Financial statements analysis in the Case Study: method, report and worked cases

Most candidates can calculate ratios. Far fewer can tell the financial story behind them, and that is what the Case Study rewards. This topic gives you a method for the analysis, question lists for each of the three statements, a quadrant technique for the statement of financial position and a worked past case.

The information and the three steps

The financial information in a case is usually truncated: management accounts, extracts or summarised statements. This avoids the need for full disclosures. Unless the case says otherwise, treat the accounts as properly prepared by competent professionals and suitable for audit. Do not question the basis of preparation unless there is a specific signal, for example that the auditors have challenged the accounts.

The analysis has three steps: an initial analysis, a detailed analysis of the key statements including ratios, and the use of the analysis in the exam. Skill in this work takes time to build, both in how long a single analysis takes and in how many sets of statements you must analyse. Reading someone else’s analysis can make it look easy.

There is no substitute for doing it yourself, so practise for accuracy and speed.

Step 1: the initial analysis

The initial analysis is a rapid review to get the financial headlines and an understanding of the whole business. Skim, but do not miss obvious features. Ask the questions below.

Keep the context in view from the start. A business that appears to be growing may be doing badly if the whole economy is growing faster. Equally, avoid final judgements from a first impression. A recession may not be the real reason for poor results, and a more worrying cause may lie underneath.

Step 2: the detailed analysis

The detailed analysis examines each of the three key statements, with the notes, and breaks the work into components. Always remember that the three statements connect. Some of the links between the income statement and the statement of financial position, which you can call bridges, depend on judgement. They include closing inventory, depreciation, amortisation and impairment, deferred income and provisions such as impairment of receivables.

Each one affects reported profit, so consider changes in them and test the related assets in the statement of financial position for materiality.

Ratio analysis is a very useful starting point, in the same category as a strategic review such as SWOT, but it is only the start. You must calculate the families of ratios for profitability, liquidity, return on capital employed, financial structure and asset efficiency quickly and accurately. Ratios allow comparison:

• between current and past results;
• between current results and budgets or forecasts;
• between the business and an external or industry standard;
• between one subsidiary or division and another;
• across business segments or revenue streams; and
• between the company and a rival or takeover target.

The real skill is explaining what the results mean and what caused the changes.

The income statement: how is the business performing?

Ask these questions, and answer each in numbers and in words.

• Revenue. What is the trend, by how much and why? Have the sales mix or revenue streams changed, and what did that do to profit?
• Gross profit. Is it rising or falling in naira and in percentage terms? Do products earn different margins?
• Costs. How do costs move against revenue? Which are fixed and which variable, and what is the operating gearing? Is any single cost figure unusual?
• Profit. Are operating profit and profit before tax satisfactory and stable?
• Bridging items. Are closing inventory, depreciation and disposal results, deferred income, impairment of receivables, accruals and prepayments consistent from year to year, and how material are they?
• Tax and dividends. Is the tax charge reasonable? Does the dividend policy make sense and stay consistent?

The numbers matter, in naira and in percentages, but the quality of your comment shows professional expertise.

The statement of financial position: is it stable?

Assess financial position, the quality of assets and liabilities and whether the statement is strong or weak. Besides ratios such as receivables days, look at content, structure and stability. A good tool is quadrant analysis, which splits the statement into non-current assets, long-term funding, current assets and current liabilities. Then ask:

1. Do non-current assets and long-term funding balance? A shortfall means long-lived assets are being funded by short-term credit, which is dangerous.
2. What is the quality of non-current assets? Tangible assets with a clear market value are safer than intangibles such as goodwill that may not sell in a crisis.
3. Is long-term funding mainly equity and retained profits, or mainly debt, which is riskier?
4. Is the debt soft, such as directors’ loans, or hard, such as external borrowing with high interest and a near repayment date? When is it due, and can the business repay it?
5. Do current assets and current liabilities balance, and is that right for this kind of business?
6. How liquid are the current assets? Are they mostly stock and slow receivables, or is there enough cash?
7. Are current liabilities soft, such as trade payables and accruals, or hard, such as overdrafts and tax and payroll liabilities that cannot be negotiated?

Extend the analysis to the notes, where more detail is given.

The statement of cash flows: is it generating or using cash?

The statement of cash flows combines information from the other two statements, but it is more than a third statement. It can be the real starting point of the analysis, because it shows how the business is managed in financial terms at every level, from credit control to board decisions on investment and dividends. Ask:

• How well does the business generate cash from operations, starting from operating profit with non-cash items added back?
• Is working capital managed in line with activity, or is cash being soaked up by receivables and inventory? Are payables managed responsibly? Link back to your days ratios.
• Is the return on investment adequate, and how much is paid to service finance?
• What was the cash effect of tax, and is it consistent with the liability?
• Is there a sound policy for replacing non-current assets, funded by long-term money?
• Can the business afford its dividends, and is its long-term financing strategy suitable?
• Is it using its liquid resources well, and what is happening to its cash balance?

Step 3: using the analysis in the exam

The paper holds a large volume of financial information that you must analyse quickly, and you should expect to answer detailed financial statements analysis questions to a high standard. Scripts that perform poorly usually contain pages of correct ratios with little written analysis. That shows only basic numerical skill and earns few points. Examiners reward your understanding of the statements and your ability to explain the figures to the reader.

Answer the requirement as set, and keep these in mind.

For every figure, ask why it changed, so what it means for the business and whether you are comparing like for like, after adjusting for non-recurring items. Also add knowledge, by telling the reader something they may not know, without speculating beyond the evidence. Add understanding by explaining technical features simply. Add value by evaluating, concluding and recommending.

