Literature Review - Grade: C PDF

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Literature review project on ratio analysis ...

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Stage 3 – Literature Review Project BS3112 2015

“The roles of the interpretation of accounts and ratio analysis in analysing the financial performance and financial position of an incorporated entity.”

By Emma Pang

1302807

Word Count: 3628

A literature review submitted in part fulfillment of the requirements for the award of BA / BA (Honours) Accounting and Finance

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Abstract The interpretation of accounts and ratio analysis can produce valuable information in which the company can use to aid the decision making process. Ratio analysis will allow the company to identify the key areas of weakness and strength within the company and in turn the management will be able to make relevant decisions in order to rectify these issues as effectively as possible. Ratio analysis can also be used to set budgets for the company, this ensures that the company is staying on track with their income and expenditure. By setting budgets the company will also be able to make a comparison between budgeted and actual income and expenditure. Ratio analysis allows the company to make comparisons to highlight how their performance has been for the financial year. Comparisons can be made between current years figures and previous years figures. They will also be able to compare figures with the industry competitors and industry averages. This allows the company to see which areas need improvement and consider the options they have to try and ensure that their performance is better than the last. There are also many internal and external users of financial information. They all have a different interest in the company and also have the ability to influence the company in different ways. There are also many internal and external factors which must be taken into consideration when conducting a ratio analysis, as this will help the company to fully understand the outcome of the ratio analysis. Although there are many benefits to conducting a ratio analysis, however, they can not be wholly depended upon as they do have their limitations.

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Acknowledgements I would like to show an appreciation to the following people who have assisted me through this literature review:Mrs Bosede Oghughu Literature Review Supervisor

The Robert Gordon University Aberdeen Business School

Anne Nichol Faculty Liaison Advisor- Librarian

The Robert Gordon University Aberdeen Business School - Library

All the staff at the Learning Support Center at The Robert Gordon University, your help and support is greatly appreciated.

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Table of Contents Section

Page

1.0

Introduction

1

2.1

Roles of Interpretation of Accounts

2

2.2

The Importance of Ratio analysis for the Company and it's Stakeholders

3/4

2.3

Benefits and Limitations of Ratio analysis

5/6

3.0

Conclusion

7

4.0

References

8/9/10

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1.0 Introduction Aim The aim of this literature review is to discuss the main roles of, the interpretation of accounts, the importance of ratio analysis in analysing and evaluating a company's financial performance and financial position. It is essential that all companies analyse their financial accounts and carry out relevant ratio analysis. By doing so it allows the company to establish their main areas of weaknesses and areas of strength and in turn the management will be able to make quick decisions with the intention of making the company more profitable in the future. The information which is gathered from conducting the analysis of financial accounts and ratio analysis will answer many of the questions which the stakeholders of the company may have. Examples of these are whether or not the management are maximising their profits; how liquid is the company and are the shareholders receiving sufficient return on their investments. This literature review will not only discuss the benefits of the interpretation of accounts and ratio analysis but also consider any limitations which they may have.

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2.1 Roles of the Interpretation of Accounts It is essential for companies to analyse their financial accounts to allow comparisons to be made between current year performance with prior years figures. Comparisons can also be made with their main industry competitors and averages. This can highlight the areas of weakness, which will allow them to investigate reasons why those specific areas may not have been as profitable as they had projected. By doing this it allows management to make decisions to rectify these issues as soon as possible to ensure they can maximise their profit margins going forward. The interpreting of accounts is important, because it ensures that the company is staying on track and consistently hitting both short-term targets and constantly staying focused on working towards longterm goals at the same time. The interpretation of the statement of comprehensive income allows the company to compare the performance for the current year to prior years and also their competitor's figures. By making these comparisons the company will be able to identify whether or not they are making efficient use of their stock. The interpretation of the statement of financial position allows the company to identify if they had sufficient liquid assets to meet their short-term debts; are they taking full advantage of the free credit facilities available to them; and is the level of debt healthy compared to their competitors and the industry averages. The interpretation of the cash flow statements helps the company identify whether or not the net debt position of the company has changed significantly and if so what are the reasons for this; had the company managed their cash flow effectively throughout the year and is the level of liquidity healthy compared to previous years and to it's competitors. After the company have analysed their accounts, they will be able to use the information they have gathered to set budgets, cash flows and forecasts. Budgets are set based on prior year figures to anticipate future planned expenditure, and in turn they will be able to manage their expenditure. Budgeting is used for monitoring and controlling expenditure within the company, this allows the company to use the budget as a benchmark to compare actual expenditure to budgeted expenditure for the year. These comparisons between budget and actual allow progress on a regular basis and changes can be made quickly and efficiently to resolve issues. Forecasting also allows the company to set targets, this gives the managers and employees goals which can help increase motivation. Staff will always be working towards a goals set, this means the staff will feel more accomplished when they hit their targets and this may lead to rewards for their efforts. By using budgets this allows managers to plan and delegate authority. This means that employees will be given more responsibility within the company which can lead to increased motivation and can help boost team moral, as their staff will feel more empowered and important within the company.

