FINANCIAL STATEMENT ANALYSIS: A TOOL FOR PERFORMANCE EVALUATION

financial statement analysis_2

A Case Study of Oceanic Bank

By IBRAHIM UMAR PGA/09/07766

M.Sc Assignment

Submitted to

Dr M.I Kida CNA

Department of AccountancyUniversity of Maiduguri

Jan 2010

Financial statements are prepared to meet external reporting obligations and also for decision making purposes They play a dominant role in setting the framework of managerial decisions But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital , common size percentages, trend analysis and ratios analysis.

This study intends to analyze financial statement of Oceanic bank in Nigeria in order to come up with an in-depth fact finding on its performance and to see if there is any connection between the recent global economic crisis and its overall performance

INTRODUCTION1.1 Background

Financial statement represents crucial information to various users who have interest in a diverse field All financial statements are essentially historically historical documents They tell what has happened during a particular period of time However most users of financial statements are concerned about what will happen in the future Stockholders are concerned with future earnings and dividends Creditors are concerned with the company's future ability to repay its debts Managers are concerned with the company's ability to finance future expansion

Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account (Pandy, 2003)

Although financial statement analysis is a highly useful tool, it has two limitations These two limitations involve the comparability of financial data between companies and the need to look beyond ratios

Comparison of one company with another can provide valuable clues about the financial health of an organization (Remi, 2006) Unfortunately, differences in accounting methods between companies sometime make it difficult to compare the companies' financial data For example if one company values its inventories

by the LIFO method and another firm by average cost method, then direct

comparisons of financial data such as inventory valuations and cost of goods sold between the two firms may be misleading Some times enough data are presented in foot notes to the financial statements to restate data to a comparable basis Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.

1.2 RESEARCH PROBLEM

Financial statement represents crucial information to various users who have interest in a diverse field Comparison of one company with another can provide valuable clues about the financial health of an organization but unfortunately, differences in accounting methods between companies sometime make it difficult

to compare the companies' financial data

The needs of financial accounting information users are diverse that they find it difficult to understand the information contained in the statement so presented

by the organization and as such there is need to analyze the statement into meaningful form for decision making and performance evaluation

1.3 OBJECTIVES OF THE STUDY

Analysis of banks through financial statements is more difficult than other type of companies due to the innovation of new and complex financial instruments One

of the indicators of bank`s performance is the behavior of their stock prices because it reflects the market’s evaluation of the bank’s performance which is also used as part of performance evaluation Moreover, financial management theories provide many indicators for assessing a bank’s performance

The main purpose of this research is to analyze the financial statements of the bank and its development over time as reflected in its reports during three years from 2004 to 2008

The study, in addition, has the following specific objectives:

I the study intends to analyze financial statement to measure performance over time,

II link any relationship between the bank’s performance and the recent economic crisis,

III predict future prospects of the bank

1.4 RESEARCH QUESTIONS

The recent economic crisis and non performing loans cases in the Nigerian commercial banks have raised question which necessitated this research undertaking The study intends to answer the following questions:

1 Are the Nigerian commercial banks performing well?

2 What are the overall performance indices of the Nigerian commercial banks?

3 Are the financial reports understandable to the external users?

4 What are the limitations attributable to financial statement analysis of the banks?

1.4 SIGNIFICANCE OF THE STUDY

The study will provide investors with enough ideas to decide about the investment of their funds in specific banks in Nigeria Regulatory authorities (e.g IASB) can assess whether banks are following the accounting standard or not, government agencies will gain from the research to analyze taxation due from banks It will also aid the selected bank in evaluating its performance over time and it will be a guide for future research

1.5 SCOPE AND LIMITATION

This study will analyze only Oceanic banks` performance from 2004 to 2008 However, there are some reasons for choice of only one bank for the study; the

time frame for the research work is too short to obtain data from more banks The purpose is neither to investigate how the banks evaluate financial instruments to report in their financial statements nor to review the banking regulations and the governance systems Author will focus only on the financial data available in financial reports Another delimiting factor is that the researcher has to only rely

on the financial reports provided by the banks on their websites because insight information is not accessible Financial constraints are also obstacle to a wider study

LITERATURE REVIEW2.1 INTRODUCTION

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account (Pandy, 2003)

Financial statements are prepared to meet external reporting obligations and also for decision making purposes They play a dominant role in setting the framework

of managerial decisions But the information provided in the financial statements

is not an end in itself as no meaningful conclusions can be drawn from these statements alone However, the information provided in the financial statements

is of immense use in making decisions through analysis and interpretation of financial statements (James C 2002)

Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios.2.2 TOOLS AND TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

Following are the most important tools and techniques of financial statement analysis (Remi A 2006):

