LOCAL LITERATURE

Definition of Financial Analysis

According to Philippine Trade Training Center (PTTC, 2017), “A financial statement is a

formal record of the financial activities of a business, person or other entity. Relevant

Financial Statement is presented in a structured manner and in a form easy to

understand. Financial Analysis is the process of reviewing and analyzing a company’s

financial statements to make better economic decisions. “

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Advantages of Financial Statement Analysis

Aside from compliance, audited financial statements could bring more benefits and

advantages. According to Tax Accounting Center (2017), “analyzing financial statements

could provide you a number of advantages such as, appraisal of the company’s operations

with the new policies and strategies implemented, determining the strength and

weaknesses of the company’s financial figures that you may optimize opportunities and

remedy weaknesses to prevent wasting financial resources, lastly, it determines the

industry’s position to its competitors.”

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FOREIGN LITERATURE

Objectives of Financial Analysis

According to Fraser and Ormiston (2009), the objectives will vary depending on the

perspective of the financial statement user and the specific questions that are addressed

by the analysis of the financial statement data. Among the several perspectives are that

of the creditor, the investor, and the management.

Each of these stakeholders would have to have questions that need to be answered. For

instance, a creditor is usually concerned with the ability of an existing or prospective

borrower to make interest and principal payments on borrowed funds. The investor

usually attempts to arrive at an estimation of a company’s future earnings stream in order

to attach a value to the securities being considered for purchase or liquidation. Lastly,

financial statement analysis from the standpoint of management relates to all of the

questions raised by creditors and investors because these user groups must be satisfied

in order for the firm to obtain capital as needed.

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Profitability Ratio in a Financial Analysis

Reilly and Brown (2005) stated that financial statement analysis seeks to evaluate

managerial performance in several important areas including profitability, efficiency and

risk. The ultimate goal of that analysis is to provide insights that will help

us project future managerial performance. They also suggest that financial ratios

should be examined relating to the economy, the firm’s industry, firm’s main competitors

and the firm’s past relative ratios. The issue of trade-off between liquidity and profitability

has been discussed intensively since this it is crucially important for companies.

Qualitative Characteristics of Financial Information

The qualitative characteristics will provide assistance when choices have to be made

between reporting policies - whether by preparers, auditors, those participating in the

standard-setting process, regulators or others - and be indicative of the qualities that

users can expect of the financial information provided to them.

According to Libby et al. (2007), for financial Information to be useful, should possess

some qualitative characteristics as discussed below:

Source: Libby, R et al. (2007). Financial Accounting.5 th Edition: New York, McGraw –

Hill Companies, Inc.

Relevance

For information that is disclosed in the financial reports to be useful at all, it should be

legally relevant. That is, it must be associated with the decisions it is designed to aid and

facilitate. What is relevant for one group of financial information users may not be

relevant for another group of users, thus, there is no such thing as all-purpose financial

report in the context. 10 The information should be relevant to the decision made by the

users of the information. It should make a difference in their decisions. Typically, this

means the information must be:

• Timely. This means that, the financial information should presented on time. It will

enable also users to make decision concerning the information on time too.

• Have predictive value. Also for financial information to be relevant, must be able to

predict values in future.

• Provide useful feedback on past decisions. The financial information should be providing

feedback of what has been decided in the past.

Reliable

The information should be reliable and dependable. This means that users should have a

trust on the financial information supplied with. By having the trust on the information,

the users will be comfortable on relying on it when making decisions. And this reliance

will be only achieved if the following concepts are observed:

• Faithful representation. The information represents what it claims to represent. For

example, if the reported value of a common stock holding purports to be the current

market value, that value should be approximately what the stock could be sold for by the

company holding it.

• Verifiability. Another person or entity should be able to recreate the reported value

using the same information that the reporting entity had.

• Completeness. The reported information should not be missing a material fact or

consideration that would make the reported information misleading. The information

should provide users a sounded picture of the economic activities of the reporting entity.

By this, it means that every aspect of the business which can be reported in monetary

terms 11 should be reported as far as possible to give information concerning the result

completely.

• The concept of neutrality is sometimes incorporated into the concept of reliability. This

means the financial information should be fair to all parts of interests.

Comparable and Consistent

Accounting practices should be uniform both within the corporations and other

organizations. Ideal financial reports of one enterprise should be readily comparable with

those of another in the same industry. Nevertheless, adoption of different accounting

policies like the method of depreciation and stock pricing has made this difficult. For

accounting information to be useful, it must allow for comparisons across time and across

competing interests (such as competing companies or industries). For instance an

Organization should provide financial data for at least two years (E.g. 2012 and 2013).

Also an entity should present their financial information in the way that can be compared

with the competing companies in the same industry. This leads to a need for some

consistency, wherever such comparisons are to be expected. For example, comparisons

of two companies would be very difficult and potentially misleading if one discounts all

its liabilities while the other discounts none of its liabilities. For trend analysis the company

must make sure that it obeys consistency in using their Accounting policies like methods

of depreciation and stock valuation methods. If these accounting policies will be used

consistently, now it will be useful for users to make a comparison of profitability,

performance and financial position of the same company between years.

