Study Unit 3

Financial Reporting and Analysis

Master of Business Administration

NQF Level 9

MBA5903

2024
 MBA 5903 Study Unit 3: Financial Reporting and Analysis

STUDY UNIT 3: FINANCIAL REPORTING AND ANALYSIS.

1. Introduction

We have seen in study unit 2 how factors such as increased competition, availability of substitute products,
and rapid technological developments increase business risk as witnessed in the case of South African Post
Office (SAPO). SAPO lost a cumulative amount of R19bn over the past years, citing problems such as the
ageing IT infrastructure and very high operating costs that exceed 200% of revenue (Schrieber 2023). The
company was last profitable in 2004; in July 2023, it was granted authority to undergo business rescue by
the high court in Pretoria (Mantshantsha 2023).

Investors want to know whether the company will be able to operate efficiently to derive business growth
and continue paying dividends. Creditors consider the risk of the company defaulting on making payments
of interest and principal on debt securities (investment worthiness). Financial statement analysis enables
various stakeholders to evaluate risks, business performance and evaluation, financial health, and growth
prospects of the company.

In this study unit, the discussions will focus on the ability of a company to generate sufficient positive cash
flows to meet its maturing financial obligations, manage assets effectively, maintain an efficient cost structure
and adequate capital structure, and generate sufficient profits. All these matters are necessary for the goal
of shareholder wealth maximisation. Finally, we will discuss the concept of Economic Value Added (EVA) as
a performance measure that will encourage managers to make decisions to increase shareholder wealth.

2. Learning outcomes

On completion of this unit, you can expect to achieve the following:

1. Financial statements: You will obtain a clear understanding of the various reports used to
communicate financial information to stakeholders.

2. Analysis of financial statements: You will perform a rigorous analysis of financial statements for
two periods based on percentage changes. Also, you will calculate and interpret financial ratios and
apply a trend analysis to the results of a series of accounting periods.

3. Accounting data: You will identify the warning signs regarding the quality of accounting data.

4. Limitations of using accounting data: You will discuss the limitations of financial statements and
financial ratio analysis to perform financial analysis.

3. Assessment criteria

In assessing your progress in financial analysis, we will evaluate your ability to:

• discuss the various reports used to communicate financial information to stakeholders.

• perform a rigorous analysis of financial statements for two periods based on percentage changes.

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 MBA 5903 Study Unit 3: Financial Reporting and Analysis

• calculate and interpret financial ratios and apply a trend analysis to the results of a series of
accounting periods.

• identify the warning signs regarding the quality of accounting data.

• discuss the limitations of financial statements and financial ratio analysis to perform financial analysis.

4. Financial information

The Companies Act (2008) obligates company directors to produce annual financial statements at the end
of every financial year and present these to shareholders at the annual general meeting (AGM). The financial
statements must be prepared in compliance with International Financial Reporting Standards (IFRS) and
fairly present the financial position of the company and the results of operations for the financial year.

Now, follow this link to download the Companies Act and read sections 24–31 of Part C: Transparency,
accountability, and integrity of companies in Chapter 2:

https://www.justice.gov.za/legislation/acts/2008-071amended.pdf

Now reflect on the information that the financial statements should provide to indicate the financial position,
financial performance, and cash flows of an entity. Also, discuss various reports that annual financial
statements should comprise.

King IV advocates integrated thinking, which recognises that a company operates within a network of
interdependencies that influence its business. JSE-listed companies are required to produce an integrated
report outlining the corporate strategy, governance, risk management framework, financial performance, and
business growth prospects.

Follow the link below and read the Fundamental Concepts in PART 2 of King IV Report (2016):

https://www.iodsa.co.za/page/king-iv

Now reflect on the following:

1. Corporate citizenship

2. Stakeholder-inclusive approach

3. Sustainable reporting

4. Integrated reporting

5. The resources and relationships to create value (the Capitals).

5. Financial ratios

Various stakeholders have varying objectives and expectations and therefore tend to approach financial
analysis from different perspectives. Consequently, there exists no single financial ratio that can meet the
various analytical needs. As a ratio expresses the relationship between two variables, such relationship
should be direct, clear, and understandable to render it meaningful. Furthermore, analysts should understand
what factors will influence the ratios that they employ to forecast the future.

