Lecture 1 Financial Analysis [Autosaved]_024508_105616

ACCOUNTING FOR FINANCE
PROGRAMME: ODINARDY DIPLOMA IN ACCOUNTING FINANCE AND BANKING(ODA,

ODA IT & ODFB II)
MODULE CODE: AFU 06105
Facilitator: Mr. Odrano Mwanana
NTA Level: SIX (6)
Semester: One
Academic year: 2021/2022
30/12/2022 Copyright © 2022 odrano mwanana 1

LECTURE 1
TOOLS OF FINANCIAL ANALYSIS AND CONTROL
Copyright © 2022 odrano mwanana 30/12/2022 2

INTRODUCTION
Financial analysis is a process of selecting, evaluating, and
interpreting financial data, along with other pertinent
information, in order to formulate an assessment of a
company’s present and future financial condition and
performance.
Information needed
•Financial disclosure – e.g. annual report
•Market data – e.g. market price of stock, volume traded, value of bonds
•Economic data – e.g. GDP, consumer spending

FINANCIAL STATEMENT ANALYSIS
• What is financial statement analysis?
”Tearing apart” the financial statements and
looking at the relationships
• Financial statements summarize and provide an
overview of events relating to the functioning of a
firm.
• Financial statement analysis helps identify
- a firm’s strengths and
- weaknesses
- so that management can take advantage of a firm’s
strengths and make plans to counter weaknesses of the
firm.

• Essence of Financial statement analysis
- The strengths must be understood if they are to
be used to proper advantage and weaknesses
must be recognized if corrective action needs to
be taken

METHODS OF
• Common-Size Statements
- Horizontal Analysis
- Vertical Analysis
• Trend Percentages
• Ratio Analysis

COMMON-SIZE STATEMENTS
Financial statements that show

only percentages and no
absolute monetary amounts

TREND PERCENTAGES
Show changes over time in

given financial statement items
(can help evaluate financial information of
several years)

RATIO ANALYSIS
Expression of logical relationships between

items in a financial statement of a single
period (e.g., percentage relationship between
revenue and net income)

COMMON-SIZE ANALYSIS
Common-size analysis is the restatement of
financial statement information in a standardized
form.
Financial statements that show only

percentages and no absolute monetary
amounts
Types
-Horizontal common-size analysis
-Vertical common-size analysis

COMMON-SIZE ANALYSIS (CONT…)
Horizontal common-size analysis uses the amounts in
accounts in a specified year as the base, and subsequent
years’ amounts are stated as a percentage of the base
value.
• Useful when comparing growth of different accounts over time.
• When viewed graphically, reveals different growth patterns among
accounts
Using comparative financial statements to calculate

monetary (Tshs) or percentage changes in a financial
statement item from one period to the next

COMMON-SIZE ANALYSIS (CONT…)
Vertical common-size analysis uses the
aggregate value in a financial statement for a
given year as the base, and each account’s
amount is restated as a percentage of the
aggregate.
• Balance sheet: Aggregate amount is total assets.
• Reveals proportion of asset investment among
accounts.
• Reveals capital structure (proportions of capital).
• Income statement: Aggregate amount is revenues or
sales.
• Reveals profit margins.
VERTICAL ANALYSIS
For a single financial statement, each

item is expressed as a percentage of
a significant total, e.g., all income
statement items are expressed as a
percentage of sales and all balance
sheet items are expressed as a
percentage of total assets

EXAMPLE: COMMON-SIZE ANALYSIS
Consider the CS Company, which reports the following financial information (Tshs mil):
Year 2008 2009 2010 2011 2012 2013
Cash 400.00 404.00 408.04 412.12 416.24 420.40
Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65
Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29
Intangibles 400.00 402.00 404.01 406.03 408.06 410.10
Total assets 6,500.00 6,713.30 6,934.12 7,162.74 7,399.45 7,644.54
1.Create the vertical common-size analysis for the CS Company’s assets.

2.Create the horizontal common-size analysis for CS Company’s assets, using 2008 as
the base year.
Hint: Common-Size Analysis

•Vertical common-size analysis: Take each account in a given year, and divide it by
the total assets.
•Horizontal common-size analysis: Take each account, and compare a given year’s
value with the base year’s value (2008 in this case).

