FINANCIAL STATEMENTS ANALYSIS

GENERAL DEFINITIONS AND CONCEPTS OF FINANCIAL STATEMENTS

ANALYSIS
Analysts are employed in a number of functional areas. Commonly, analysts evaluate an
investment in some type of security that has characteristics of equity (representing an ownership
position) or debt (representing a lending position). In arriving at investment decisions or
recommendations, analysts need to evaluate the performance, financial position, and value of the
company issuing the securities.
Company financial reports, which include financial statements and other data, provide the
information necessary to evaluate the company and its securities. Consequently, the analyst must
have a firm understanding of the information provided in each company’s financial reports,
including the financial notes and other forms of supplementary information.

The term financial analysis is also known as the analysis and interpretation of financial
statements. It refers to the process of determining financial strengths and weaknesses of the firm
by establishing strategic relationship between the items of the balance sheet, profit and loss
account and other operative data.
It’s also a process of evaluating the relationship between component parts of a financial
statement to obtain a better understanding of a firm’s position and performance.

SCOPE OF FINANCIAL STATEMENT ANALYSIS

The role of financial reporting by companies is to provide information about their performance,
financial position, and changes in financial position that is useful to a wide range of users in
making economic decisions. The role of financial statement analysis is to take financial reports
prepared by companies, combined with other information, to evaluate the past, current, and
prospective performance and financial position of a company for the purpose of making
investment, credit, and other economic decisions.
In evaluating financial reports, analysts typically have an economic decision in mind.
Examples include the following:
❖ Evaluating an equity investment for inclusion in a portfolio.
❖ Evaluating a merger or acquisition candidate.
❖ Evaluating subsidiaries or operating divisions of a parent co.
❖ Deciding whether to make a venture capital or other private equity investment.
❖ Determining the creditworthiness of a co that has made a loan request.
❖ Extending credit to a customer.
❖ Examining compliance with debt covenants or other contractual arrangements.
❖ Assigning a debt rating to a co or bond issue.
❖ Valuing a security for making an investment recommendation to others.
❖ Forecasting future net income and cash flow.

In general, analysts seek to examine the performance and financial position of companies as
well as forecast future performance and financial position. Analysts are also concerned about
factors that affect risks to the company’s future performance and financial position. An
examination of performance can include an assessment of a company’s profitability (the ability
to earn a profit from delivering goods and services) and its cash flow – generating ability (the
ability to produce cash receipts in excess of cash disbursements). Profit and cash flow are not
equivalent. Profit represents the excess of the prices at which goods or services are sold over all
the costs of providing those goods and services (regardless of when cash is received or paid).
Example below illustrates the distinction between profit and cash flow.
Sennett Designs (SD) sells imported furniture on a retail basis. SD began operations during
December 2006 and sold furniture for cash of €250,000. The furniture that was sold by SD was
delivered by the supplier during December, but the supplier has granted SD credit terms,
according to which payment is not due until January 2007. SD is obligated to pay €220,000 in
January for the furniture it sold during December.
1. How much is SD’s profit for December 2006 if no other transactions occurred?
2. How much is SD’s cash flow for December 2006?
Solution to 1. SD’s profit for December 2006 is the excess of the sales price (€250,000) over the
cost of the goods that were sold (€220,000), or €30,000.
Solution to 2. The December 2006 cash flow is €250,000

Although profitability is important, so is the ability to generate positive cash flow. Cash flow is
important because, ultimately, cash is needed to pay employees, suppliers, and others to continue
as a going concern. A company that generates positive cash flow from operations has more
flexibility in funding needed investments and taking advantage of attractive business
opportunities than an otherwise comparable company without positive cash flow. Additionally,
cash flow is the source of returns to providers of capital. Therefore, the expected magnitude of
future cash flows is important in valuing corporate securities and in determining the company ’ s
ability to meet its obligations. The ability to meet short - term obligations is generally referred to
as liquidity , and the ability to meet long - term obligations is generally referred to as solvency.
MAJOR FINANCIAL STATEMENTS AND OTHER INFORMATION SOURCES
Think of financial statements as consisting of certain pieces of important information about the
firm's operations that are reported in the form of (1) an income statement, (2) a balance sheet,
and (3) a cash flow statement.

The income statement

The income statement presents information on the financial results of a company’s business
activities over a period of time. The income statement communicates how much revenue the
company generated during a period and what costs it incurred in connection with generating that
revenue. Net income (revenue minus all costs) on the income statement is often referred to as the
“bottom line” because of its proximity to the bottom of the income statement.
Income statements are reported on a consolidated basis, meaning that they include the revenues
and expenses of affiliated companies under the control of the parent (reporting) company. The
income statement is sometimes referred to as a statement of operations or profit and loss (P & L)
statement. The basic equation underlying the income statement is Revenue – Expenses = Net
income.

Balance Sheet
The balance sheet (also known as the statement of financial position or statement of financial
condition ) presents a company’s current financial position by disclosing resources the company
controls (assets) and what it owes (liabilities) at a specific point in time. Owners ’equity
represents the excess of assets over liabilities. This amount is attributable to the owners or
shareholders of the business; it is the residual interest in the assets of an entity after deducting its
liabilities. The three parts of the balance sheet are formulated in an accounting relationship
known as the accounting equation: Assets = Liabilities + Owners’ equity (that is, the total
amount for assets must balance to the combined total amounts for liabilities and owners’ equity).

Cash Flow Statement

Although the income statement and balance sheet provide a measure of a company’s success in
terms of performance and financial position, cash flow is also vital to a company’s long-term
success. Disclosing the sources and uses of cash helps creditors, investors, and other statement
users evaluate the company’s liquidity, solvency, and financial flexibility. Financial flexibility
is the ability to react and adapt to financial adversities and opportunities.
The cash flow statement classifies all company cash flows into operating, investing, and
financing activity cash flows. Operating activities involve transactions that enter into the
determination of net income and are primarily activities that comprise the day - to - day business
functions of a company. Investing activities are those activities associated with the acquisition
and disposal of long - term assets, such as equipment. Financing activities are those activities
related to obtaining or repaying capital to be used in the business.
Statement of Changes in Owners’ Equity
The income statement, balance sheet, and cash flow statements represent the primary financial
statements used to assess a company’s performance and financial position. A fourth financial
statement is also available, variously called a “statement of changes in owners’ equity,”
“statement of shareholders’ equity,” or “statement of retained earnings.” This statement
primarily serves to report changes in the owners’ investment in the business over time and assists
the analyst in understanding the changes in financial position reflected on the balance sheet.

Financial Notes and Supplementary Schedules

Financial notes and supplementary schedules are an integral part of the financial statements. By
way of example, the financial notes and supplemental schedules provide explanatory information
about the following:
❖ Business acquisitions and disposals
❖ Commitments and contingencies
❖ Legal proceedings
❖ Stock option and other employee benefit plans
❖ Related - party transactions
❖ Significant customers
❖ Subsequent events
❖ Business and geographic segments
❖ Quarterly financial data

Additionally, the footnotes contain information about the methods and assumptions used to
prepare the financial statements. Comparability of financial statements is a critical requirement
for objective financial analysis. Financial statement comparability occurs when information is
measured and reported in a similar manner over time and for different companies. Comparability
allows the analyst to identify and analyze the real economic substance differences and
similarities between companies.
GENERAL DEFINITIONS AND CONCEPTS OF FINANCIAL STATEMENTS
ANALYSIS
FINANCIAL STATEMENT ANALYSIS - COMPANY’S FINANCIAL PERFORMANCE
OBJECTIVES.

Interested Parties:
We have two interested groups that’s;
❖ The top Management of the company, middle level managers, and lower level
employees.
❖ Creditors and investors as well as customers.
Expectation for Both groups in terms of underlying concepts:
a) Relevance: Is the information capable of making a difference in the decisions made by the
users. Financial information is capable of making a difference in decisions if it has a predictive
value, confirmatory value or both.
b) Predictive value: Financial information has a predictive value if it can be used as an input to
process the processes employed by users to predict future outcomes i.e. the information can be
used to predict future outcomes.
c) Comparability: This enables users to identify and understand similarities and differences
among items in the financial statements.
d) Timeliness: Having Information available to decision makers in time to influence their
decisions. Thus this confirms relevance.

