Several aspects of ratio analysis are important to understand. First, the computed ratio is not “the answer.” The ratio is an indicatorof some aspect of a company’s performance, telling what happened but not why it happened. Net profit margin is calculated by dividing net income by revenue: A second important aspect of ratio analysis is that…
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The analyst may also want to examine comparable performance over time. Again, the nominal currency amounts of sales or net income may not highlight significant changes. To address this challenge, horizontal financial statements (whereby quantities are stated in terms of a selected base year value) can make such changes more apparent. Another obstacle to comparison…
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The Objectives of the Financial Analysis Process Distinguish between Computations and Analysis Analysts often need to communicate the findings of their analysis in a written report. Their reports should communicate how conclusions were reached and why recommendations were made. For example, a report might present the following: An effective narrative and well supported conclusions and…
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The cash flow statement consists of three sections:
How Accounting Choices and Estimates Affect Earnings and Balance Sheets Assumptions about inventory cost flows provide another example of how accounting choices can affect financial reporting. Companies may assume that their purchases of inventory items are sold to customers on a first-in, first-out (FIFO) basis, with the result that the remaining inventory reflects the most…
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An understanding of the choices that companies make in financial reporting is fundamental to evaluating the overall quality—both financial reporting and earnings quality—of the reports produced. Choices exist both in how information is presented (financial reporting quality) and in how financial results are calculated (earnings quality). Choices in presentation (financial reporting quality) may be transparent…
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Market Regulatory Authorities Typical features of a regulatory regime that most directly affect financial reporting quality include the following: Auditors Audit opinions provide financial statement users with some assurance that the information complies with the relevant set of accounting standards and presents the company’s information fairly. Private Contracting Aspects of private contracts, such as loan…
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If motivation exists, an analyst should consider whether the reporting environment is conducive to managers’ misreporting. It is important to consider mechanisms within the reporting environment that discipline financial reporting quality, such as the regulatory regime. Motivations Managers may be motivated to issue financial reports that are not high quality to mask poor performance, such…
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