Vertical Common-Size Analysis:
Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%
Graphically:

EXAMPLE: COMMON-SIZE ANALYSIS (CONT…)
Vertical Analysis – Interpretation:
•The relative investment in fixed assets (currently
around 52% of assets), when compared with
current assets, has increased since 2008.
•The proportion of assets that are current assets
have decreased slightly over time.

Horizontal Common-Size Analysis (base year is 2008):
Year 2008 2009 2010 2011 2012 2013
Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%
Graphically:

EXAMPLE: COMMON-SIZE ANALYSIS (CONT…)
Horizontal Analysis – Interpretation:
•Net plant and equipment has increased more than
other assets since 2008 (annual rate of 4%).
•Intangibles have increased the least over time.

WORKED EXAMPLES

WORKED EXAMPLE 1: HORIZONTAL ANALYSIS
Assume that the management of UD Co Ltd

provides you with comparative balance sheets for
the years ended December 31, 2015 and 2014 as
well as income statements for the two years.
Management asks you to prepare a horizontal
analysis on the information.

UD COMPANY
COMPARATIVE BALANCE SHEET, 31 DECEMBER, 2015 AND 2014
2015 2014
Assets
Current Assets
Cash 12,000 23,500
Accounts Receivable, Net 60,000 40,000
Inventory 80,000 100,000
Prepaid Expenses 3,000 1,200
Total Current Assets 155,000 164,700
Property and Equipment
Land 40,000 40,000
Building & Equipment, Net 120,000 85,000
Total Land & Equipment 160,000 125,000
Total Assets 315,000 289,700

UD COMPANY
COMPARATIVE BALANCE SHEETS, DECEMBER, 2015 AND 2014 (CONT…)
2015 2014
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable 67,000 44,000
Notes payable 3,000 6,000
Total current liabilities 70,000 50,000
Long-term liabilities:
Bonds payable, 8% 75,000 80,000
Total liabilities 145,000 130,000
Stockholders’ equity:
Preferred stock 20,000 20,000
Common stock 60,000 60,000
Additional paid-in capital 10,000 10,000
Total paid-in capital 90,000 90,000
Retained earnings 80,000 69,700
Total stockholders’ equity 170,000 159,700
Total liabilities
Copyright andmwanana
© 2022 odrano stockholders’ equity 315,000 289,700
30/12/2022 22
UD COMPANY
COMPARATIVE INCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2015 AND 2014
2015 2014
Net sales 520,000 480,000
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less: income tax (30%) 7,500 9,600
Net income 17,500 22,400

WORKED EXAMPLE: 1 ANSWERS

UD COMPANY
COMPARATIVE BALANCE SHEET, 31 DECEMBER, 2015 AND 2014
2015 2014 Increase (Decrease)

Amount %
Assets
Current Assets
Cash 12,000 23,500
Accounts Receivable, 60,000 40,000
Net
Inventory 80,000 100,000
Prepaid Expenses 3,000 1,200
Total Current Assets 155,000 164,700
Property and Equipment
Land 40,000 40,000
Building & Equipment, 120,000 85,000
Net
Total Land & Equipment 160,000 125,000
Total Assets
Copyright © 2022 odrano mwanana 315,000 289,700 30/12/2022 25
UD COMPANY
COMPARATIVE BALANCE SHEETS, DECEMBER, 2015 AND 2014 (CONT…)
2015 2014 Inc Dec
Current Liabilities:
Total current liabilities 70,000 50,000
Bonds payable, 8% 75,000 80,000
Total liabilities 145,000 130,000
Stockholders’ equity:
Preferred stock 20,000 20,000
Common stock 60,000 60,000
Additional paid-in capital 10,000 10,000
Total paid-in capital 90,000 90,000
Retained earnings 80,000 69,700
Total stockholders’ equity 170,000 159,700
Total liabilities
Copyright andmwanana
© 2022 odrano stockholders’ equity 315,000 289,700
30/12/2022 26
HORIZONTAL ANALYSIS EXAMPLE
Calculating Change in Tshs Amounts
Tshs = Current Year – Base Year

Change Figure Figure

Calculating Change in Monetary Amounts
Tshs = Current Year – Base Year

Change Figure Figure
Since we are measuring the amount of the change

between 2014 and 2015, the Tshs amounts for
2014 become the “base” year figures.