Analysis objectives:
Managers, creditors, and investors want measures that relate to the following objectives:

❖ Profitability.
❖ Total Asset Management:
❖ Liquidity
❖ Financial Risk: Effective use of debt and shareholders investments. Predictability of future
profitability and liquidity
❖ Operating asset Management: (total revenue growth and minimizing investments).
Standards of comparison:
Rule of thumb measures: A company’s past performance, and Industry norm.
Rule of Thumb measures:
E.g. Use of key financial ratios – Current ratios: 2:1 or higher is more desirable. Current
Liabilities to Net worth ratio
Past Performance: Comparing financial measures or ratios of the same company over time with
that of other companies.
Industry norms: shows how a company compares with other companies in the same industry.
E.g. industry average rate of return on investment.

Search about the limitations for the above rule of thumb measures.

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING:

The conceptual framework sets out a comprehensive set of concepts for financial reporting,
standard setting, guidance for preparers of financial reports and interpreting the standards of the
financial statements.
The conceptual framework for financial reporting describes the objective of and the concepts for
general purpose financial reporting.
A conceptual framework is a statement of generally accepted theoretical principles which form
the frame of reference for financial reporting.
It provides a basis for the development of new accounting standards and the evaluation of those
already existing.
It also provides information that is useful in the business and economic decision making process.
It determines which events should be accounted for, how they should be measured, and how they
should be communicated to the user.
Advantages of a conceptual framework:
a) Standards/rules are built on the foundation of sound, agreed principles hence avoiding
haphazard and firefighting approach.
b) Fundamental principles/concepts such as prudence, matching concepts are tackled in a
more consistent manner,
c) Avoidance of a financial reporting environment governed by specific rules but rather by
general principles.
d) It bolsters standard setters against political pressure from various lobby groups and
interested parties.
e) Some standards may concentrate on profit or loss and other comprehensive income or
statements of financial position, as appropriate.
Disadvantages
a) It is not certain that a single conceptual framework can be devised which will suit all
users.
b) Given the diversity of user requirements, there may be a need for a variety of accounting
standards each produced for a different purpose and with different concepts as a basis.
c) It is not clear that a conceptual framework makes the task of preparing and then
implementing standards any easier than without a framework.
d) Another disadvantage of following this concept is the conflict that may arise between the
framework and the accounting standards that were already in use before the conceptual
framework was introduced. The conflict can arise due to the difference in the practices
prescribed by the preceding accounting standards and the latest conceptual framework.
The already established standards occasionally differ from the fundamental principles of
conceptual framework and thus, the conflict.
e) There is another limitation with following the conceptual framework. It is possible that
the opportunity offered by the framework is not acceptable to all the parties. The
framework may be beneficial to only some interested group of individuals who are
recognized as users. On the contrary, the framework may present some opportunities that
are not acceptable to other parties. Therefore, the same framework may not work for all
the parties alike.

PURPOSE OF THE CONCEPTUAL FRAMEWORK

● Assist the international accounting standards Board to develop IFRS standards that are
based on consistent concepts.
● Assist preparers to develop consistent accounting policies when no standard applies to a
particular transaction or other event, or when a standard allows a choice of accounting
policy
● Assist all parties to understand and interpret the standards.
● It assists users of financial information in interpreting financial statements prepared in
compliance with the standards.
● It assists in preparation of financial statements.
● It's important to auditors in forming an opinion on whether the financial statements
comply with the standards.
SCOPE OF THE CONCEPTUAL FRAMEWORK

1) THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING:

The objective of financial reporting is to provide financial information about the reporting entity
that is useful to existing and potential investors, lenders, and other creditors in making decisions
relating to providing Resources to the entity. Those decisions involve decisions about:
● Buying, selling or holding equity and debt instruments.
● Providing or setting loans and other forms of credit.
● Exercising rights to vote on or otherwise influence management's actions that affect the
use of the entity's economic resources.

2) THE UNDERLYING ASSUMPTION UNDER THE CONCEPTUAL FRAMEWORK

FOR FINANCIAL REPORTING
The assumption under the conceptual framework for financial reporting to achieve the above
objective is the going concern.
The going concern assumes that when preparing accounts, the Business will continue to operate
in the same manner for the foreseeable future.
Financial statements are normally prepared on the assumption that the reporting entity is a going
concern and will continue in Operation for the foreseeable future.
Hence it's assumed that the business concern has neither the intention nor the need to enter
liquidation or to cease trading. If such an intention or need exists, the financial statements may
have to be prepared on a different basis. If so, the financial statements describe the basis used.

3) QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

If financial information is to be useful, it must be relevant and faithfully represent what it
purports to represent.
The usefulness of Financial Information is enhanced if it's comparable, verifiable, timely, and
understandable.

Fundamental qualitative characteristics

The fundamental qualitative characteristics are relevance and faithful representation.

Relevance
Information is relevant if it is capable of making a difference in the decisions made by the users.
Information could be capable of making a difference in a decision even if some users choose not
to take advantage of it or are already aware of it from other sources.
Financial information is capable of making a difference in decisions if it has a predictive value,
confirmatory value or both.
Financial information has a predictive value if it can be used as an input to process to processes
employed by users to predict future outcomes.
Financial information has a confirmatory value if it Provides feedback about (confirms or
changes) previous evaluations.

Faithful representation
For information to be faithfully presented it must be complete, neutral and free from error i.e. it
should not be biased.

Enhancing qualitative characteristics

Comparability, verifiability, timeliness, and understandability are the Qualitative characteristics
that enhance the usefulness of Information that both is relevant and provides a faithful
representation of what it purports to represent.
Comparability: This enables users to identify and understand similarities and differences among
items in the financial statements.
Verifiability: This helps users to ensure that information is faithfully represented.
Two knowledgeable and independent observers can look at the financial statements and all come
up with a similar Conclusion or final consensus. This confirms the faithfully presented
information.
Timeliness: Having Information available to decision makers in time to influence their
decisions. Thus this confirms relevance.
Understandability: Information is easy to be understood by the users.

4) ELEMENTS OF FINANCIAL STATEMENTS

The elements of the financial statements defined in the conceptual framework are:
● Assets, liabilities and equity, which relate to a reporting entity's Financial position, and;
● Incomes and expenses which relate to a reporting entity's Financial Performance.

Asset
Is the present Economic resource controlled by the entity as a result of past events.
An Economic resource is a right that has the potential to produce economic benefits.
Thus this discusses three aspects i.e.
● Right.
● Potential to produce economic benefits, and;
● Control.

Liabilities
Is the present obligation of the entity to transfer an Economic resource as a result of past events.
For a liability to exist, three criteria must all be satisfied i.e.:
● The entity has an obligation.
● The obligation is to transfer an Economic resource.
● The obligation is a present obligation that exists as a result of past events.
Note: An obligation is a duty or responsibility that an entity has no practical ability to avoid.

Equity:
This is the residue interest in the assets of the entity after deducting all its liabilities i.e. E = A - L

Incomes:
Means an increase in the assets or a decrease in the liabilities that result in the increase in equity
other than those relating to contributions from equity holders.
The Contributions from equity holders are not incomes but rather that's Capital.

Expenses:
Means a decrease in the assets or an increase in the liabilities that result in a decrease in equity
other than those relating to distributions to equity holders (drawings)

5) RECOGNITION OF ELEMENTS OF FINANCIAL STATEMENTS

Is the process of capturing for inclusion in the statement of financial position or the statement of
Financial Performance an item that meets the definition of one of the elements of financial
statements (an asset, liabilities, equity, income, and expenses)
For these items to be recognized, the following criteria are to be followed:
● It's probable that any future Economic benefits associated with the item will flow to or
from the entity.
● The item's costs or values can be measured reliably

6) DERECOGNITION OF THE ELEMENTS OF THE FINANCIAL STATEMENTS

Is the removal of all or part of a recognized asset or liability from the entity's statement of
financial position.
De-recognition occurs when that item no longer meets the definition of an asset or of a liability.
● For an asset, de-recognition occurs when the Business concern loses control of all or part
of the recognized asset.
● For a liability, de-recognition occurs when the entity no longer has a present obligation
for all or part of the recognized liability.

