Accounting and Financial Analysis

Accounting and Financial Analysis

[Chapter Introduction and Objectives]:
Although regulations limit managerial discretion in financial reporting, managers still have leeway in choosing accounting policies. Consequently, analysts are required to make adjustments to reported results in order to make meaningful comparison of performance of different companies. This chapter highlights the issues in accounting analysis. The chapter also covers techniques of financial analysis like ratio analysis. This chapter has the following objectives:

• Highlight building blocks of accrual accounting
• Highlight why managers make changes in accounting policies
• Highlight factors affecting accounting quality
• Discuss ratio analysis
• Introduce sustainable growth analysis

Shares in troubled healthcare software provider iSoft Group, PIc. fell over 25% in morning trading after the company announced that annual profits would be lower
than forecast due to a change in accounting policy (iSoft Shares Slump Again on Accounting Policy Change, 2006). Manchester, UK-based iSoft said that, under
a new accounting policy for revenue recognition, pretax profit for the year to 30 April 2006 would be between £3 million ($5.5 million) and £7 million ($12.9 million),
compared to earlier estimates of between £I 7 million ($31.4 million) and £22 million ($40.7 million). The company also lowered its guidance for annual
sales to between £195 million ($360.5 million) and £200 million ($369.7 million) from earlier forecasts in the range £210 million ($388.2 million) and £215 million
($397.5 million). iSoft said that it was looking to reduce operating costs by around £30 million ($55.5 million) by the end of the current financial year, and as a result it was planning to cut around 150 staff from its UK operation, representing about 15% of total headcount in the UK. The company estimated the cost of this action
at around £3 million ($5.5 million). Over the last 6 months, iSoft has been beset by concerns over its contracts with the UK National Health Service. The company is the main application provider on the Accenture-Ied Northeast and East of England 'clusters', and was publicly blamed by Accenture for causing costly delays to the
project. In January 2006, iSoft shares on the London stock exchange were trading at just under 400 pence ($7.39). However, a series of sharp falls has pushed the company's share value down to below 100 pence ($1.85) in less than 6 months. Following this latest slump, shares in iSoft were trading at just over 60 pence ($1.11).

Financial statements are reports of business performance of the company during the year. Financial statements are used by different groups of people for different purposes. Lenders are interested in financial statements to assess the credit worthiness of the company; investors are interested in assessing the profit potential, bankers in fixing the working capital limit; academic researchers in the quality of disclosure, etc. Nobody would be as much interested as the managers of the company simply because their personal fortune and jobs are tied to the performance of the company. They would be interested, for example, in assessing the indebtedness of the company and when they come due in relation to cash flow available or the impact of extending credit to customers on the financial condition of the company. The set of analytical tools available is the same regardless of who you are; only the emphasis changes.

A company's management is responsible for anticipating future imbalances in the company's financial system before its severity is reflected in the company's financial
statements. The starting point for a financial forecast is the formulation of management goals and product market strategy, which in turn determines the outlook for sales. The firm's strategy and sales growth will determine the investment in fixed assets and working capital to support these strategies. The effectiveness of these strategies coupled with competitive reaction will influence the company's financial performance and future need for finance. Needless to say, future profitability is necessary for access to capital markets.

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