Calculating Change as a Percentage
Percentage Tshs Change

= × 100%
Change Base Year Figure

UD Co Ltd
Comparative Balance Sheets
December 31, 2015 and 2014
Increase (Decrease)
2015 2014 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid ex penses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
$12,000 – $23,500 = $(11,500)

UD Co Ltd
Increase (Decrease)
2014 2013 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid ex penses 3,000 1,200
Total current assets 155,000 164,700
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
($11,500 ÷ $23,500) × 100% = 48.9%

UD Co Ltd
Increase (Decrease)
2015 2014 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid ex penses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7

• Let’s apply the same procedures to the liability and stockholders’ equity
sections of the balance sheet.

UD Co Ltd
Increase
(Decrease)
2015 2014 Amount %
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
• Now, let’s apply the procedures to the income statement

UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2015 and 2014
Increase (Decrease)
2015 2014 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating ex penses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest ex pense 6,400 7,000 (600) (8.6)
Net income before tax es 25,000 32,000 (7,000) (21.9)
Less income tax es (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

UD Co Ltd
Increase (Decrease)
2015 2014 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Gross margin 160,000 165,000 (5,000) (3.0)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
Sales increased by 8.3% while net income

decreased by 21.9%.

UD Co Ltd
Increase (Decrease)
2015 2014 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Gross margin 160,000 165,000 (5,000) (3.0)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
There were increases in both cost of goods sold (14.3%) and

operating expenses (2.1%). These increased costs more than
offset the increase in sales, yielding an overall decrease in net
income (21.9%).
WORKED EXAMPLE 2: VERTICAL ANALYSIS
Assume that the management of BS Company

Ltd asks you to prepare a vertical analysis for the
comparative balance sheets of the company.

BS COMPANY LTD
BALANCE SHEETS, AS AT 31 DECEMBER 2015 AND 2014
Assets 2015 2014

Cash 82,000 30,000
Accounts Receivable 120,000 100,000
Inventory 87,000 82,000
Land 101,000 90,000
Equipment 110,000 100,000
Accumulated Depreciation (17,000) (16,000)
Total Assets 483,000 387,000
Liabilities and Stockholders’ Equity
Wages payable 33,000 17,000
Common Stock 170,000 160,000
Retained Earnings 164,000 100,000
Total
Copyright © 2022 odrano mwanana
483,00030/12/2022 387,000
40
WORKED EXAMPLE 2 – ANSWERS

VERTICAL ANALYSIS EXAMPLE
BS Co Ltd
Balance Sheet (Assets)
At December 31, 2015 and 2014
% of Total Assets
2015 2014 2015 2014
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%

BS Co Ltd
Balance Sheet (Assets) as at December 31, 2015 and 2014
% of Total Assets
2015 2014 2015 2014
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
$82,000 ÷ $483,000 = 17% rounded

$30,000 ÷ $387,000 = 8% rounded
BS Co Ltd
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 2015 and 2014
% of Total Assets
2015 2014 2015 2014
Acts. Payable $ 76,000 $ 60,000 16% 16%
W ages Payable 33,000 17,000 7% 4%
Notes Payable 50,000 50,000 10% 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%
$76,000 ÷ $483,000 = 16% rounded

WORKED EXAMPLE 3: TREND ANALYSIS
Assume that MD Co Ltd provides you with the

following operating data and asks that you
prepare a trend analysis (Figures in Tshs mil).
2015 2014 2013 2012 2011

Revenue 2,405 2,244 2,112 1,991 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Income 372 278 242 188 119

WORKED EXAMPLE 3 – ANSWER

TREND PERCENTAGES EXAMPLE
Assume that MD Co Ltd provides you with the

following operating data and asks that you
prepare a trend analysis.
MD Co Ltd
Operating Data
2015 2014 2013 2012 2011
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119
$1,991 - $1,820 = $171

TREND PERCENTAGES EXAMPLE
Using 2011 as the base year, we develop the
following percentage relationships.
MD Co Ltd
Operating Data
2015 2014 2013 2012 2011
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%
$1,991 - $1,820 = $171

$171 ÷ $1,820 = 9% rounded
FINANCIAL RATIO ANALYSIS

RATIO ANALYSIS
• Financial statements report both on a firm’s
position at a point in time and on its operations
over some past period.
• From management’s viewpoint, financial
statement analysis is useful both as a way to
- anticipate future conditions and
- more important, as a starting point for planning actions
- that will influence the future course of events or
- to show whether a firm’s position has been improving or deteriorating over
time.