Understandable

Preparation of financial report should be in accordance with general accepted accounting

principles (GAAPs) so that the parties interested to these information can easily

understand them. The financial information are intended to be understood by their users

who have reasonable knowledge of business, economic activities and accounting and who

are willing to study the information diligently. Typically there is a belief that, for

information to be understandable, information contained in the various financial

disclosures and reports must be transparent (i.e., clearly disclosed and readily

discernable).

Accuracy
The financial reports should disclose correct and accurate information about the financial

health of the business. They should only factual information; no false information is to be

included. False information could lead to wrong decision making. Once the financial

information are incorrect, it will be misleading the users and end up making wrong

decision too.

The Importance of Financial Information in relation to Investment Decisions

As Gentry & Fernandez (2008) stated, “reports and interviews with company officials were

the most important sources of financial information in assessing the firm’s value and

therefore informing investment decision or equity selection process.” Investment decision

makers use financial statement of different firm’s for financial decision making purposes.

In this instance, financial analyst becomes useful in gathering, analyzing, and interpreting

the accounting results to potential investors for use in making investment decisions.

Publication of financial statement provides a way for banks or firms to present its financial

health or otherwise to shareholders, creditors, general public and to potential investors,

to enable them make rational investment decisions.

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Financial Statement Analysis: A Tool for revealing Red flags & Strengths in an

Investment Decision

Gentry & Fernandez (2008) said that, “Financial statement analysis can reveal the red

flags of an investment opportunity. On the other hand, they can also reveal the strength

of the company as well as the potential profit of investing in a particular company.” By

their nature, financial statements are retrospective, which means an investor should

never look at a single statistic or matrix in making investment decisions. For instance, an

actual or potential investor must analyze the statement of financial position, to assess

the company’s assets, liability and ownership equities (net worth) at a particular point in

time. Also, the investor will assess the income statement to know company’s expense

income and profit or loss over a specific period of time. He will also assess the cash flow

statement, to find out how the company raised up cash through investors or creditors;

how cash is used to acquire assets and inventory; how the assets and inventory allows

the organization to generate cash to pay for business expenses; and finally how the cash

is returned to investors and creditors. Moreover, the purpose of cash flow analysis is to

estimate the amount an investor would receive from an investment, based on future free

cash-flow projections for the company, at least in the short term, financial information is

like an x-ray, they provide multiple angles for proper diagnosis of the company. Each

financial statement provides the user a unique perspective, and together the statements

point a clearer and complete picture into the financial condition of a company.

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Users of Financial Information

According to Wild (2011). Accounting is often called the language of business, all

organizations set up an accounting information system to communicate data to help

people make better decisions. The accounting information system serves many kind of

users who can be divided into two groups; internal and external users as discussed below.
Source: Wild, J. J. (2011). Financial Accounting: Information for decisions. 5th Edition.

New York: McGraw – Hill Companies, Inc.

The Internal users

These are users of the financial information from within an Organization. This includes

management and employees.

I. Management Team:

This is the management of the entity itself. They are concerned with the overall financial

worth of the enterprise. Management has the overall responsibility to see that the

resources of the firm are used most effectively and efficiently and that the firm’s financial

position is always sound. They need the financial statement for planning, controlling and

decision making on the day to day operations and long range (strategic) plan of the

organization.

II. Employees:

Employees are interested in the company’s profitability and stability. They are after the

ability of the company to pay salaries and provide employee benefits. They may also be

interested in the company’s financial position and performance to assess the possibility

of company expansion and career opportunities.

The External Users

These are persons or agencies outside the organization who are interested with the

company’s operations. These persons and agencies include;

I. Prospective Investors:

Investors who wish to become shareholders of the firm are more concerned about the

firm’s long- run survival and earnings. They give more confidence in those firms that

show steady growth in earnings. As such they concentrate on the analysis of the firm’s

present and future profitability.

II. Trade Creditor:

Trade creditors like suppliers and other short term lenders are more interested in the

firm’s ability to meet their short term obligations. They will confirm their analysis on the

evaluation of the firm’s liquidity position based on the analysis of the firm and determine

the terms and conditions of any lending (or supply) to the firm e.g. security, repayment

time etc.

III. Suppliers:

Suppliers of long-term debt would be more concerned with the firm’s long-term solvency

and survival. They analyze the firm’s profitability over time, its ability to generate cash to

be able to pay interest and repay principal and the relationship between various sources

of funds (capital structure relationship). Long-term creditors do analyze the historical

financial statement but they place more emphasis on the firm’s projected or pro-forma

financial statements to make analysis about its future solvency and profitability.

IV. Banks and Other Financial Institution:

They study a company’s financial statements to enable them grant loans. They evaluate

the ability of the entity to meet its obligations and the entity’s capital structure

relationship.

