PAPER NO. 8 FINANCIAL STATEMENTS ANALYSIS
UNIT DESCRIPTION
This paper is intended to equip the candidate with the knowledge, skills and attitudes that will enable him/her to analyse and interpret the financial statements of a firm.
LEARNING OUTCOMES
A candidate who passes this paper should be able to:
• Demonstrate an understanding of the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating a company’s performance and financial position
• Identify and evaluate the information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information/various alternative sources of financial information
• Prepare financial statements, including consolidated financial statements, in accordance with IFRSs or other relevant standards
• Analyse financial statements and related disclosures
• Project financial statements such as statement of financial position, income statement, budgets among others
CONTENT
1. Overview of financial statements analysis
1.1 Definition of financial statements analysis
1.2 The roles of financial reporting and financial statements analysis
1.3 Different reporting environment frameworks (financial reporting standards setting boards
– International Accounting Standards Board – IASB, Financial Reporting Standards – FASB and regulatory authorities
1.4 Objective of financial statements
1.5 Steps in analysing financial statements (Define the purpose and context of analysis, collect data, process data, analyse data, communicate recommendations and periodic reviews)
1.6 Importance and challenges of financial statements analysis: change, globalism and technology
1.7 Sources of information for analysis (financial statements – statement of financial position, comprehensive incomes statement, statement of cash flows, statement of changes in owners’ equity, auditors’ report, notes to financial statements, management commentary, supplementary information, sustainability reports and integrated reports), filing with regulatory authorities and press reports)
1.8 Approaches to analysing financial statements (macroeconomic environment, industry and company – either top down or bottom up)
2. Financial reporting on assets and liabilities
2.1 Structure and format of the statement of financial position
2.2 Current assets and non- current assets
2.3 Current liabilities and non- current liabilities
2.4 Investment properties; presentation, measurement (historical cost and fair value) and disclosure
2.4 Non-recurrent items and non-operating items; discontinued operations (exclude disposal of subsidiaries) extra ordinary items, unusual or infrequent items, changes in accounting policies
2.5 Financial instruments (financial assets and financial liabilities): marketable securities, derivatives, hedges etc., presentation, recognition, measurement, de- recognition, disclosures and impairment
2.6 Non-current assets held for sale
2.7 Intangible assets; finite useful life and indefinite useful life, amortisation and impairment, disclosures.
2.8 Leases: Types of leases (operating and finance lease); presentation, disclosure, recognition, off balance sheet leverage from operating leases.
2.9 Income taxes: accounting profit and taxable income (Differences between the recognition of revenue and expenses for tax and accounting purposes), deferred tax assets and liabilities, tax base of assets and liabilities, current tax payable, temporary and permanent timing differences, recognition and measurement of current and deferred tax, presentation and disclosure
2.10 Employee benefits (post-employment benefits): types of post-employment benefits; impact of the assumptions used such as discount rates, return on plan assets and salary growth on the defined benefit obligation and period expenses; pension plan footnote disclosure, effect on underlying economic liability (asset) of a company’s pension and other post-employment benefits; share based compensation
2.11 Multinational operations: foreign currency transactions; translation of foreign currency in the financial statements, effects of changing prices and inflation
2.12 Accounting policies, changes in accounting estimates and errors (prior period errors)
2.13 Events after the reporting period
2.14 Impact of taxation on financial analysis
3. Financial statement analytical tools
3.1 Financial analysis techniques; financial analysis framework/process; computations and analysis
3.2 Value, purpose and limitation of ratio analysis
3.3 Calculation and Interpretation of ratios in context
3.4 Profitability analysis: Desegregation and interpreting return on assets (ROA), return on capital employed (ROCE), relating ROA to ROCE, DuPont analysis, Return on shareholders’ fund (ROSF); Analysis of growth and sustainable earning; growth analysis, analysis of changes in profitability and sustainable earnings, analysis of growth in shareholder’s equity, growth, sustainable earnings and the evaluation of price to book (P/B) ratios and price to earnings (P/E) ratios
3.5 Dividend ratios: Dividends pay-out ratio, dividend yield
3.6 Analysis of liquidity and efficiency-current ratios, quick ratio/acid test ratio, cash ratio, and cash conversion cycle, receivable turnover in days, payables turnover days, inventory turnover days, working capital requirements and measures.