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2.2 The Importance of Ratio Analysis for the Company and it's Stakeholders Ratio analysis is used to assist with the decision-making process and to aid the financial interpretation and planning of the company's finances for the future. Ratio analysis has been used to asses financial performance for over a centurn. The two core purposes of ratio analysis is firstly for predictive purposes and to anticipate future performance, and secondly to make comparisons between pervious years performances and between competitors and industry averages. They will mainly be used by the managers of the company but will also be used by both internal and external stakeholders of the company. According to Barnes, P (1987) “The positive use of financial ratios has been of two types: by accountants and analysts to forecast future financial variables, e.g. estinated future profit by multiplying predicted sales by the profit margin (the profit/sales ratio), and, more recently, by researchers in statistical models for mainly predictive purposes such as corporate failure, credit rating, the assessment of risk, and the testing of economic hypotheses in which inputs are financial ratios.” Ratios can be categorised into three functional areas, profitability, liquidity and efficiency. Once calculated, these ratios can be used to compare between prior years, with competitors and also with the industry averages. This process is called ratio analysis. Profitability ratios consist of: return on capital employed (profit margin); return of assets and return on net worth (return on equity). Liquidity ratios consist of: the quick ratio; current ratio; current liabilities to net worth; current liabilities to inventory; total liabilities to net worth and fixed assets to net worth. Efficiency ratios consist of: collection period; sales to inventory; assets to sales; sales to net working capital and accounts payable to sales. According to Mankin, J.A. and Jewell, J.J (2014) “two basic uses of financial ratios as normative and positive. Normative uses include comparing a firm's ratios to another company or to and industry average. Positive uses include estimation of future variables such as profit margins, returns, debts, and market prices. Positive uses can also include using predictive modles for corporate failure, bond ratings, and credit risk.” A stakeholder is an individual who has an interest in the company and is affected by the activity of the company. However, stakeholders also have some level of control or influence over the company. This level of influence depends on the level of involvement or interest they have with the company. Internal stakeholders include: the owner(s), the management and employees of the company. External stakeholders may include: shareholders, potential shareholders, short-term/ long-term creditors, the government and local authorities, competitors, analysts, customers and the general public. The owner(s) of the company is/ are the main stakeholder(s) as they are have the greatest amount of influence and involvement in the company. They are concerned with the outcome of the ratio analysis because they will want to know how the level of performance has been for the financial year and if it has changed, if so then what are the reasons for this. The management of the company are also interested in the overall performance of the company because they are the ones who are in control of the day-to-day decision making of the company. They will want to know which areas require improvement and begin to consider the options they have to rectify the issues which have become apparent. Page 7

The employees of the company have an interest in the company as they are concerned about their job security and future prospects or potential career progression within the company. The employees are mainly concerned with the stability and profitability of the company. If the company is doing well and is making healthy profits then the employees may see this as a good opportunity to speak about remuneration, they may also want to know about pension schemes. They can also have an influence on the company because if the employees believe they are not being paid a fair enough wage then they can threaten to take industrial action, such as a strike or a go slow. This can have a major impact on the company because they will have a reduction in profits as they will cease trading for a period of time, it can also cause bad publicity and may tarnish the reputation of the company. The shareholders of the company have an interest in the company as they want to ensure that they are getting adequate dividends and they will also want to make a decision on whether to make further investments or to sell their shares. They also have an influence on the company as they can exercise their rights to vote at the Annual General Meeting (AGM) if it is a public limited company. Potential shareholders are mainly interested in the risk factor involved when making the decision whether or not to they want to make an investment in the company. They will want to ensure that they will receive adequate return on their investment or is there just too much risk involved to invest. Short-term/ long-term creditors are primarily interested in the solvency of the company. They will want to know whether or not credit should be granted to the company, as they must consider the company's ability to repay their installments on time when they fall due. They also have an influence over the company as they have the ability to grant or refuse to give the company credit or a loan.The lenders must also consider the risk factor involved before making a decision. The government and local authorities will be interested in the company's financial statements for fiscal purposes as the government (HMRC) will want to check to ensure the company is paying the correct amount of tax. The government and local authorities will focus more on the future plans for the company as they will want to know if they have any plans which will affect the local area. If so then they will begin to persuade the company to honour their wishes and may try and negotiate. The competitors will be interested to see how the company has preformed in the financial period as they will want to know if they have increased their market share. They will also want to see if the company has disclosed any future plans, if so they will be able to check that they do not conflict with their own plans. Analysts, for example an economist, will use the company's financial information for their own research and for their statistical records. The customers have an interest in the financial statements of a company as they want to ensure they are obtaining the best value for their money. Also if they are loyal customers they will want to know if the company is still going to be providing their good/ services for the foreseeable future. They can also have an influence on the company because if the company change something that they do not like or approve of then they can choose to go to a competitor instead. The general public are interested to see if the company have any plans in the foreseeable future which may affect the local area for example the environment or the local traffic levels.