7) MEASUREMENT OF ELEMENTS OF FINANCIAL STATEMENTS.

Is the process of determining the monetary amounts at which the elements of financial statements
are to be recognized and carried in the statement of financial position and the statement of
comprehensive incomes.

Measurement bases
A historical cost: Is a measure of value used in accounting in which the value of an asset on the
balance sheet is recorded at its original cost when acquired by the entity.
A Current cost: Is the cost that would be required to replace an asset in the current period. It's
the price of the item now in the market.
Fair value: Is a broad measure of an asset's worth and is not the same as market value, which
refers to the price of an asset in the marketplace. In accounting, fair value is a reference to the
estimated worth of a Company's assets and liabilities that are listed on a Company's financial
statement.
Present value: Is the Current worth of the future sum of the cash flows given a specified rate of
return.
Replacement cost: If one is to replace an item, how much will it cost to replace it is what is
depicted under replacement cost.
8) CONCEPT OF CAPITAL AND CAPITAL MAINTENANCE
We maintain capital either by looking at the financial Capital maintenance and the physical
capital maintenance.
● Financial capital maintenance: under this concept, a profit is earned only if the financial
(or money) amount of the net assets at the end of the period exceeds the financial (or
money) amount of the net assets at the beginning of the period after excluding any
distributions to and Contributions from owners during the period.
● Physical Capital maintenance: under this concept, a profit is earned only if the physical
productive capacity (or operating capability) of the entity at the end of the period exceeds
the physical productive capacity at the beginning of the period after excluding any
distributions to and Contributions from owners during the period.

REVIEW OF THE FINANCIAL REPORTING REGULATORY REQUIREMENTS.

Financial Regulatory framework
a) Ensures Relevance & Faithful presentation of financial Information.
b) Facilitates Compliance enforcement with GAAP.
c) Facilitates Harmonization (users and preparers of financial statements). International &
National comparison easily made.

Benefits to Multinationals
● Access to foreign investor funds
● Improved Management control
● Eases Appraisals for takeovers and mergers
● Eases compliance with overseas stock exchanges Requirements
● Eases Preparation of group accounts
● A reduction in audit costs
● Effective usage of accounting staff
● Time and money is saved
● Control activities of foreign multinational companies
● Eases Tax computations
● Enhancement of regional economic group’s activities
● Eases work for Accounting /Auditing.

Barriers of the regulatory framework of financial reporting

❖ Different purposes of financial reporting.
❖ Different legal systems
❖ Different user groups
❖ Needs of developing countries.
 ❖ Nationalism
❖ Cultural differences
❖ Unique circumstances
❖ Absence of strong accountancy

REGULATORY FRAMEWORK FOR ACCOUNTING: (ACCOUNTING RULES)

Having looked at the conceptual framework of financial reporting, qualitative characteristics, and
so forth, we now have to summarize a number of rules that underlie accounting practice.
Accounting rules are imposed on accountants in order to make sure that their reporting is free
from bias. Accounting legislation requires financial accounts be prepared and presented in
conformity with GAAP (generally Accepted Accounting Principles). GAAP refers to accounting
principles or practices that are regarded as permissible by the accounting profession. It includes
requirements of the Co. acts, stock exchange etc.

Accounting principles
Also known as accounting concepts, conventions or postulates, are basic ground rules which
must be followed when financial accounts are being prepared and presented. They are also
referred to as assumptions or prepositions that underlie the preparation and presentation of
financial reports. Most of these have already been discussed earlier.

Accounting bases
These are methods developed for applying fundamental concepts to financial transactions and
items for the purpose of final accounts and in particular:
● For determining the accounting periods in which revenue and costs should be recognized
in the profit and loss account.
● For determining the amounts at which material items should be stated in the balance
sheet.

Accounting policies
These are the specific accounting bases selected and consistently followed by a business
enterprise as being in the opinion of management, appropriate to its circumstances and best
suited to present fairly its results and financial position.

Accounting standards
These are guideline statements or rules issued by professional accounting bodies governing
accounting practice, relating to how accounts should be prepared and presented.
INSTITUTIONAL FRAMEWORK FOR FINANCIAL REPORTING IN UGANDA
Introduction
The American Accounting Association (AAA) defined Accounting as the process of identifying,
measuring, and communicating economic information to permit informed judgments and
decisions of users of the information. Accounting is viewed not as an end in itself but a language
that is useful in decision making. This implies that; the continued existence of Accounting is
dependent on its usefulness to the society and users of accounting information in their decision
making process.
The published financial statements prepared by directors of limited liability companies remain
the primary means of informing shareholders and other users about the financial performance,
progress and position of the business. The quality of decisions that users of accounting
information make is largely dependent on the quality of information available to them. This
therefore implies that for accounting information to be of acceptable quality, it must meet some
established standards and principles released by the various institutional frameworks regulating
the preparation and reporting of such information. This therefore seeks to discuss the institutional
framework for financial reporting in Uganda.
Overview of International Financial Reporting Standards (IFRS)
International Financial Reporting Standards (IFRS) are a set of international accounting
standards stating how particular types of transactions and other events should be reported in
financial statements.
IFRS are issued by the International Accounting Standards Board, and they specify exactly how
accountants must maintain and report their accounts.
IFRS were established in order to have a common accounting language, so business and accounts
can be understood from Co. to Co. and country to country.

Institutional framework for financial reporting in Uganda

In accordance with the Accountants Act 2013, the Institute of Certified Public Accountants of
Uganda determines private sector accounting standards in Uganda. Since 1998, the institute has
adopted IFRS without modifications for the preparation of financial statements, and the
standards become effective in Uganda on the effective dates prescribed by the IASB.
All listed entities, banks, insurance companies, and publicly accountable entities are required to
apply IFRS. Companies that are not required to use IFRS are permitted to use IFRS or IFRS for
SMEs, which the institute has also adopted.

Conclusion
All in All, we conclude that a regulatory framework for the preparation of financial statements is
necessary for a number of reasons i.e.:
 ● To ensure that the needs of the users of financial statements are met with at least a basic
minimum of information.
● To ensure that all the information provided in the relevant economic arena is both
comparable and consistent.
● To increase users' confidence in the financial reporting process.
● To regulate the behavior of companies and directors towards their investors. Also as
mentioned before the IFRS were established in order to have a common accounting
language, so business and accounts can be understood from Co. to Co. and country to
country. Therefore it is necessary that the statutory framework that guides the preparation
of the financial information be strengthened and harmonized to ensure that the adoption
of the IFRS framework for financial reporting is not just nominal but real.
Note: The ICPAU is the official accountancy standard-setting body in Uganda. The ICPAU is
mandated by the Accountants Act, 2013, to: regulate and maintain the standards of accountancy
in Uganda; and to prescribe and regulate the conduct of accountants and practicing accountants
in Uganda.

NECESSITY AND FOCUS OF FINANCIAL STATEMENTS ANALYSIS

Financial statement analysis is used to identify the trends and relationships between financial
statement items. Both internal management and external users (such as analysts, creditors, and
investors) of the financial statements need to evaluate a company's profitability, liquidity, and
solvency. The most common methods used for financial statement analysis are trend analysis,
common‐size statements, and ratio analysis. These methods include calculations and
comparisons of the results to historical company data, competitors, or industry averages to
determine the relative strength and performance of the company being analyzed.
The focus of financial statement analysis is to evaluate the financial strength and
performance of a company so that important decisions can be made.
Financial analysis refers to the application of analytical tools of a company's financial statements
to understand the financial health of a business for a given period of time.