3.7 Solvency analysis: debt to assets ratio, debt to total capital ratio, interest coverage.
3.8 Investment analysis: Return on investment (ROI) among others
3.9 Analytical tools and techniques; ratio analysis, common size analysis, regression analysis (use of scatter plots), technical and fundamental analysis, and graphical presentation (pie charts and bar charts)
3.10 Model building and forecasting; sensitivity analysis, scenario analysis, simulation (Monte Carlo simulation).
3.11 Application of ratio analysis – cross sectional analysis, trend analysis, forecast financial statements, credit analysis and rating, equity analysis
4. Analysing the financial statements
4.1 Income statement: Components (revenues and expenses) and format of the income statement (multi step and single step), revenue recognition and expenses recognition; analysis of the income statement-common size analysis (Horizontal and vertical) and ratio analysis, convert income statements to common – size income statements; evaluate a company’s financial performance using common – size income statements and financial ratios based on the income statement;
4.2 Statement of financial position; components and format of statement of financial position (assets, liabilities and equity), off balance sheet items; analysis of the statement of financial position-common size analysis (Horizontal and Vertical), cross sectional analysis, ratio analysis, convert balance sheets to common- size balance sheets and interpret common- size balance sheets;
4.3 Statement of changes in equity; components of equity, equity valuation ratios, demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components;
4.4 Cash flow statements; component and format of the cash flow statement, categories of cash flow items (operating activities, investment activities and financing activities) direct and indirect methods for preparing cash flow statements; cash flow statement analysis-evaluation and uses of cash, common size analysis, free cash flow to the firm and free cash flow to equity, cash flow ratios, analyse and interpret both reported and common- size cash flow statements; calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
4.5 Understand and analyse the pervasive importance of income tax effect on reported financial results.
5. Quality of earnings and earnings management
5.1 Simple measures of earnings quality (selection and application of accounting principles and business risk)
5.2 Categories of earnings: Earnings before interest, tax depreciation and amortisation (EBITDA), operating earnings, Earnings before interest and tax, earnings after tax (EBIT), earnings after tax, net income, among others.
5.3 Measures of the accrual component of earnings and earning quality
5.4 Earnings per share (EPS); Basic EPS, diluted EPS, using EPS to value firms, simple and complex capital structure, criticism of EPS.
5.5 Price to earnings ratio (P/E ratio)
5.6 Segment reporting; geographical segments, segment disclosure requirements, segment ratios (segment margin, segment turnover, segment ROA, Segment debt ratio)
6. Intercorporate investments
6.1 Subsidiaries
6.2 Associate companies
6.3 Jointly controlled entities
6.4 Measurement and disclosure
6.5 Evaluating the effect of inter-corporate investments on financial statements given the different accounting treatment
7. Key sectorial ratios and metrics
7.1 Market benchmarks: Key sectorial ratios and industry specific metrics; consumer information, competitors’ performance, market expectations.
8. Qualitative and other current issues in the Analysis of financial statements
8.1 Qualities of useful financial statements; relevance, comparability, verifiability, predictive value, faithful representation and neutrality.
8.2 Analysis of company prospects and risks using qualitative information (strategy and business environment analysis)
8.3 Red flags and accounting warning signs that may indicate financial statements are of poor quality
8.4 Accounting scandals: Case studies
8.5 Accounting shenanigans on the cash flow statement; creative accounting and manipulating financial statements
8.6 Misrepresentation in the financial statements
8.7 Improper manipulation of earnings
8.8 Adjustments that may be required to make financial statements comparable
9. Contemporary issues and emerging trends
Accounting for climate changes and analysis of financial statements
Sample study and reference material
1. Subramanyam, K. R. (2014). Financial Statement Analysis (11th edition). New York: McGraw-Hill.
2. Gibson, C. H. (2013). Financial Reporting and Analysis – Using Financial Accounting Information (13th edition). Australia: South-Western.
3. Robinson, T. R., Henry, E., & Pirie, W. L. (2020). International Financial Statement Analysis (4th edition). Wiley.
4. Kasneb e-learning resources (link on the kasneb website).
5. Kasneb approved study packs.