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2.3 The Benefits and Limitations of Ratio analysis Doing a ratio analysis can be very beneficial for any company. One of the main benefits is that it simplifies the financial statements as it gives a clear overall conclusion for the stakeholders of the company who may not understand the financial statements, such as potential investors. Ratio analysis creates a common understanding in which investors and analysts can communicate the strengths and weaknesses of the company. It also allows the investors and analysts to understand the industry and identify which companies are the stronger entities and which are the weaker competitors. Another benefit of ratio analysis is that entrepreneurs looking to start up a new business can present ratios to potential leaders and investors, which will give these individuals a glimpse of what the potential performance of the company will be like in the future. This will allow the company to use industry averages as a benchmark to compare their ratios and will allow the potential leaders and investors to make a decision on whether they think the company is viable and whether it is going to produce an adequate return on their initial investment. The major benefit of ratio analysis is that it can be interpreted and used to analyse performance trends over a number of years. It can also be used to make comparisons between prior years performances and also with other competitors in the same industry. One of the main uses for ratio analysis is for planning, although the ratios are calculated using historic information it can be useful in anticipating future trends, meaning that the company will have the ability to forward plan for the coming financial years. Ratios analysis is particularly beneficial for locating weaknesses within the company, this is important as it highlights the areas which require more attention and improvements. By identifying the weaknesses, the managers will be able to set goals for the company as a whole and their staff to ensure that the company is constantly improving and reaching their targets. However, there are many limitations to using ratio analysis. One of the main limitations of ratio analysis is that the information which is being used to calculated these ratios is historic, therefore the information is no longer up to date. This means that situations within the company may have changed since that information was gathered or the industry may have changed significantly meaning that it may be difficult for the company to compare ratios to prior years and they simply will not be able to make reliable forecasts or budgets. Another limitation is that making comparisons with other companies can be challenging due to the fact that the comparison will only be valid if the other company is the same size and type. It is also difficult to make comparisons with other companies because many companies only publish a small amount of their financial information. Other companies must also be using the same ratio calculation and formulae for the comparison to be valid, as some companies may change their calculations slightly in order to suit their own needs. Other companies may also use a different basis to calculate their non-current assets, for example it may be based on historic costs, or their revaluations may be carried out on different dates. When making comparisons with other companies, it may be inaccurate as they may have adopted a different method of calculating depreciation, inventory valuation, or the other company may simply just have either a more optimistic or pessimistic view when calculating the adjustment of current and non-current assets. Another limitation of ratio analysis is that when comparisons are being made over a number of years, external

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factors such as the general economic climate such as inflation, are not taken into account. This means that the comparison of ratios may not be very reliable. There are also many internal and external factors which must be considered when interpreting and comparing ratios. Firstly, the internal factors which should be considered is that ratios must be interpreted along with the narratives provided in the annual reports in order to make full sense of the variation in the ratios between prior years. The ratios must also be analysed with other ratios and not just comparing the same ratio over a number of years, e.g they should not just compare gross profit percentage this year with the gross profit from last year, it should be analysed in conjunction with other ratios. Another internal factor which should be taken into account is that ratios may be distorted as figures which are taken from the end of the year may not be a true reflection of the normal performance of the company. Any ratios which are based on inventory may be misleading if they are calculated based on figures from the end of the year, due to the fact that the christmas period can be the busiest time of the year for some businesses. Another internal factor which can cause problems is when the ratio is compared to the norm, for example the current ratio could be 2:1 would not be the norm for a large supermarket such as Asda. Due to the fact that they have a very short inventory holding period and they mostly just have cash sales which means that they would not produce a trade receivables collection period ratios. The external factors which must be taken into account when interpreting ratios are whether or not there has been a change in fashion or a downturn in the industry, this can have a major knock on eff...