It's the assessment of strengths and weaknesses in the financial position of a business and the
operating performance for a given period.

Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or
profitable in comparison to the industry standards or past performance. it assesses two main
features/characteristics of an organization which include:
● Operating performance of the firm over a given period of time, and;
● Financial position of the firm as at a given period of time
The analysis is concerned with assessing the impact of financial decisions such as capital
budgeting, financing, working capital management and earnings management decisions on
operating performance and financial position of the business.

The main purpose of financial analysis is to provide information to various stakeholders to

aid in making informed business decisions. These decisions could be to invest in a company,
to lend funds to the co; to SS goods on credit to the company, to advocate for a pay rise/bonus
among others financial planning.

Financial planning on the other hand refers to the process of compiling and analyzing the future
financial courses of action for a given period of time. It’s concerned with the preparation of
forecasted statements and budgets, which indicate the future financial needs and position of the
business.

Users of financial analysis information:

1) Suppliers and trade creditors: these are interested in information that will help them
determine whether the amounts owing to them will be paid on time (profitability and liquidity)

2) lenders/banks: lenders want information that will enable them to decide whether their loans
will be paid when due, and whether or not to issue new loans to the firm (liquidity, leverage,
long term solvency)

3) Investors/potential investors: those SS risk capital in the form of funding, this group are
concerned with the risk inherent in, and the return provided by their investments (operating
efficiency, market valuation, profitability).

4) Customers: customers will be interested in the continuance of the firm, especially if they
depend on it themselves (efficiency)

5) Employees: employees may wish to know about the stability and profitability of their
employers. This will give them confidence about their job security and could be used to discuss
salary and conditions of employment (profitability, liquidity and solvency).

6) Management: these are tasked with overseeing the operation of their firm and are interested
in establishing the general performance of the firm (all the ratios)

7) The government and government agencies: Government normally monitors the

operation/activities of the companies and is also interested in the level of profitability of the firm
for tax assessment purposes.

8) The general public: these will be affected by a firm in a number of different ways, especially
how a firm can contribute to the local economy.
Nature of financial analysis
Financial analysis is presented in terms of percentages, ratios, and in relative values. it is
based on the information obtained from the financial statements.

The information generated helps to predict, compare, evaluate, and analyze the financial position
of the firm as well as its operating performance.

It’s important to note that the preparation of financial statements is in itself not enough because
they indicate results in absolute terms e.g. current assets = 500,000,000, current liabilities =
350,000,0000 not indicating whether these figures are low or high.

Information obtained from financial statements must be analyzed to provide a basis for decision
making and planning. This can be done using the various tools of financial analysis so as to
obtain meaningful information.

Let’s assume that firm A generates profit after tax of shs. 300,000,000 after investing total
capital worth shs.800,000,000 and firm B generates shs.700,000,000 after investing total capital
worth shs.2,000,000,000.
by computing return on capital employed;

Firm A
ROCE = (300,000,000 ÷ 800,000,000)
ROCE = 37.5%

Firm B
ROCE = (700,000,000 ÷ 2,000,000,000)
ROCE = 35%

In summary:
In absolute terms, firm b is performing much better than firm a based on profit after tax
generated but based on return on capital employed, firm a is better performing business.

TOPIC 2: STEWARDSHIP AND THE ROLE OF MANAGERS

Stewardship imposes a responsibility to the management of an organization for effective
control.
The basic purpose of accounting is to act as a steward to the company owners and other
interested parties in a business.
IASB requires assessing the Stewardship role of manager in the current conceptual framework
(general purpose of financial reporting)

HOW IS STEWARDSHIP HELP IN DECISION MAKING?

 • Stewardship influences the organization to conduct audit of their financial
statements by an independent auditor.
• Stewardship helps in accurate valuation of a company by recording and providing
accurate information to the decision makers.
• It protects the interest of all related parties to the business by disclosing right
information to the right parties.
• Stewardship helps to fulfil the regulator body’s requirements.
• It highlights the responsibility not only the management but also other stakeholders
(regulators, investors and credit providers etc.)
• It facilitates accurate recording & disclosure of financial information

TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS

These include;
• Horizontal analysis,
• Trend analysis,
• Vertical analysis or the common size analysis.
• Ratio analysis

VERTICAL ANALYSIS
Common‐size analysis (also called vertical analysis) expresses each line item on a single year's
financial statement as a percent of one line item, which is referred to as a base amount.
Common - size analysis involves expressing financial data, including entire financial statements,
in relation to a single financial statement item, or base.
Items used most frequently as the bases are total assets or revenue. In essence, common - size
analysis creates a ratio between every financial statement item and the base item.
Expresses each line item of a single year's financial statement as a percent of another identified
line item, which is a reference item. this technique converts each line of financial statement data
to an easily comparable figure measured as a percent i.e. income statement items are stated as a
percent of net sales and balance sheet items are stated as a percent of total assets(or total
liabilities and shareholder's equity)
In other words, a common size income statement is an income statement in which each account
is expressed as a percentage of the value of sales. This type of financial statement can be used to
allow for easy analysis between companies or between time periods of a co.
Common - size analysis (financial statements)
1. Common - Size Analysis of the Balance Sheet
A common - size balance sheet is prepared by dividing each item on the balance sheet by the
same period’s total assets and expressing the results as percentages.
A statement where balance sheet items are expressed in the ratio of each asset to total assets and
the ratio of each liability is expressed in the ratio of total liabilities is called common size
balance sheet.
From the following Balance Sheets of XYZ Ltd. as at 31st March, 2021 and 2020, prepare a
Common-size Balance Sheet
Balance Sheet
As at 31st March, 2021 and 2020

Particulars Not 31 march,2021 31 march,2020

e (shs) (shs)
I. EQUITY AND LIABILITIES
1.Shareholders’ Funds
(a) Share Capital 10,000,000 5,000,000
(b) Reserves and Surplus 2,000,000 3,000,000
2.Non-Current Liabilities
Long-term Borrowings 8,000,000 5,000,000
3.Current Liabilities
Trade Payables 4,000,000 2,000,000
Total 24,000,000 15,000,000
II. ASSETS
1.Non-Current Asset
Fixed Assets - Tangible Assets 15,000,000 10,000,000
2.Current Assets 9,000,000 5,000,000
Cash and Cash Equivalents 24,000,000 15,000,000
Total

Solution
Common-size Balance Sheet of XYZ Ltd.
As at 31st March, 2020 and 2021

Particulars Note Absolute amounts Percentage of

balance sheet total
I. EQUITY AND 2020 (Shs) 2021(Shs) 2020(%) 2021(%)
LIABILITIES
1.Shareholders’ Funds
(a) Share Capital 5,000,000 10,000,000 33.33 41.67
(b) Reserves and Surplus 3,000,000 2,000,000 20.00 8.33
2.Non-Current Liabilities
Long-term Borrowings 5,000,000 8,000,000 33.33 33.33
3.Current Liabilities
Trade Payables 2,000,000 4,000,000 13.33 16.67
Total 15,000,000 24,000,000 100.00 100.00
II. ASSETS
1.Non-Current Asset
Fixed Assets - Tangible 10,000,000 15,000,000 66.67 62.50
Assets
2.Current Assets
Cash and Cash 5,000,000 9,000,000 33.33 37.50
Equivalents
Total 15,000,000 24,000,000 100.00 100.00

Note: % is calculated on the basis of total of equity and liabilities/total assets

% of Share Capital (31st March, 2020) = 5,000,000/15,000,000 = 33.33%
In the same manner, other percentages may be calculated

2. Common - Size Analysis of the Income Statement

A vertical common - size income statement divides each income statement item by revenue, or
sometimes by total assets (especially in the case of financial institutions).
Illustration
Consider company x with the statement of comprehensive income as indicated below and its
associated common size income statement for the year 2004 and 2005.