RATIO ANALYSIS (CONT…)
• Ratio analysis begins:
- with the calculation of a set of financial ratios
- designed to show the relative strengths and
- weaknesses of a company as compared to
- Other firms in the industry
- Leadings firms in the industry
- The previous year of the same firm
• Ratio analysis helps to show whether the firm’s
position has been improving or deteriorating
• Ratio analysis can also help plan for the future

RATIOS
Ratios can be expressed in three different ways:

1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. Tshs (e.g., EPS of Tshs 225)
CAUTION!
“Using ratios and percentages without
considering the underlying causes may
lead to incorrect conclusions.”

FINANCIAL RATIO ANALYSIS
• Financial ratio analysis is the use of relationships among financial statement
accounts to gauge the financial condition and performance of a company.
• We can classify ratios based on the type of information the ratio provides:

WHO ANALYSES FINANCIAL STATEMENTS?
• Who analyzes financial statements?
- Internal users (i.e., management)
- External users
- Examples?
- Investors, creditors, regulatory agencies & …
- Financial analysts
- Auditors
- Researchers
- etc
A FIRM’S STAKEHOLDERS
A company has responsibility to different interested parties
Government
Creditors
Employees Customers
The firm
Managers Society
Shareholders

• What do internal users use it for?
Planning, evaluating and controlling company
operations
• What do external users use it for?
Assessing past performance and current
financial position and making predictions about
the future profitability and solvency of the
company as well as evaluating the effectiveness
of management

ACTIVITY RATIOS
• Turnover ratios reflect the number of times assets flow into and out of the
company during the period.
• A turnover is a gauge of the efficiency of putting assets to work.
• Ratios:
Note: A way of looking at turnover ratios is to consider that the denominator is the
investment that is being put to work and the numerator is the result of that effort.

OPERATING CYCLE COMPONENTS
• The operating cycle is the length of time from when a company makes an
investment in goods and services to the time it collects cash from its accounts
receivable.
• The net operating cycle is the length of time from when a company makes an
investment in goods and services, considering the company makes some of its
purchases on credit, to the time it collects cash from its accounts receivable.
• The length of the operating cycle and net operating cycle provides information
on the company’s need for liquidity: The longer the operating cycle, the greater
the need for liquidity.
Number of Days of Inventory Number of Days of Receivables
| | | |
Buy Inventory on Pay Accounts Sell Inventory on Collect Accounts

Credit Payable Credit Receivable
Number of Days of Payables Net Operating Cycle
Operating Cycle

LEARNING ACTIVITY
• Discussion question: Why do we say that a
company with a long operating cycle has a greater
need for liquidity?

OPERATING CYCLE FORMULAS

OPERATING CYCLE FORMULAS

LIQUIDITY
• Liquidity is the ability to satisfy the company’s short-term obligations using
assets that can be most readily converted into cash.
• Liquidity ratios:

SOLVENCY ANALYSIS
• A company’s business risk is
determined, in large part, from the
company’s line of business.
• Financial risk is the risk resulting from
a company’s choice of how to finance
the business using debt or equity.
• We use solvency ratios to assess a
company’s financial risk.
• There are two types of solvency ratios:
component percentages and coverage
ratios.
- Component percentages involve
comparing the elements in the
capital structure.
- Coverage ratios measure the ability
to meet interest and other fixed
financing costs.

SOLVENCY RATIOS

LEARNING ACTIVITY
Discussion question: Is it possible for a company
to have solvency ratios, such as the debt-to-assets
and debt-to-equity ratios, that are increasing over
time, yet the coverage ratios are not increasing?