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For effective application of ratios, they must be compared with historic ratios, industry ratios, or management
performance goals and standards to identify trends or patterns, if any. Ratios may be categorised into six
primary groups:

Now, reflect on these primary groups and work through the illustrative example in your textbook (Drake
Manufacturing Company Financial Statements: Table 3.1).

6. Structured Ratio Analysis: Du Pont analysis

Financial managers are tasked with the objective of maximising shareholder wealth. The Du Pont model
employs the return on equity (ROE) as the metric of this objective. Its strength lies on its ability to broadly
categorise many financial ratios as follows: income, investment (business activity), and capital structure.
This technique enables focusing attention on the potential areas for improvement and thereby providing an
overall understanding of the business.

Now, continue with the Drake manufacturing company financial analysis to consolidate your understanding
of the relationship between the company’s ROI and the factors that influence it.

However, despite the usefulness of financial ratios, we need a thorough understanding of financial
statements and a company’s business model to perform effective financial analysis.

Follow this link to read about the factors that limit the efficacy of financial ratio analysis:

https://corporatefinanceinstitute.com/resources/accounting/limitations-ratio-analysis/learn

7. Economic Value Added (EVA)

You have learned that traditional financial ratio analysis is hamstrung by weaknesses inherent in reported
accounting information. The major shortcoming is that there exists no direct link between performance
measurement and the creation of shareholder wealth over time.

EVA is a financial performance metric that seeks to determine the true economic profit of a business. This
measure and performance-based incentives will encourage managers to make decisions that will increase
shareholder wealth. Take note of the following:

• Every company requires funds to drive and sustain its operating activities.

• Funds are generated internally by employing current assets and/or raising external finance, a costly
option due to the interest charged.

• Businesses fund their operations by equity, that is, funds provided by shareholders through share
issues, and/or debt, e.g., loans, bonds, debentures, leased liabilities.

• Equity has a cost too (Ke) – the dividends paid out to shareholders, and these are non-mandatory in
contrast to the interest charged on debt, a financial obligation.

• A company therefore needs to invest in projects that offer returns above its cost of capital (Ke + Kd)
to increase its value.

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Hence, EVA = Return – (WACC*Invested Capital)

= NOPAT – (WACC* Invested Capital)

Note// Net Operating Profit after Tax (NOPAT): Remember that WACC includes finance cost, and therefore
we would be double counting if we used the Net Profit figure.

Example

Company A generated an operating profit of R318 813 for the year ended 30 June 2022. The total capital
employed was R4 557 821 and its cost of capital, was 15%. Determine if the company created value in the
financial period under review. Corporate tax in the country is 27%.

EVA = NOPAT – (WACC* Invested Capital)

= 318 813 *(1-0.27) – (15% * R4 557 821)

= R232 733 - R683 673

= - R450 940

No economic value added as the business returned a profit that is less than the cost of invested capital.

8. CONCLUDING REMARKS

In this study unit, you have learned how investors will gain insights into the financial position and performance
of a company through financial statement analysis. It was mentioned that financial information enables
investors to estimate future cash flows and evaluate risks associated with such cash flows. Financial ratios
through trend analysis provide analysts with a dynamic view of a company’s financial performance.

Ratios can be broadly categorised into liquidity, asset management, debt management, profitability, cash
flow, and market ratios. The discussions proceeded to Du Pont structured analysis, a technique that enables
analysts to derive overall understanding of a business. Analysts were cautioned about the weaknesses
inherent in the accounting information that put limitations on ratio analysis.

Finally, we discussed the concept of “economic profit” and how it will motivate managers to make financial
decisions that will increase the wealth of shareholders. In study unit 4, we will explore the significance of
capital investment decisions.

REFERENCES

Correia, C. et al. (2019) Financial Management. 9th edn. Lansdowne: Juta.

MKrishna, G.P., Paul, P.H., and Erik, P., (2021) Business Analysis and Valuation: IFRS Standards edition.
5th edn. United Kingdom: CENGAGE Learning.

Moyer, R.C., McGuigan, J.R., and Rao, R.P., (2021) Contemporary Financial Management. 14th edn.
Mexico: CENGAGE Learning.

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