Normal income Common size

statement income statement
2005 2004 2005 2004
Sales 19,500 14,800 100% 100%
COGS 14,000 9,800 72% 66%
Gross 5,500 5,000 28% 34%
profit
Taxes 2,500 2,000 13% 14%
Total 3,000 3,000 15% 20%
profit

Benefits of vertical analysis

● Simple to implement and easy to understand.
● It helps in comparing the numbers of a Co between different time periods.
● It helps in identifying where the Co has put the resource.
● It helps in understanding the percentage/share of the individual items, and the structural
composition of components.

Drawbacks
● There lacks firm decision owing to a lack of standard percentage or ratio regarding the
components in the financial statements.
● It does not vigilantly follow accounting concepts and conventions.
● It does not help in measuring the liquidity.
● Owing to the lack of consistency in the ratio of the elements, it does not provide a quality
analysis of the financial statements.

HORIZONTAL ANALYSIS
Comparative financial statements show financial information for the current year and the
previous year.
Changes from the previous year to the current year are computed in both currencies-e.g., Shs/$
and percentages.

a) Relative terms
Percentage Change = (Comparative/current year amount - Base year amount) ÷ Base year
amount × 100
Absolute amounts = current year – base year.
b) Absolute terms
For absolute, one can say, the revenues increased from 20,000/= to 30,000/= from 2019 to 2020.
Then for relative, you would say that revenues increased by 50% from 2019 to 2020

Illustration
To illustrate, consider an investor who wishes to determine Company ABC’s performance over
the past year before investing. Assume that ABC reported a net income of $15 million in the base
year, and total earnings of $65 million were retained. The company reported a net income of $25
million and retained total earnings of $67 million in the current year.
From the example above, Company ABC increased its net income and retained earnings over the
year by $10 million and $2 million, respectively. Therefore, the company’s net income grew by:
[($25 million – $15 million) / $15 million] x 100 = 66%
On the other hand, the company’s retained earnings grew by:
[($67 million – $65 million) / $65 million] x 100 = 3.07%

This technique is also referred to as an index analysis; it expresses each item of the financial
statement as a percentage of the same item in a particular base year. This is used to assess the
firm's performance in comparison to the past performance in the particular base year.

Illustration
Consider a firm with the following information; extract a horizontal common size analysis (index
analysis) with 2014 as a base year.

Items 2014(shs.000) 2015(shs000) 2016(shs000)

Sales 80,000 100,000 120,000

Cost of sales 50,000 55,000 60,000

Gross profit 30,000 45,000 60,000

Administration 5,000 6,000 8,000

Interest 10,000 10,000 12,000

Profit before tax 15,000 29,000 40,000

Tax 30% 4,500 8,700 12,000

Profit after tax 10,500 20,300 28,000

Items 2014(shs000) 2015(shs000) 2016(shs000)

Sales 100% 125% 150%

Cost of sales 100% 110% 120%

 Gross profit 100% 150% 200%

Administration 100% 120% 160%

Interest 100% 100% 120%

Profit before tax 100% 193% 267%

Tax 30% 100% 193% 267%

Profit after tax 100% 193% 267%

Benefits
● The key advantage of using horizontal analysis is that it allows for the visual identification of
anomalies from long-running trends.
● By presenting data on a comparative basis, changes in the data are more readily apparent. In
addition, the use of horizontal analysis makes it easier to project trends into the future.
● Yet another advantage of this form of data presentation is when trends can be compared to
those of competitors or industry averages, to see how well an organization’s performance
compares with that of other entities.
● A further advantage is that it requires little skill to spot anomalies in a trend, while other
forms of analysis may require extensive experience to discern whether the numbers in a
presentation are indicative of problems.
● Horizontal analysis can help you compare a company's current financial status to its past
status

Drawbacks
● A common problem with horizontal analysis is that the aggregation of information in the
financial statements may have changed over time, due to ongoing changes in the chart of
accounts, so that revenues, expenses, assets, or liabilities may shift between different
accounts and therefore appear to cause variances when comparing account balances from one
period to the next.
● Horizontal analysis can be misused to report skewed findings. This can happen when the
analyst modifies the number of comparison periods used to make the results appear unusually
good or bad. For example, the current period's profits may appear excellent when only
compared with those of the previous month, but are actually quite poor when compared to the
results for the same month in the preceding year. Consistent use of comparison periods can
mitigate this problem. Also, when an analysis is presented on a repetitive basis over many
reporting periods, any changes in the comparison periods should be disclosed, to make
readers aware of the difference.
Horizontal vs vertical analysis
● Both horizontal and vertical analysis can be used by internal and external stakeholders.
● Both forms of analysis can help you pick out trends and patterns in financial data and
develop strategies.
● Both forms of analysis can help you analyze various financial statements, including
balance sheets and income statements.
However, there are also some differences between the two that are important to understand. The
primary differences between horizontal and vertical analysis include:
● Horizontal analysis is performed horizontally across time periods, while vertical analysis
is performed vertically inside of a column.
● Horizontal analysis represents changes over years or periods, while vertical analysis
represents amounts as percentages of a base figure.
● Horizontal analysis usually examines many reporting periods, while vertical analysis
typically focuses on one reporting period.
● Horizontal analysis can help you compare a company's current financial status to its past
status; while vertical analysis can help you compare one company's financial status to
another's.

TREND ANALYSIS AND INDUSTRY COMPARISON

From ratio analysis, we obtain indicators about the different positions of the business and these
indicators form the basis of decision making. However, these ratios alone don't provide a clear
assessment of the firm's position and performance and therefore trend analysis and industry
comparison have to be considered in making conclusions.

YEAR 2000 2001 2002 2003 2004

current ratio 6.5:1 4:5:1 4:2:1 3.6:1 2.1:1

Trend analysis helps to determine if the firm's position or performance is declining, improving or
stagnant overtime. In addition to trend analysis, you have to compare the firm's ratios with those
of other firms in the same industry to determine if the firm is above average, below average or
same as average.

Benefits
● Trend analysis helps the analyst to make a proper comparison between the two or more firms
over a period of time. It can also be compared with industry average. That is, it helps to
 understand the strength or weakness of a particular firm in comparison with other related
firm in the industry.
● Trend analysis (in terms of percentage) is found to be more effective in comparison with the
absolutes figures/data on the basis of which the management can take the decisions.
● Trend analyses is very useful for comparative analysis of date in order to measure the
financial performances of firm over a period of time and which helps the management to take
decisions for the future i.e. it helps to predict the future.
● Trend analysis helps the analyst/and the management to understand the short-term liquidity
position as well as the long-term solvency position of a firm over the years with the help of
related financial Trend ratios.
● Trend analysis also helps to measure the profitability positions of an enterprise or a firm over
the years with the help of some related financial trend ratios (e.g. Operating Ratio, Net Profit
Ratio, Gross Profit Ratio etc.).

Drawbacks
● It is not so easy to select the base year. Usually, a normal year is taken as the base year. But it
is very difficult to select such a base year for the purpose of ascertaining the trend.
Otherwise, comparison or trend analyses will be of no value.
● It is also very difficult to follow a consistent accounting principle and policy particularly
when the trends of business accounting are constantly changing.
● Analysis of trend percentage is useless at the time of price-level change (i.e. in inflation).
Trends of data which are taken for comparison will present a misleading result.

RATIO ANALYSIS
A ratio analysis shows the relationship that exists between two items on the financial statements.
These items are normally expected to have a relationship e.g. current assets and current
liabilities, debt and equity etc.
Financial ratios indicate relative positions about the status of the business as opposed to financial
statement information which shows absolute figures.

TYPES OF RATIOS:
There are five main types of ratios to be considered:

1) Liquidity ratios: This measures the ability of the firm to meet its short term obligations as
they mature. it relates current assets to current liabilities to establish the level of liquidity of the
firm.

2) Profitability ratios: This ratio measures the ability of the firm to earn returns from its
investments. it relates profits to the various items (sales, total assets, equity) of the financial
statement to establish its level of profitability.

3) Activity/efficiency ratios: these ratios measure the efficiency with which a firm utilizes the
available resources at their disposal in generating returns/sales.
4) Gearing/ leverage ratios: the ratios measure the solvency of the firm and whether it is able to
meet its long term obligations.

