Issues in Financial Analysis: A Case Study Approach

 

Coursework Assignment:

Discuss, with relevant examples, to what extent you agree with McSweeney’s comments.

 

Financial analysis is defined by Investopedia as the process of evaluating businesses, projects, budgets and other financial-related entities to determine their investment suitability (Investopedia, 2011). Typically, financial analysts to a large extent focus on the calculation of a range of financial ratios based on the externally available data such as income statement, balance sheet and cash flow statement. Though to some extent it does tell us the profitability and stability of the targeted entity, the validity of financial analysis still attracts much criticism. For instance, McSweeney (2001) believes that the traditional description of changes in financial numbers or ratios is valueless.  Instead, financial data must be interpreted. This essay largely agrees with his idea by discussing the key limits of such acontexutal analysis and the advantages of incorporating the contextual business context into consideration. A number of case studies will be employed.

 

Case 1

Company A is British clothes retailer and one of the six dominant players in the market. Its Creditors Days Ratio – Creditors divided by Sales multiplied by 365 has been keeping around 18 days for a few years, much shorter than that of the industry average, which is about 45 days. In addition, the average Creditors Days for other five industry leaders is 56. Compared 18 with 45 or 56, there is a big difference. However, the limitation of ratio analysis or acontextual analysis is that it fails to answer the unexplained difference here. It is totally unclear that whether the 18 days suggest the strength or weakness of Company A. It is likely that the company is perceived to be at a risky situation and its ability to obtain credit is very low. Therefore, its Creditor Days is much shorter than others’. Even we know that it is a sign of strong performance of Company A, we are still unsure that how does the company achieve this performance. Perhaps it pays quickly just to exchange for greater suppliers discounts, or a much higher proportion of its supplies come from sources that requires pre-payments (McSweeney, 2001). Hence, though acontexutal analysis can tell some state of the company’s financial situation, it is unable to explain why it exists and thereby is not very useful in considerations of whether this financial status will continue or not.

 

Furthermore, many financial analysis textbooks state that if the Current Ratio – current assets divided by current liabilities is around 2:1, the business is in a very good status. For instance, Hough (1994) ever claimed that the current ratio of 2:1 is the most appropriate level for most business. Nevertheless, by doing detailed empirical testing, a number of scholars such as Beaver (1996) concluded that this rule is not as good as Hough claimed in predicting the future of the company. The shortage of the rule is that it includes the inventory at cost in Current Assets, thus excluding any mark-up and underestimating the sales revenue generated from that inventory and the definition of bank overdrafts as Current Liabilities due to the reason that they are usually repayable within twelve months. For instance, in the Case 1 above, Company A has Debtor Days of about 4 days. Hence, its Current Ratio is 4:18 which is about 0.6:1, much smaller than the benchmark of 2:1. From this aspect, Company A should be regarded as not insufficient – a totally contradictory conclusion compared to the initial one. Consequently, the acontextual approach has shown another limitation since the predictions based on the financial ratios ignore any significant positive or negative future events, abnormal events, borrowing ability and assumes that the speed of turnover of Current Assets is the same as that of Current Liabilities. This assumption is based on the prerequisite that the power relationship between a company and its suppliers and buyers is the same, while in the reality it is often very different (McSweeney, 2001).

 

Finally, the reliability and validity of financial information from external resources are questioned. For instance, critics argue that these static accounts are only a snapshot of the business performance and thereby fail to describe the details of what happened inside the organization during a period of time (Atrill and McLaney, 2008). In addition, a lot of corporate activities, such as an off-balance sheeting (OBS) transaction, cannot be shown on the financial statements since it does not concern holding an asset or the issuance of a liability. Typical examples include loan commitments, guarantees and derivatives (Casu, Girardone and Molyneux, 2006). Finally, balance sheet is prepared subjectively and on the basis of historic data, which is regarded as little usage for the future (Elliott and Elliott, 2011).

