Forensic Analysis of Financial Statements

Continuing with our series,

In previous five articles (Published on CAclubindia), We had discussed:

Article-1: Basics of Financial Analysis
Article-2: Basics of Understanding Business and Industry
Article-3: SWOT Matrix as a tool for systematic understanding of a business
Article-4: PESTEL Matrix as a tool for systematic understanding of a business
Article-5: Porter's five forces as a tool for systematic understanding of a business

In last articles, about business and industry analysis discussed. In this article, we are switching to quantitative aspect of financial analysis. There are four commonly known methods for financial statement analysis.

METHODS OF FINANCIAL STATEMENT ANALYSIS

• Horizontal analysis (Trend analysis)
• Vertical analysis (Common Size analysis)
• Ratio analysis
• Peer comparison

HORIZONTAL ANALYSIS: The simplest way of doing analysis, a base year is select then later year or years figures are compared against that i.e. relative changes happened over a period of time.

For example,

In above example, 2013 is a base year and later year figures are converted based on that year. In 2014, Sales grew by 20% but gross profit grown by 17% only. Possible reasons for deviation may be Sales has grown in absolute value but per unit realization decreased, cost of goods increased either there is an increase in price per unit of consumption or there is an increase in consumption at the constant price per unit production i.e. production efficiency increased. Same can be analyzed for other years as well

Drawbacks of using this method

• Selection of base year is very critical to analysis since all later years figures are translated into base year figure.
• This analysis throws just changes in numbers, it failed to include qualitative factors i.e. Industry policy changes, taxation and legal policy changes etc.
• It failed to include the impact of internal material events of the organization like changes in management, new product line introduced etc.

This method may be useful if there is no material changes occurring during tenure under analysis. Business is running on the constant assumption for various factors. Various ratios are can also be calculated as previous year as a base for the current year, for example, increase in sales YoY.

VERTICAL ANALYSIS

In this type of analysis, various line items are shown as Percentage of one common variable for every year.

Like, for balance sheet - Total Assets will be taken as the base and then after all line items will be converted into a percentage of Total Assets. For-Profit Loss - Generally Sales is taken as the base figure then all expenses are considered as a percentage of Total sales figure.

Example

Given below is the example of a Balance sheet, the same can be applied to Profit-Loss Account as well.

In above example, all figures are converted in percentage for given year's total figure. If you see total external liabilities other than debt was 40% in 2015 then rose to 59% in 2016 then again reached to nearby 40% i.e. 42% in 2017, while total other assets were 47% in 2015, rose to 60% in 2016 then declined to 57% in 2017. Here it is important to note that even though external liabilities declined to 42% from 59% in 2017 but other assets still nearby 60% i.e. 57% in 2017. One possible reason can be funded are blocked in Trade receivables and Inventories or reduced payment days for Trade creditors. One need to find reasons for the same why the entity is not able to collect payment in time but started paying creditors in reduced time.

Drawbacks of using this method

• This analysis throws just changes in numbers, it failed to include qualitative factors i.e. Industry policy changes, taxation and legal policy changes etc. But somewhat you can rely on if you compare with other peers entities.
• It failed to include the impact of internal material events of the organization like changes in management, new product line introduced etc.
• Different entities carry different business models.

This method is especially useful for analyzing relative changes between two accounting periods. Despite its limitation, you can compare target entities' proportion to that of all other entities in Industries. Exceptions need to be investigated. (Which covered in Peer comparison)

RATIO ANALYSIS

Ratio analysis is used to evaluate various aspects of a company's operating and financial performance such as its efficiency, liquidity, profitability, and solvency. The trend of these ratios over time is studied to check whether they are improving or deteriorating. Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations. Ratio analysis is a cornerstone of fundamental analysis. (Source: Investopedia)

Since it is the basic concept so it is not discussed in detail and numerous material available on the web for ratio analysis. Nevertheless, remember, interpretation is a key to ratio analysis. Ratio analysis alone will not help rather it must be always interpreted in the context of another variable. Further, there is no benchmark for any ratio since each industry has unique standards for various ratios.

E.g., Say Profitability ratio of a particular year got affected then one of the reason could be said increase in tax rates and entity is not able to pass on the increased cost to end consumer being a highly competitive market. Here, a decrease in profitability ratio alone will not help to understand the reason why rather it needs to look upon with Policy changes industry-wide.

Ratios are majorly expressed In following Forms:

In percentage - E.g. Various profitability ratios like Net profit or Gross profit 25% or 5.15% etc.
In Proportion - E.g. Debt Equity ratio expressed as 2:1 or 3.5:1 etc.
In times (pure number) - E.g. Fixed Turnover or total asset turnover ratio expressed as 5 or 9.8 times etc.
In period - E.g. Trade receivable and Trade payable days as 90 days or 180 days etc.

BROAD BIFURCATION OF RATIOS:

Liquidity Ratios

• Current ratio
• Quick or Acid test ratio
• Cash Ratio

Operating Ratios (including Profitability ratios)

• Gross Profit ratio
• Operating ratio
• Expense ratio
• Net profit ratio
• Stock Turnover ratio
• Fixed Turnover ratio
• Debtor Turnover ratio
• Total Assets Turnover ratio
• Return on Equity
• Return on Capital Employed

Leverage Ratios

• Debt to Equity ratio
• Debt to total assets ratio
• Interest coverage ratio

Valuation Ratios

• Price-Earnings (P/E) ratio
• PEG (PE Growth) ratio
• Market Value to Book Value ratio
• EV/EBITDA ratio
• Market Value to Sales ratio
• Market Value to Cash Flow ratio

Example: You can refer below link for better understanding with the detailed case study.
https://www.atozinbanking.com/index.php/study-material-on-banking/83-financial-ratio-analysis-with-case-study

Limitation of Ratio Analysis
One cannot use Ratio in absolute terms. It is always to be used relatively.

PEER COMPARISON (Extension of Ratio Analysis)

Peer Comparison is not a unique method of analysis rather it is the mixture of above three methods. In these methods, one entity is compared with another entity in same/similar industry or against the benchmark of Industry as a whole. Based on peer comparison, one may find the deviation from Industry practices and need to find out reasons for such deviation.

One of the best sources is 'Screener.in' wherein you can find readily available ratios for listed entities, and customize other entities ratios by adding various columns. (Will also write guide on how to use screener more effectively if time permits)

The author can also be reached at tehsinblog@gmail.com or http://knowledgekhan.blogspot.in/

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