5) Investment ratios: the ratios show the potential of the business to generate returns on
investment and the value the market attaches to the firm's shares.

1) LIQUIDITY RATIOS
Is explained by the relationship between the current assets and the current liabilities. There are
two commonly used ratios in determining liquidity of the firm i.e. current ratio and acid test
ratio/quick ratio.

a)Current ratio:
Current ratio = current assets ÷ current liabilities
Current ratio = 400,000,000 ÷ 100,000,000
Current ratio = 4:1

This means that current assets would have to decline by four times before the firm can fail to
meet its short term obligations. Generally, the higher the current ratio, the healthier the liquidity
positions of the firm. A ratio of 2:1 is conveniently recommended but the best ratio is the one
which matches the situation of the business and its nature.

A very high current ratio is undesirable because it indicates an accumulation of current assets
which assets are idle hence earn no return. On the other hand, a low ratio is also undesirable
because it indicates that the firm's liabilities are over weighing the current assets. A suitable ratio
that avoids both extremes should be sought. This requires firms to find out the average ratio of
the industry so that they compare with the firm's ratios.

b) Acid test/quick ratio

This helps to overcome the weaknesses in the current ratio such as the inclusion of slow moving
items (i.e. inventory and slow paying or bad debtors).
Quick assets are those that can be quickly converted into cash with minimum loss.

Acid test ratio = (current assets - (inventories + bad debts)) ÷ current liabilities

Generally a quick ratio of 1:1 is considered appropriate. However it is important to note that an
appropriate ratio depends on the nature of the firm and condition under which it operates.
It is advisable to keep a ratio as much as possible near the industry levels.

2) EFFICIENCY/ACTIVITY RATIOS
These show how efficiently the resources of the firm are being utilized in as far as generation of
sales revenue is concerned.
These ratios use two dimensions to determine the efficiency of usage of the available resources
and these are:
● The turnover rate; this considers the number of times inventories or debtors are
converted into sales.
● The turnover period; this considers the length of time it takes to convert an item of
inventory into sales or debtors into cash.

1) Inventory turnover rate

= cost of sales ÷ average inventory

Average inventory = (opening inventory + closing inventory) ÷ 2

Question
Assume a business has an opening inventory worth 300,000 and a closing inventory amounting
to 200,000 while cost of sales was, 500,000. Compute the inventory turnover rate.
Average inventory = (300,000 + 200,000) ÷ 2
Average inventory = 250,000

Inventory turnover rate = 500,000 ÷ 250,000

Inventory turnover rate = 2 times

This means that the business is able to turn inventory into sales two times in a year. The higher
the number of times inventory is turned into sales, the more efficient the firm is in managing
inventories and the vice versa.

2) Inventory turnover period.

This measures the number of days it takes for a firm to keep inventory in the store before
converting it into sales. The lower the inventory turnover period, the more efficient the firm is in
managing inventory.

Inventory turnover period

= (average inventory ÷ cost of sales) × number of days in the year.

From the previous illustration;

Inventory turnover period = (250,000 ÷ 500,000) × 365 = 183 days

3) Debtors’ turnover rate

This measures the efficiency with which a business is able to turn debtors into cash. it's used to
determine the number of times debtors are converted into cash in a given year.

Debtors’ turnover rate = credit sale ÷ average debtors.

Assuming BBS (u) ltd has debtors amounting to 650,000/= at the beginning of the year, and
810,000/= at the end of the year. Its sales were entirely on credit and the turnover level was
2,190,000/=. Compute the debtors' turnover rate and period for BBS (u) ltd
Solution:
Debtors’ turnover rate = credit sale ÷ average debtors

Average debtors = (opening debtors + closing debtors) ÷ 2

Average debtors = (650,000 + 810,000) ÷ 2
Average debtors = 730,000/=

Debtors’ turnover rate = 2,190,000 ÷ 730,000

Debtors’ turnover rate = 3 times.

This indicates that the business collects cash from its debtors three times in a year. It should be
noted that the higher the number of times debtors are collected, the more efficient it's being
utilized.

4) Debtors’ turnover period.

This is used to measure the number of days/length of time it takes for the business to collect cash
from its debtors

Debtors' turnover period = (average debtors ÷ credit sale) × 365

Using the above illustration:

Debtors’ turnover period = (730,000 ÷ 2,190,000) × 365 = 122 days.

This indicates that the business takes approximately four months before it collects cash from its
debtors. this shows a very lenient credit policy and funds are tied up in debtors for a very long
time.

5) Creditors’ turnover rate

The analysis measures the number of times a business is able to pay its suppliers in a year.

Creditors' turnover rate = credit purchases ÷ average creditors.

Average creditors = (opening creditors + closing creditors) ÷ 2

Assume bib and associates (u) ltd purchases from its supplier on credit, and during the year the
business received credit worth 5,000,000/= its account payable at the beginning of the year was
1,200,000/= and the closing balance amounted to 800,000/=. Compute the creditors’ turnover
rate and period.

Creditors’ turnover rate = credit purchases ÷ average creditors

Average creditors = (opening creditors + closing creditors) ÷ 2

Credit purchases = 5,000,000/=
Average creditors = (1,200,000 + 800,000) ÷ 2
Average creditors = 1,000,000
Creditors’ turnover rate = 5,000,000 ÷ 1,000,000 = 5 times

This shows that bib and associates pays its suppliers five times in the year. It is usually advisable
that a firm should not offer a more generous credit terms than that of its suppliers.

6) Creditors’ turnover period

The analysis is used to determine how long the business takes before paying its suppliers. It also
helps to determine the credit terms offered by the suppliers.

Creditors’ turnover period = (average creditors ÷ credit purchases) × 365

From the previous illustration, the creditors’ turnover period is;

Creditors’ turnover period = (1,000,000 ÷ 5,000,000) × 365
Creditors’ turnover period = 73 days

This implies that bib and associates (u) ltd takes approximately 2 months and 13 days to pay its
suppliers. Alternatively, it shows that bib and associates (u) ltd is given up to 73 days to pay for
the credit purchases obtained from its suppliers.

7) Asset turnover
Asset turnover analysis measures the efficiency with which the business utilizes the available
assets to generate revenue/turnover. The ratio shows the ability of the firm to generate sales from
the resources committed to fixed and current assets. The higher the rate, the more efficient the
firm is at utilizing its assets.

Total assets turnover = sales/turnover ÷ total assets.

Assuming that team Julius (u) ltd invested assets worth shs.200,000,000 in a travel and tour
business and its turnover for the year was worth shs.350,000,000. Compute the total assets
turnover.

Total assets turnover = sales/turnover ÷ total assets.

Total assets turnover = 350,000,000 ÷ 200,000,000 = 1.75 times
This shows that team Julius is able to generate 1.75 times of sales for every unit of shillings
invested in fixed and current assets.

3) PROFITABILITY RATIOS.
These ratios measure the ability of the firm to generate returns from its investments and therefore
looks at the relationship between profit and various components of both statement of
comprehensive income and statement of financial position.

1) Net profit margin

This ratio shows a percentage of return on every unit of sales. The higher the margin, the more
profitable the business is and vice versa.
Net profit margin = (profit after tax ÷ total sales) × 100%
Assume a business made a net earnings of shs.180,000,000 at the end of the financial period
while its sales volume was shs.900,000,000. Compute the net profit margin of the business.

Net profit margin = (180,000,000 ÷ 900,000,000) × 100%

Net profit margin = 20%

This analysis indicates that after deducting the cost of sales and other operating expenses, the
business was to earn 20% margin (return) on every unit of sales made.

2) Return on investment
This uses the net earnings in relation to the capital employed to determine the earning obtained
from every unit of investment. ROI measures the amount of return on an investment relative to
the investment's cost.
To calculate ROI, the profit after tax (or return) of an investment is divided by the cost of the
investment (capital employed) and the result is expressed as a percentage or a ratio. The higher
the ratio, the better the profitability position of the business.