1 Horizontal and Vertical Analysis

2 Ratios Analysis

2.3 HORIZONTAL ANALYSIS OR TREND ANALYSIS

Comparison of two or more year's financial data is known as horizontal analysis,

or trend analysis Horizontal analysis is facilitated by showing changes between years in both Naira and percentage form (Pandy 2003) Showing changes in Naira form helps the analyst focus on key factors that have affected profitability

or financial position Showing changes between years in percentage form helps the analyst to gain perspective and to gain a feel for the significance of the changes that are taking place For example a N1 million increase in sales is much more significant if the prior year's sales were N 2 million than if the prior year's sales were N 20 million In the first situation, the increase would be 50% that is undoubtedly a significant increase for any firm In the second situation, the increase would be 5% that is just a reflection of normal progress

2.3.1 Trend Percentage

Horizontal analysis of financial statements can also be carried out by computing

trend percentages Trend percentage states several years' financial data in terms

of a base year The base year equals 100%, with all other years stated in some percentage of this base (Remi O 2006) The trend analysis is particularly striking when the data are plotted

2.3.2 Vertical Analysis

Vertical analysis is the procedure of preparing and presenting common size statements According Pandy (2004), common size statement is one that shows the items appearing on it in percentage form as well as in monetary form Each item is stated as a percentage of some total of which that item is a part Key financial changes and trends can be highlighted by the use of common size statements Common size statements are particularly useful when comparing data from different companies

One application of the vertical analysis idea is to state the separate assets of a company as percentages of total sales

The main advantages of analyzing a balance sheet in this manner are that the balance sheets of businesses of all sizes can easily be compared It also makes

it easy to see relative annual changes in one business (Helfert E 1997)

Another application of the vertical analysis idea is to place all items on the income statement in percentage form in terms of sales

By placing all items on the income statement in common size in terms of sales, it

is possible to see at a glance how each Naira of sales is distributed among the various costs, expenses, and profits And by placing successive years' statements side by side, it is easy to spot interesting trends Managers and investment analysis often pay close attention to the gross margin percentage since it is considered a broad gauge of profitability The gross margin percentage

is computed by the following formula (Oye A 2005):

[Gross margin percentage = Gross margin / Sales]

The gross margin percentage tends to be more stable for retailing companies than for other service companies and for manufacturers Since the cost of goods sold in retailing exclude fixed costs When fixed costs are included in the cost of goods sold figure, the gross margin percentage tends to increase or decrease with sales volume The fixed costs are spread across more units and the gross margin percentage improves

While a higher gross margin percentage is considered to be better than a lower gross margin percentage, there are exceptions Some companies purposely choose a strategy emphasizing low prices and (hence low gross margin) An increasing gross margin in such a company might be a sign that the company's strategy is not being effectively implemented

Common size statements are also very helpful in pointing out efficiencies and inefficiencies that might other wise go unnoticed

2.4 RATIOS ANALYSIS

A ratio simply means one number expressed in terms of another A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured (Pandy 2003)

The term "accounting ratios" is used to describe significant relationship between figures shown on a balance sheet, in a profit and loss account, in a budgetary

control system or in any other part of accounting organization Accounting ratios

thus shows the relationship between accounting data (Helfert E 1997)

Ratios can be found out by dividing one number by another number Ratios show how one number is related to another It may be expressed in the form of co-efficient, percentage, proportion, or rate (Oye A 2005) For example the current assets and current liabilities of a business on a particular date are N200, 000 and N100, 000 respectively The ratio of current assets and current liabilities could be expressed as 2 (i.e 200,000 / 100,000) or 200 percent or it can be expressed as 2:1 i.e., the current assets are two times the current liabilities Ratio sometimes is expressed in the form of rate For instance, the ratio between two numerical facts, usually over a period of time, e.g stock turnover is three times a year (Remi A 2006)

The ratios analysis is the most powerful tool of financial statement analysis Ratio simply means one number expressed in terms of another A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured Ratios can be found out by dividing one number by another number Ratios show how one number is related to another

Ratio is an indicated quotient of two mathematical expressions According to Pandy (2004), it is a benchmark for evaluating the financial position and performance of a firm Financial or accounting ration is the formula for analyzing financial data used to measure solvency, efficiency or profitability of a company

on the basis of its published financial data (Encarta, 2007)

2.4.1 CLASSIFICATION OF ACCOUNTING RATIOS

Ratios may be classified in a number of ways to suit any particular purpose Different kinds of ratios are selected for different types of situations Mostly, the purpose for which the ratios are used and the kind of data available determine the nature of analysis The various accounting ratios can be classified as follows:Classification of Accounting Ratios / Financial Ratios

(A)

Traditional Classification or

Statement Ratios

(B)Functional Classification

or Classification According to Tests

(C)Significance Ratios or Ratios According to Importance

• Profit and loss