Operating problems--apparent lack of operating success (continued operating losses; prospective revenues doubtful; ability to operate jeopardized; incapable management; poor control over operations).

Specific signs of financial distress include the beginning of a liquidation or restructuring process, a declining share of a major product market, deferment of payments to short-term creditors, the omission of dividends, bond rating changes, bond default, overdrawn bank account, illiquidity, and insufficiency of cash flows. Financially healthy firms usually have an adequate return on investment and a sound balance sheet.

When accountants determine that there is substantial doubt that a company will be able to continue as a going concern, extensive disclosures are usually necessary. Users of financial statements should pay particular attention to such disclosures.

Judgment Plays Major Role

Financial reporting is not an end in itself but is intended to provide information that is useful in making business and economic decisions. Financial statements are designed to present and measure the economic consequences of transactions and events. They are not the result of a precise measurement and valuation process. Judgment plays a critical role in interpreting and analyzing financial statements. An analyst is expected to know this and to act accordingly.

Charles J. Woelfel, Ph.D., CPA is professor of accounting, University of North Carolina at Greensboro, Greensboro, N.C.
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Title Annotation:financial statement evaluations
Author:Woelfel, Charles J.
Publication:Business Credit
Date:Feb 1, 1993
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