Return on investment (ROI) = (profit after tax ÷ investment or capital employed)

Consider a firm making profit after tax of shs.180,000,000 with a total investment value of
shs.1,600,000,000, determine the return on investment (ROI)
ROI = (180,000,000 ÷ 1,600,000,000) × 100%

ROI = 11.25%

This indicates that for every unit of shillings invested in the business, the firm is able to generate
11.25% in returns. In other words, the firm makes a profit after tax of 11.25% on its investment.

Investment can be defined in terms of total assets, net assets, fixed assets, ordinary share capital
(equity), preference share capital. Hence depending on the definition these ratios can be given as:

1) Return on total assets (ROTA) = (pat ÷ total assets) × 100%

2) Return on net assets (RONA) = (pat ÷ net assets) × 100%

3) Return on fixed assets (ROFA) = (pat ÷ fixed assets) × 100%

4) GEARING/LEVERAGE RATIOS:
These ratios help to assess whether the firm can meet its long term obligations and be able to
survive in the long run. it measures the solvency of the firm in the long run given its financial
obligations arising from the capital structure.

a)Debt to equity ratio.

This shows the extent to which the firm finances its investments using the borrowed funds as
compared to shareholders' funds (equity). It also determines how leveraged the firm is in its
capital structure. The higher the debt equity ratio, the higher the leverage position of the firm.
And it also means that the firm has high interest obligations to be met periodically. We can also
say that it is a measure of the relationship between the funds contributed by lenders and the funds
contributed by shareholders. it also shows the extent to which shareholders' equity can meet a
Co's obligations to lenders in the event of liquidation.

Debt to equity ratio = long term debt ÷ total equity

Consider a business with a capital structure of shs.900,000,000 from the financial institutions,
shs.200,000,000 obtained from the shareholders’ and shs.100,000,000 as retained earnings.
Determine the debt equity ratio of the business.
Debt equity ratio = 900,000,000 ÷ 300,000,000 = 3:1

This shows that the total debt is three times higher than owner's equity and this also implies that
75% of the business is financed through borrowings while 25% of the business is financed by
owner's equity.
It also indicates that the borrowed funds cannot be covered by the owner's equity in the event of
liquidation.
This also means that investors would be required to multiply their contribution by three times to
be able to cover the borrowed funds in case of liquidation.

b) Debt to total assets

This ratio shows the extent to which the firm's assets are financed using borrowed funds.

Debt to total assets = (debt ÷ total assets) × 100%

From the above example

Debt to total assets = (900,000,000 ÷ 1,200,000) × 100%
Debt to total assets = 75%

This analysis indicates that 75% of the total assets are financed through borrowings.

c) Times interest earned ratio

This measures the ability of the firm to meet interest and other fixed financing costs/ charges. It
shows the number of times that the firm's earnings would cover interest obligations (fixed
finance charges) before they decline to zero. A higher ratio means that the solvency position of
the firm is good and encouraged.

Times interest earned ratio = EBIT ÷ annual interest charge.

Assuming Mr. X generated EBIT amounting to 60,000,000 at the end of the financial year, he's
charged 30% tax on income and obtained a 5% debt worth 200,000,000 two years ago.
Determine the time interest earned ratio.

Times interest earned ratio = EBIT ÷ annual interest charge

Time interest earned ratio = 60,000,000 ÷ 10,000,000 = 6 times.
5) INVESTMENT RATIOS
These show the valuation of the firm in the capital market. it measures the potential of the
business to generate return on an investment by looking at the earnings per share, dividend per
share, price earnings ratio and the dividend yield in the given period.

a)Earnings per share

This measures the amount of net profit after tax attributable to shareholders; in other words, it
measures profitability per share by determining the amount of earnings attributable to a unit of
share.

EPS = PAT ÷ number of outstanding shares

b)Dividend per share

This ratio measures the amount of earnings declared as dividend attributable to a unit of share in
a given financial year. This is based on the retention/dividend policy of the firm.

DPS = total dividend for the year ÷ number of shares.

c) Price earnings ratio

This measures the valuation of the Co's shares as perceived by the investors. it determines how
much an investor is willing to pay for a unit of share given its current earnings.
a company with a low price earnings ratio indicates that the market perceives it as a lower risk or
lower growth or both as compared to a company with a higher price earnings ratio.

Price earnings ratio = price per share ÷ earnings per share

Consider ABC incorporation generated net earnings of ugx 60,000,000 and declared a 40%
dividend during the year. The outstanding number of shares of the co is 100,000 shares currently
trading at ugx 6,000 each. Compute the following:
1-Earnings per share.
2-Dividend per share.
3-Price earnings ratio.

EPS = pat ÷ number of outstanding shares

EPS = 60,000,000 ÷ 100,000
EPS = shs.600

DPS = total dividend for the year ÷ number of shares.

Total dividend for the year = 40% * 60,000,000 = 24,000,000

DPS = 24,000,000 ÷ 100,000

DPS = shs.240
Price earnings ratio measures the expectations of the market on the firm's performance and how
much they would be willing to pay for its shares.

Price earnings ratio = price per share ÷ earnings per share

PER = 6,000 ÷ 600 = 10 times.

This means that investors are willing to pay for the shares 10 times more than what it is earning
currently because the firm's growth is expected to continue.

Advantages of ratio analysis.

Ratio analysis is widely used as a powerful tool of financial statements analysis. it establishes the
numerical or quantitative relationship between two figures of a financial statement to ascertain
strengths and weaknesses of a firm as well as its current financial position and historical
performance.

1) Forecasting and planning: the trend in costs, sales, profits and other facts can be known by
computing ratios of relevant accounting figures of the last few years. This trend analysis with the
help of ratios may be useful for forecasting and planning future business activities.

2) Measurement of operating efficiency: ratio analysis indicates the degree of efficiency in the
management and utilization of its assets. Different activity ratios indicate the operational
efficiency. In fact, solvency of the firm depends upon the sales revenues generated by utilizing
its assets.

3) Communication: ratios are effective means of communication and play a vital role in
informing the position of and progress made by the business concern to the owners or other
parties.

4) Control of performance and cost: ratios can also be used for control of performance of the
different divisions or departments of an undertaking as well as control of costs.

5) Inter-firm comparison. Comparison of performance of two or more firms reveals efficient

and inefficient firms, thereby enabling the inefficient firms to adopt suitable measures for
improving their efficiency. The best way of inter-firm comparison is to compare the relevant
ratios of the organization with the average ratios of the industry.

6) Indication of long term solvency position: ratio analysis is also used to assess the long term
debt paying capacity of the firm. Long term solvency position of a borrower is a prime concern
to the long term creditors, security analysts and the present and potential owners of a business.

7) Aid to decision making: ratio analysis helps to take decisions like whether to SS goods on
credit to a firm, whether bank loans will be made available etc.
Weaknesses of ratio analysis
● Computation of ratio analysis requires information obtained from financial statements. if
this information is not accurate, indicators given by ratio analysis will not reflect what
actually happened.
● Differences in accounting conventions for example use of straight line depreciation and
declining balance depreciation to prepare statements among different firms in the same
industry can give misleading information.
● Quantitative in nature; ratio analysis is mainly quantitative and ignores qualitative factors
like quality of labour, loyalty of employees etc. which may be significant and yet not
reflected in financial statements where ratios are determined (in relation to decision
making).
● Historical data, ratios are generally calculated from past financial statements hence do not
provide indicators of the future.
● Changes in economic conditions, performance of a firm in a given period is largely
influenced by the economic conditions prevailing at the time. Ratio analysis does not
capture changes in those conditions (boom and slump) to provide a basis for decision
making.

Basis of comparison
After computing the various ratios and attaching meaning to them, we may not be in position to
establish whether we are performing well or poorly.
There is need to compare these ratios with other basis to be able to gauge the performance of the
firm and this may be done using the following:
● Past performance
● Industry performance
● Forecasted financial performance.
● Competitor's ratios.