V. Government:

Governing bodies of the state, especially the tax authorities, are interested in an entity's

financial information for taxation and regulatory purposes. Taxes are computed based on

the results of operations and other tax bases. In general, the state would like to know

how much the taxpayer is making to determine the tax due thereon.

VI. Educational/Research Institution:

They require the accounting information for teaching and research purpose. These

include universities and other education centers.

VII. Public:

Public are interested in many ways especially the economic life and the sustainability of

the company in its operations.

VIII. Stock Exchange:

Stock exchange may derive several conclusions from the figures of financial statement

such as performance, profitability prospects of change in the share value and health of

the company.

IX. Customers:

When there is a long-term involvement or contract between the company and its

customers, the customers may be interested in the company’s ability to continue

existence and its stability of operations. This need is also sensitive in cases where the

customers depend upon the entity.

For example, a distributor (reseller), the customer in this case, is dependent upon the

manufacturing company from which it purchases the items it resells.

X. Potential Buyers (Acquirers):

Potential buyers of the firm through acquisition or merger are more concerned about the

potential profitability of the firm in the future as such they decide on the reasonable price

to pay and the actions to be taken on the purchase of the firm or merger.

Definition and Nature of Investment Decisions

As postulated by Pandey (2010), investment decisions or analysis has to do with an

efficient allocation of capital. It involves decision to commit the firm’s funds to the long-

term assets. Such decisions are of considerable importance to the firm since they tend to
determine its value size by influencing its growths, profitability and risk The investment

decisions of a firm are generally known as the capital budgeting decision may be defined

as the firm’s decision to invest its current funds most efficiently in the long-term assets

in anticipated of an expected flow of benefits over a series of years.

According to Canada and White (2010) Investment Decision are the series of decisions

by individual economic units as to how much and where resources will be obtained and

expected for future. Situation where capital expenditure decisions are made or taken,

they are based primary with measurement of capital productivity which provides an

objective means of measuring the economic worth of individual investment proposals in

order to have a realistic basis for choosing among the firm’s long run property.

Source: Pandey, I. M. (2010). Financial Management. 10th Edition. New Delhi: Vikas

Publishing House

Importance of Investment Decision

Investment decisions require special attention because of the following reasons;

a) They influence the firm’s growth in the long-run.

b) They affect the risk of the firm.

c) They involve a commitment of large amount of funds.

d) They are irreversible or reversible at substantial loss.

e) They are among the most difficult decisions to make.

Growth: the effects of investment decisions extend into the future and have to be endured

for a longer period than the consequences of the current operating expenditures.

A firm’s decision to invest in long- term assets has a crucial influence on the rate and

directions of its growth. A wrong decision can prove disastrous for the firm. On the other

hand, inadequate investment in assets would make it difficult for the firm to complete

successfully and maintain its market share.

Risk: A long-term commitment of funds may also change the risk complexity of the firm.

Risk arises in investment clue to the inability to anticipate the occurrence of the possible

future events with certainty and consequently, cannot make any adoption of an

investment increase average gain but causes frequent fluctuations in its earnings, the

firm will become more risky. Thus, investment decisions shape the basic character of a

firm.

Funding: Investment decision generally involve large amount of funds which make it

imperative for the firm to plan investment programs very carefully and make an advance

arrangement for procuring financial internally or externally.

Irreversibility: Most investment decision is irreversible. It is difficult to find a market for

such capital items once they have been acquired. The firm will incur heavy losses if such

assets are scrapped.

Complexity: Investment decisions are among the firms which are mostly difficult to make

decisions. There are assessments of future events which are difficult to predict. It is really

a complex problem to correctly estimate the future cash flow of an investment.

The uncertainty in cash flow is caused by economic, political, social and technological

forces.

Role of Financial Information in Investment Decision Making

The aim of financial information is to provide information about an entity to interested

parties. The information contained in the reports, however, it can only become

meaningful through financial interpretations derived from the analysis of the reported

data. This interpretations and decision unveils the essence of financial reports, as the

major custodian of financial information necessary for any investment decisions.

Investment decisions are not made on a vacuum hence; there are bases on which they

will stand.

One major tool for these investment decisions is the ratio analysis. Financial analysis is

the judgmental process which aims at evaluating the current and past financial positions

and the results of an entity. The primary objectives of determining the best possible

estimate about the future conditions and performances. It provides a quick diagnostic

look at an entity’s financial health and trigger off subsequent financial and operational

analysis, the figures that are used in the financial analysis are being dedicated from the

financial information which in turn inform our decision maker. Several ratios exists but

this research work will look on other major rules that are used in investment decision like

NPV, IRR and the major issue to note here is that financial information are the major

source of the raw materials for the investment decisions.

• In the expansion of the existing business, the financial information can enable the

decision maker, by informing on the profitability of the business and its going concern

status.

• In acquisition of a new investment project, the financial information give the raw

information to the investor, for analyzing the future expected profitability of the business.

• On replacement of the investment project, also the financial information enables the

decision maker to assess the contribution margin of the project. This is done to improve

efficiency and reduce cost.

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