PROFITABILITY
• Margins and return ratios provide information on
the profitability of a company and the efficiency of
the company.
• A margin is a portion of revenues that is a profit.
• A return is a comparison of a profit with the
investment necessary to generate the profit.

PROFITABILITY RATIOS: MARGINS

PROFITABILITY RATIOS: RETURNS

OTHER RATIOS

OTHER RATIOS

EXAMPLE: SHAREHOLDER RATIOS
Calculate the book value per share, P/E, dividends per
share, dividend payout, and plowback ratio based on the
following financial information (Tshs):
Book value of equity 1000 million

Market value of 5000 million
equity
Net income 300 million
Dividends 120 million
Number of shares 100 million

EXAMPLE: SHAREHOLDER RATIOS
Book value per share 10.00 There is Tshs 10 of equity, per the books,
for every share of stock.
P/E 16.67 The market price of the stock is 16.67

times earnings per share.
Dividends per share 1.2 The dividends paid per share of stock.
Dividend payout 40% The proportion of earnings paid out in the

ratio form of dividends.
Plowback ratio 60% The proportion of earnings retained by the

company.

EFFECTIVE USE OF RATIO ANALYSIS
• In addition to ratios, an analyst should describe
the company (e.g., line of business, major
products, major suppliers), industry information,
and major factors or influences.
• Effective use of ratios requires looking at ratios
- Over time.
- Compared with other companies in the same line of
business.
- In the context of major events in the company (for
example, mergers or divestitures), accounting changes,
and changes in the company’s product mix.

PROBLEMS IN FINANCIAL
STATEMENT AND RATIO ANALYSIS
• Developing and Using Comparative Data
• Distortion of Comparative Data
• Notes to Financial Statements
• Interpretation of Results
• Differences in Accounting Treatment
• Window Dressing
• Effects of Inflation

NOTE: TRICKS OF THE ACCOUNTING TRADE

ISSUES
• Creative accounting
- the letter of the accounting standards is abided by,
but there is a deliberate attempt to flatter the figures
- When judgement calls are required there is a bias to
shoe a favourable figure
- The accounting regulators periodically try to close
loopholes to bring accounts back to a true and fair
view, but many managers and their accountants are
adept at outwitting the rule setters
• Fraud
- When the rules are completely flouted

PROBLEMS WITH RATIO ANALYSIS
• When some firms (especially large ones)

operate different divisions in different
industries it becomes difficult to develop a
meaningful set of industry averages for
comparative purposes.
- Thus, ratio analysis is more useful for narrowly
focused firms than for multidivisional ones
• Most firms want to be better than average, so
merely attaining average performance is not
necessarily good.
- As a target for high-level performance, it is best to
focus on the industry leaders’ ratios.
- Benchmarking helps in this regard.
Problems (Cont...)
• Inflation may have badly distorted firms’ balance
sheets – recorded values are often substantially
different from “true” values.
- Further, since inflation affects both depreciation charges and
inventory costs, profits are also affected.
- Thus, a ratio analysis for one firm over time, or a comparative
analysis of firms of different ages, must be interpreted with
judgement.
• Seasonal factors can also distort a ratio analysis (e.g.
for inventory turnover ratio where the industry is
prone to seasonal fluctuations).
- This problem can be minimized by using monthly averages (e.g.
inventory turnover and receivables) when calculating turnover
ratios.

Problems (Cont...)
• Firms can employ “window dressing”
techniques to make their financial statements
look stronger than they really are.
- For example, imagine a construction firm which borrows
on a two-year basis on December 29th, 2015, holds the
proceeds of the loan as cash for a few days, and then
pays off the loan ahead of time on January 2nd, 2016.
- This exercise has improved the company’s liquidity
ratios (current and quick ratios) and made its year-end
2015 balance sheet look good.
- However, the improvement was strictly window dressing
because after January 2nd, 2016 the balance sheet is back
at the old level.