 

Because of these limitations, McSweeney (2001) points out that it is necessary to incorporate the contextual business contexts into consideration. Compared to the acontextual approach, the value of contextualizing the data is that it includes both the internal (within the company) and external influences that may have an impact on company’s financial performance and accounting indicators. These influences include management action, macro-economic conditions, customer preferences and changes, industry relations, market share and company, government actions, marketing strategies so on and so forth (Doyle, 1992; Baden-Fuller, 1995).  For example, as shown in the tables below, in a specific period of time, the computer industry as whole performed much better than other industries (Table 1), while within that industry there was also a huge variation between companies in the same period (Table 2). This means that companies’ performance does not depend only on internal resources, but also on the creation and development of core competencies and capabilities, of which Wernerfelt (1984) argues that knowledge is the essential part. Using this approach, analysts could begin to think with some precision about what might happen under different stories about the future.

 

Table 1 – Total Industry Shareholders Return 1989-1999

Aerospace

16.1

Airlines

8.7

Computers

57.7

Food Producers

11.3

Hotels and Casinos

2.0

Top 500 Median

12.8 (41 Sectors)

 

Table 2: Total Company Shareholder Return 1989-1999

Computers

 

IBM

19.0

Sun

53.0

Dell

97.0

Apple

12.0

Metals

 

Nucor

15

Reynolds

6

Bethlehem

-1

Source: www.fortune.com citied in McSweeney (2001)

 

Based on the principles of contextual approach, a possible explanation of Company A’s special Creditor Days level in Case 1 is as follows. The company is in a relatively strong financial status and enjoys a considerable power over its suppliers due to the combination of a few major purchasers including Company A and multiple large numbers of small suppliers. Company A mainly sells its own-branded products and is the exclusive purchaser of many of its suppliers’ entire production. In other words, Company A enjoys great bargaining power over its suppliers. However, just because of such supplier dependency, many of the suppliers are unable to survive unless they receive payment earlier than 45 days. In order to keep the relationship between these suppliers, Company A is regarded as a form of banker to them through rapid payment. Thus, in return, suppliers increase their dependency and allow lower prices of payment for Company A (McSweeney, 2001).

 

To sum up, this essay has explained the reason why it is necessary for analysts to consider both the acontextual and contextual business contexts when they are conducting analysis of an organisation. The central reason is that due to the absence of theories and understandings within which to interpret the financial data, the usefulness of acontexutal analysis is rather limited. It fails to explain why certain empirical patterns are observed or why these patterns are expected to be observed in the future. Hence, by incorporating contextual business contexts into consideration, it provides richer explanations of what has really happened, and creates scenarios for more disciplined contingent discussion and judgement about what might happen. This essay does not claim to abandon the financial analysis, but rather to suggest a development for contextualized financial analysis which emphasises on exploring and testing extra-accounting data and drawing on theories, concepts and models from other academic disciplines. Financial analysis that relies exclusively on accounting data is no longer appropriate. Instead, we need a different notion of interpreting accounting data.

Reference:

Atrill, P., McLaney, E., Harvey, D., Jenner, M., and Weil, S. (2010). Accounting: An Introduction. Auckland, New Zealand: Pearson.

 

Baden-Fuller, C. (1995) ‘Strategic Innovation, Corporate Entrepreneurship and Matching Outside-in to Inside-out Approaches to Strategy Research’, British Journal of Management (6): 3-16.

 

Casu, B., Girardone C. and Molyneux, P. (2006) Introduction to Banking. FT Prentice Hall: Pearson Education Limited.

 

Doyle, P. (1992) ‘What Are the Excellent Companies’, Journal of Marketing Management (8): 101-116.

 

Elliott, B. and Elliott, J. (2011) Financial Accounting and Reporting (14th Ed). UK: Prentice Hall.

 

Holmes, G., Sugden, A. and Gee, P. (2008) Interpreting Company Reports and Accounts (10th edition). Prentice Hall, Harlow.

 

Investopedia (2011) Financial Analysis (Online). Available at: < http://www.investopedia.com/> (Accessed: 28th November 2011)

 

McSweeney, B. (2001) ‘Narratives and numbers: from acontextual to contextualized financial analysis’, Accounting Forum, Vol.25, No.3, pp. 246-263.

Wernerfelt, B. (1984) ‘A Resource-Based View of the Firm’, Strategic Management Journal, 5: 171-180.

原文链接:Financial Analysis