Finally, write for the reader, in short sentences of two or three per paragraph, with no jargon.

Worked example: quadrant analysis

1. Top row.
   Non-current assets are 500 and long-term funding is 250 + 150 = 400.
   There is a shortfall of 100.
2. Bottom row. Current assets are 300 and current liabilities 400, so current liabilities exceed current assets by 100, and the current ratio is 0.75.
3. Reading. The 100 shortfall is exactly the gap in current assets. Long-lived assets are being funded by short-term credit. That is the dangerous pattern: the business must keep rolling over short-term debt or find long-term money.
4. Recommendation. Replace short-term borrowing with a term loan or new equity, and review whether any assets can be sold.

Worked past case: May 2015, Ice Age Manufacturing

The May 2015 case gave two years of statements for a manufacturer. Figures are in ₦ thousand. A strong answer builds the financial story from a few key movements.

The story. Sales rose by more than a quarter, yet profit fell by more than half, because margins narrowed and costs grew faster than revenue. Receivables almost quadrupled, which suggests relaxed credit to hold sales, and possible bad debts. Payables rose more than fivefold, so suppliers are financing the business, which clashes with the claim that supplier relations are healthy.

Cash has almost gone, and the current ratio has dropped well below the industry figure.

Scepticism. The figures are unaudited and there is an unresolved dispute with the auditors. The investment property fell in value by 30%, but management has not recorded the fall. Under International Accounting Standard (IAS) 40, Investment Property, the fair value model puts such a change in profit or loss. A loss of ₦2,250 thousand would turn the reported profit before tax of ₦135 thousand into a loss. These points weigh on the reliability of the whole analysis.

The May 2015 Pathfinder solution shows interest of ₦560 thousand on the corporate note in its amortised cost table. At the effective rate of 8% on the ₦7,500 thousand carrying amount, the charge is ₦600 thousand, and with ₦480 thousand interest paid the closing balance is ₦7,620 thousand. The Pathfinder solution is slightly different from ours.

Worked past case: November 2014, Mago Pharmaceuticals

The November 2014 case gave three years of statements for a pharmaceutical company that a client wanted to buy. Figures are in ₦ thousand.

The story. Revenue fell by about 10% in each of two years, while gross margin stayed at 40%. In 2014, administration costs rose by about 34% and distribution costs by about 43%, so operating profit fell by about 39% and profit after tax by about 43%. At the same time, inventories grew twelvefold over two years and receivables more than quadrupled, with collection time rising from 20 to 107 days.

The current ratio looks stronger, but the improvement is made of stock and slow receivables, not cash, which fell in 2014. The company is selling less, collecting slowly and carrying more stock. The marking key rewards noticing exactly this: rising inventories and receivables despite falling performance. It also expects scepticism about the reliability of the information the buyer relied on.

Writing the financial story

Open with the headline, such as profit falling despite sales growth or sales falling with rising stock. Support it with the three or four figures that prove it. Explain the likely causes from the case. State the effect on liquidity, structure and cash. Close with the reservations, such as unaudited figures, and the actions. Put the full ratio tables in the appendix, and keep the body for the story.

Worked example: comparing like for like

1. Headline. Reported profit rose by ₦50 million, which is 62.5%.
2. Adjust.
   Remove the one-off gain to find underlying profit: 130 − 40 = 90.
3. Compare. Underlying profit rose by only ₦10 million, which is 12.5%, so most of the apparent growth came from a sale of an asset that cannot be repeated.
4. Judge. Trading performance improved modestly. The board should not plan on the higher figure, and a buyer should value the business on the underlying profit.

Worked example: profit up, cash down

The three statements must tell one story. Suppose profit after tax is \u20a660 million. Depreciation of \u20a620 million is added back because it is not a cash cost. Receivables rose by \u20a650 million, inventory by \u20a640 million and payables by \u20a610 million. Cash from operations is 60 + 20 \u2212 50 \u2212 40 + 10 = nil.

A profit of \u20a660 million produced no cash at all, because customers and stock absorbed it. If the company also spent \u20a630 million on equipment, the overdraft must have grown by about \u20a630 million. The income statement alone would suggest success, while the cash flow statement shows a business that is borrowing to fund growth in working capital. That is the kind of insight the examiner rewards.

Planning your time on the analysis

The paper suggests about an hour for calculations and analysis. Use it in order: a few minutes for the initial review of the business and its context, then the calculations for the appendices, then notes of the three or four points that will carry the story. Decide early which figures belong in the body and which in the appendix.

Leave time to write the commentary, because that is where most of the marks are won.

Common mistakes

• Producing pages of ratios with no written analysis.
• Making a final judgement from the first impression, such as blaming a recession.
• Ignoring the wider context and the industry figures.
• Analysing the income statement only and leaving out cash flow and financial structure.
• Treating figures as reliable when the case gives a signal, such as an audit dispute, that they may not be.
• Missing a gap between long-term assets and long-term funding.
• Speculating beyond the evidence in the case.

Quick revision

• Three steps: initial analysis, detailed analysis, written use in the exam.
• Initial: nature, lifecycle, size, stability, wider context.
• Income statement: revenue, mix, margins, costs, bridging items. Position: quadrants, quality, soft and hard debt. Cash flow: operations, working capital, investment, dividends.
• Ask why, so what and like for like.
• Write short sentences for the reader and conclude under a heading.

Practice questions

These are original questions in the style of the Institute of Chartered Accountants of Nigeria exam. Try each one before you open the answer.

Model answer

The next topic covers analysing and interpreting a sustainability report.

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