Problems (Cont...)
• Different accounting practices can distort comparisons.
- For example, inventory valuation (i.e. LIFO, FIFO, Weighted average)
and depreciation (i.e. straight line, SYD, DDB, etc) methods can affect
financial statements and thus distort comparisons among firms.
- Also, if one firm leases a substantial amount of its productive
equipment, then its assets may appear low relative to sales because
leased assets often do not appear on the balance sheet (i.e. operating
lease for lessee and financial lease for lessor). At the same time, the
liability associated with the lease obligation may not be shown as
debt (note that leasing has often been termed as one of the “off-
balance sheet financing”.
- Therefore, leasing can artificially improve both the turnover and the
debt ratios.
• Note, however, that the accounting profession has taken steps to
reduce this problem with its disclosure requirements.

Problems (Cont...)
• It is difficult to generalize about whether a
particular ratio is “good” or “bad”.
- For example, a high current ratio may indicate a strong
liquidity position for a merchandizing firm, which is
good, or excessive cash for a bank, which is bad (because
excess cash in the bank is a non-earning asset).
- Similarly, a high fixed assets turnover ratio may denote
either a firm that uses its assets efficiently or one that is
undercapitalized and cannot afford to buy enough assets.
- Benchmarking can be used to gauge whether a firm’s
ratios are in accordance with its peers in the industry.

Problems (Cont...)
• A firm may have some ratios that look “good”
and others that look “bad” making it difficult
to tell whether the company is, on balance,
strong or week.
- However, statistical procedures can be used to
analyze the net effects of a set of ratios.
- Many banks and other lending organizations in
developed economies use statistical procedures such
as discriminant analysis to analyze firms’ financial
ratios and on the basis of their analyses, classify
companies according to their probability of getting
into financial troubles.

WHERE IT MIGHT GO WRONG
• Goodwill – When a company acquires another there
is usually a difference between the fair value of the
assets acquired and the price paid
- The difference is termed goodwill
• Determination of fair value – when a company is
acquired its assets are revalued at fair value on the
acquisition date for the purposes of consolidation in
the group accounts
• Determination of appropriate revenue – the trick of
bringing forward revenue from future years into the
current year
• Exceptional items – When companies issue press
releases about their results they tend to emphasize
“profit before exceptional items”
• Where it might go wrong (Cont...)
- Stock (inventory) valuation
- Depreciation
- Capitalization
- Off balance sheet items

WHAT TO DO
• Pay attention to the notes to the accounts
• Get data from other sources
• Focus on cash
• Check accounting policies
• Meet the management
• If in doubt don’t invest

SUMMARY
• Financial ratio analysis and common-size analysis help gauge
the financial performance and condition of a company
through an examination of relationships among these many
financial items.
• A thorough financial analysis of a company requires
examining its efficiency in putting its assets to work, its
liquidity position, its solvency, and its profitability.
• We can use the tools of common-size analysis and financial
ratio analysis, including the DuPont model, to help understand
where a company has been.
• We then use relationships among financial statement
accounts in pro forma analysis, forecasting the company’s
income statements and balance sheets for future periods, to
see how the company’s performance is likely to evolve.

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ACCOUNTING FOR FINANCE

PROGRAMME: ODINARDY DIPLOMA IN ACCOUNTING FINANCE AND BANKING(ODA,

MODULE CODE: AFU 06105

Facilitator: Mr. Odrano Mwanana

NTA Level: SIX (6)

Academic year: 2021/2022

30/12/2022 Copyright © 2022 odrano mwanana 1

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Financial statements that show

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Show changes over time in

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Expression of logical relationships between

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Financial statements that show only

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Using comparative ﬁnancial statements to calculate

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For a single ﬁnancial statement, each

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1.Create the vertical common-size analysis for the CS Company’s assets.

Hint: Common-Size Analysis

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Assume that the management of UD Co Ltd

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2015 2014 Increase (Decrease)

Calculating Change in Tshs Amounts

Tshs = Current Year – Base Year

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Calculating Change in Monetary Amounts

Tshs = Current Year – Base Year

Since we are measuring the amount of the change

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Calculating Change as a Percentage

Percentage Tshs Change

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$12,000 – $23,500 = $(11,500)

($11,500 ÷ $23,500) × 100% = 48.9%

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Sales increased by 8.3% while net income

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There were increases in both cost of goods sold (14.3%) and

Assume that the management of BS Company

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Assets 2015 2014

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$82,000 ÷ $483,000 = 17% rounded

$76,000 ÷ $483,000 = 16% rounded