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1 How to deal with questions on assessing the performance of a company? (Relevant to ATE Paper 7 Advanced Accounting) Dr. M H Ho This article provides guidance for candidates in dealing with examination questions regarding the assessment of a company s performance. If the user is to make sense of the figures in the financial statements, these figures need to be properly analyzed using accounting ratios and cash flows and then compared with previous years figures, figures from other companies or industry averages. Basic Techniques of Financial Statement Analysis The analytical measures obtained from financial statements are often expressed as ratios and percentages. There are different ways in which these measures can be analyzed. Percentage analysis (1)Vertical analysis Vertical analysis is the percentage analysis used to show the relationship of each component to the total within a single statement. In vertical analysis of the statement of financial position, each asset, liability item and shareholders equity item is stated as a percentage of the total assets, total liabilities and shareholders equity, respectively. Vertical analysis is useful in assessing relationships in a company s financial condition and operations. (2) Horizontal analysis Horizontal analysis is the percentage analysis of increases or decreases in related items in the comparative financial statements. The amount of each item on the most recent statement is compared with the related item on one or more earlier statements. Additional information may be required for evaluating the significance of the changes in the comparative figures; for example, a decrease in accounts receivable may

3 too long, the company may have liquidity problems: this can also be harmful to its relationship with suppliers. Inventory holding period This indicates how quickly a company is turning over its inventory. When deciding the appropriate level of inventory, a company should strike a balance between the cost of tying up capital and the demands from the customer. Generally, a high inventory turnover (short inventory holding period) is preferred. An unreasonably long inventory holding period may indicate an economic recession, obsolete inventory, poor sales and marketing, a change of customer taste or bad inventory management. (4) Solvency ratios Solvency ratios measure the company s ability to survive over a long period of time. Current and potential investors will be interested in a company s financing arrangements and also its risk. A company that has borrowed money obviously has a commitment to pay future interest charges and make capital repayments. This can be a financial burden and possibly increase the risk of insolvency. Examples of solvency ratios are: Gearing ratio This measures the company s commitments to its long-term lenders against its long-term capital. High gearing is viewed as risky for companies as they may face difficulties in meeting their interest and debt repayments as well as in raising further finance. Moreover, when a company borrows it increases its risk which in turn leads to higher cost of borrowing. The appropriateness of a suitable gearing level will be influenced by factors such as the risk preferences of owners and managers, industry norm, interest rates, required return to shareholders, stability of profits, the availability of equity funds, availability of suitable assets for security, and terms of loan agreements. In general, higher gearing can also benefit shareholders if the entity becomes more profitable since earnings of a highly-geared company are more sensitive to profit changes. Interest cover This ratio compares the amount of income that has been earned with the interest obligations for the same period. The lower the level of interest cover, the greater the default risk to lenders. (5) Investment Ratios There are ratios that use the current market price of a share to indicate the return an investor might earn by purchasing that share. Earnings per share This ratio represents the earnings made and available to shareholders during an accounting period. The trend in earnings per share over time is used to help assess the investment potential of a company s shares. Some companies retain a significant proportion of the

5 (2) Nature of business Business nature is another factor to consider when assessing financial performance. Low-margin businesses (e.g. supermarkets) usually have a high asset turnover, while capitalintensive industries (e.g. electrical products manufacturers) usually have a relatively low asset turnover but higher margins. (3) Causes of a change in ratios There is usually no absolute answer to an interpretation question, and remember there may be clues in the scenario given that would account for identifying plausible causes for changes in a company s ratios and cash position. For example, liquidity may have deteriorated dramatically due to significant investment in non-current assets but without a proportionate increase in sales. Both financial and non-financial factors should be considered when determining what caused the change in ratios. For example, liquidity of a company may also be affected by availability of further finance and the due dates of long-term loans. (4) Related party relationship and transactions These transactions have the potential to distort the results of a company; for example, expertise provided to a group company without charge being made by the present company or another group company. A company may have entered into certain arrangements that make its previous results not directly comparable with its current results; for example, a sale and leaseback arrangement. (5) Interrelationship among different types of ratios Looking at a single ratio in isolation is rarely useful in building a full financial picture. Instead, it is necessary to consider one type of ratios in combination with another type of ratios. For example, we have to look at management efficiency ratios when interpreting the current ratio. (6) Comparison among different periods and different companies For inter-company comparisons and comparisons made over time, considerations should be made on factors that can distort these comparisons; such factors may include differences in accounting policies, off-balance-sheet financing, inflation, creative accounting, and differences in the basis of calculating the ratios. Conclusion Accounting ratios and the statement of cash flows are important in interpreting accounting statements. Candidates should be aware of the limitations of financial performance assessment and be careful in formulating their conclusions. In the examination, it is suggested that you take a structured approach when dealing with this type of question: Prepare a statement of cash flows, if required by the question Calculate ratios in important areas such as profitability, liquidity, and gearing. Use the background information given in question to identify possible causes of any changes in ratios and the cash position, express your opinions and draw conclusions on the company s financial performance.

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