Financial Statement Analysis and Internal Control

Financial Statement Analysis and Internal Control Notes

Recap of Week 5

  • Key Topics Covered:

    • Goods and Services Tax (GST)

    • Preparation of Financial Statements:

    • Temporary Accounts: Revenue, Expenses & Dividends

    • Permanent Accounts: Assets, Liabilities, Equity

    • Key Financial Statements: 3 main statements conducting reporting.

Learning Outcomes

  • Understand the relationship between measurement systems and the accounting conceptual framework.

  • Apply principles of double-entry and accrual accounting.

  • Define and recognize criteria for assets, liabilities, income, and expenses.

  • Prepare financial statements for business entities while working collaboratively to enhance research, judgment, and verbal communication skills.

Learning Objectives for Current Lecture

  • Explore comparative analysis and tools for financial statement analysis.

  • Understand the elements of horizontal and vertical analysis.

  • Calculate and interpret ratios to assess profitability, liquidity, and solvency.

  • Identify limitations inherent in financial statement analysis.

Comparative Analysis

Types of Comparative Information

  1. Intra-entity Comparisons: Within a single entity to identify trends.

  2. Industry Averages: Compare with others in the same industry.

  3. Inter-entity Comparisons: Between different entities for competitive positioning.

Comparative Analysis Techniques

  • Horizontal Analysis: Evaluates financial data across years to identify trends.

  • Vertical Analysis: Expresses each item as a percentage of total sales or revenues for relative comparison.

  • Ratio Analysis: Evaluates relationships between different financial metrics.

Horizontal Analysis

  • Purpose: Analyzes financial statement data over a period (Trend analysis).

  • Method: Uses a base year for calculations; follows the formula:
    Change=(CurrentYear−BaseYear)BaseYearChange=\frac{\left(CurrentYear-BaseYear\right)}{BaseYear}

  • Example: Woolworths Limited’s total group sales data listed from 2009 to 2013.

Vertical Analysis

  • Definition: Evaluating financial statements by expressing each item as a percentage of a base figure (e.g., total sales).

  • Advantage: Facilitates comparisons among companies of varying sizes and tracks changes over time.

Ratio Analysis

Key Types of Ratios

  1. Liquidity Ratios: Measure the ability to meet short-term obligations.

  2. Solvency Ratios: Reflect the entity's capacity to survive long-term.

  3. Profitability Ratios: Assess overall profitability.

Liquidity Ratios

  • Current Ratio: Excludes inventory and prepaid assets. Defined as:
    extCurrentRatio=racextCurrentAssetsextCurrentLiabilitiesext{Current Ratio} = rac{ ext{Current Assets}}{ ext{Current Liabilities}}

  • Quick Ratio: Indicates immediate liquidity without relying on far less liquid inventories.

  • Receivables Turnover: Measures how efficiently a company collects its receivables.

Solvency Ratios

  • Debt to Total Assets Ratio: Indicates the percentage of assets financed through debt.

  • Times Interest Earned Ratio: Measures the ability to cover interest expenses with operating profit.

Profitability Ratios

  • Return on Equity (ROE): Indicates earnings generated per dollar of equity.

  • Return on Assets (ROA): Measures profit relative to total assets.

  • Profit Margin: Indicates the percentage of revenue that becomes profit, showing efficiency.

  • Earnings Per Share (EPS): Crucial for understanding company profitability per share.

Limitations of Financial Statement Analysis

  1. Estimates: Financial statements rely on estimates that, if inaccurate, skew results.

  2. Costing: Historical costs do not account for inflation or current market values.

  3. Data Atypicality: End-of-period data may not represent normal operating conditions.

  4. Business Diversification: Complex businesses might mislead upon generalized analysis.

Internal Control Systems

Purpose:

  • To safeguard assets, enhance financial record accuracy, and facilitate timely reporting.

Management Responsibilities:

  • Aligning internal control policies with organizational objectives and ensuring governance requires proper systems in place.

Internal Control Principles:

  • Segregation of Duties: Prevent single-person control over all activities within a process.

  • Documentation Procedures: Ensure critical processes are documented and traceable.

  • Independent Internal Verification: Reinforce system checks through independent reviews.

Control Accounts and Subsidiary Ledgers:

  • Subsidiary Ledgers: Provide details about individual customer or supplier accounts.

  • Control Accounts: Summarize data from subsidiary ledgers for overall financial assessments.

Overall, understanding these financial principles and tools is critical for evaluating business performance and ensuring corporate accountability in financial reporting.