Exercise:
The following information was extracted from Paige associates (u) ltd at the end of the financial
year 2015/2016

Statement of comprehensive income

Item June 2015(Shs 000) June 2016(shs.000)

Sales 6,000,000 8,000,000

Cost of sales 3,500,000 4,575,000

Gross profits 2,500,000 3,425,000

Interest 100,000 125,000

Operating profits 2,400,000 3,300,000

 Tax 500,000 800,000

Profit after tax 1,900,000 2,500,000

Dividend 750,000 1,000,000

Retained earnings 1,150,000 1,500,000

Statement of financial position as at June 2016

2015(Shs 000) 2016(Shs 000)
Non-current assets 5,500,000 7,000,000
Current assets
Inventory 700,000 1,100,000
Receivables 800,000 1,300,000
Cash 750,000 2,250,000 50,000 2,450,000
7,750,000 9,450,000
Current liabilities
Overdraft 100,000
Trade payables 750,000 1,000,000
Other payables 250,000 100,000
10% loan stock 1,000,000 2,000,000 1,000,000 2,200,000
5,750,000 7,250,000
Equity and LT debt
Ordinary shares @100 1,500,000 1,500,000
Retained earnings 3,250,000 4,750,000
Long term debt 1,000,000 1,000,000
5,750,000 7,250,000

Required:
Assuming the market price for Paige associates' shares are trading at ugx 400(four hundred
shillings only). Determine the key financial ratios including
a)Profitability, b) liquidity, c) efficiency, d) gearing and e) investment ratios.

Question
Uganda clays is a public listed manufacturing Ugandan company. It’s summarized financial
statements for the year ended 30th June 2020 and 2019 comparatives are:

Statements of profit or loss for the year ended 30th June :( Amounts in shs. Millions)

2020 shs 2019 shs

Revenue 29,500 36,000
Cost of sales (25,500) (26,000)
Gross profit 4,000 10,000
Distribution costs (1,050) (800)
Administrative expenses (4,900) (3,900)
Investment income 50 200
Finance costs (600) (500)
Profit (loss) before taxation (2,500) 5,000
Income tax(expense) relief 400 (1,500)
Profit (loss) for the year (2,100) 3,500

Statements of financial position as at 30 June (amounts in shs. Millions )

2020 shs 2019 shs

Assets

Non-current assets

Property, plant and 17,600 24,500

equipment

Investments at fair value 2,400 4,000

through profit

20,000 28,500

Current assets

Inventory and work in 2,200 1,900

progress

Trade receivables 2,200 2,800

Tax asset 600 Nil

Bank 1,200 6,200 100 4,800

Total assets 26,200 33,300

Equity and liabilities

Equity

Equity shares of Shs. 1 13,000 12,000

each

Share premium 1,000 Nil

Revaluation reserve Nil 4,500

Retained earnings 3,600 6,500

17,600 23,000

Non-current liabilities

Bank loan 4,000 5,000

Deferred tax 1,200 700

Current liabilities

Trade payables 3,400 2,800

Current tax payable Nil 3,400 1,800 4,600

26,200 33,300
The following information has been obtained from the Chairman’s Statement and the notes to
the financial statements:
1. ‘Market conditions during the year ended 30 June 2020 proved very challenging due
largely to difficulties in the global economy as a result of a sharp recession which has led
to steep falls in share prices and property values.
2. Due to the Coovid19 Pandemic, our investments have lost value following unfavorable
fair value changes, and the company proposes to carry out a valuation exercise.
3. There were no additions to or disposals of non-current assets during the year.
4. ‘In response to the downturn the company is proposing to make a number of employees
laid off. Sill, to have cost savings, advertising and other administrative expenses are
planned to be cut in any way possible if the performance is assessed to be worse.
5. The difficulty in the credit markets has meant that the finance cost of our variable rate bank
loan has increased from 4.5% to 8%. In order to help cash flows, the company made a
rights issue during the year and reduced the dividend per share by 50%.’
6. ‘Despite the above events and associated costs, the Board believes the company’s
underlying performance has been quite resilient in these difficult times.’
7. The Chairman is uncertain of the future if the effect of Covid19 global pandemic continue
drastically and therefore is reconsidering the entity may not remain a going concern and
therefor requests to analyze its performance for future predictions on possibility of failures.

Required:
a) Prepare a report analyzing financial performance and position of Uganda Clays as portrayed
by the above financial statements and the additional information provided.
Hint: Your analysis should be supported by any FIVE profitability (gross profit margin, net
 profit margin), liquidity (current & quick ratio), efficiency ratios (debtors collection period
& asset turnover) and gearing (debt: equity ratio) and other appropriate ratios where
necessary (up to 30 marks available).

b) Explain the relevance and limitations of ratio analysis as a tool. (10 Marks)

Solution
Profitability ratio
Gross profit margin
Net profit margin
Return on capital employed
Return on total Assets
Return on investment
Return on net assets
Return on fixed assets.

Liquidity ratios
Current ratio.
Acid test ratio or quick ratio.

Efficiency ratios
Asset turnover.
Debtor’s turnover rate.
Debtor’s turnover period
Creditor’s turnover rate
Creditor’s turnover period.
Inventory turnover rate
Inventory turnover Period.

Investment ratios
Earnings per share
Dividend per share.
Price earnings ratio.

Gearing or leverage ratios

Debt to equity ratio.
Debt to total assets.
Times Interest earned ratio.

A REPORT ANALYZING FINANCIAL PERFORMANCE AND POSITION OF

UGANDA CLAYS:
To: Management of Uganda clays Ltd
From: Financial consultant
Subject: Analysis of financial performance and position of Uganda clays for the year ended
30/06/2022
Date: 24/06/2022

I hereby analyze the financial performance and position of Uganda clays ltd for the year ended
30/06/2022. The detailed analysis is as below and the appendices are attached for further
reference.

Analysis of profitability
Generally the financial performance of Uganda clays declined during 2020. Gross profit margin
during 2020 declined from 27.8% to 13.6%. The decreasing gross profit margin is due to the
decline in the revenue that’s by 18% (29,500 – 36,000).
Additionally net profit margin equally declined during 2020 from 9.7% to -7.1%. The declining
net profit margin is as a result of the increasing operating expenses during 2020 more so
distribution costs by 31.2% (1050-800) and administration expenses by 25.6%(4,900-3,900).
Analysis of liquidity
Generally the liquidity position increased during the year end. The cash position at the bank
increased by ____%. Additionally, current ratio increased from 1.04 times to 1.8 times. This
implies that the current assets are able to meet the current liabilities other than when they fall
due.

Although current ratio is imposed during the current year, however it is still below the norm.
Therefore the entity should further improve its liquidity.

The increasing liquidity position maybe as the result of the rights issue of shares made during the
year which equally explains the high percentage increase in cash and bank balance.

Conclusion
Financial ratio analysis and common size analysis help gauge the financial performance and
condition of a co. Through an examination of relationships among these many financial items. A
thorough financial analysis of a co requires examining its efficiency in putting its assets to work,
its liquidity position, its solvency, and its profitability.
We can use the tools of common size analysis and financial ratio analysis, including the DuPont
model, to help understand where a co. has been.
We then use relationships among financial statement accounts in pro forma analysis, forecasting
the Co's income statements and balance sheets for future periods to see how the Co's
performance is likely to evolve.

Sample question:

Year 2008($) 2009($) 2010($) 2011($) 2012($) 2013($)

Cash 400.00 404.00 408.04 412.12 416.24 420.40

Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65

 Accounts 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
receivable

Net plant 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29

and
equipment

Intangibles 400.00 402.00 404.01 406.03 408.06 410.10

Total 6,500.00 6,713.30 6,934.12 7,162.74 7,399.45 7,644.54

assets

a) Calculate the vertical common size analysis for the CS Company’s assets
b) Create the horizontal common size analysis for CS Company’s assets, using 2008 as the base
year.

Topic 4
THE STATEMENT OF CASH FLOWS (IAS 7)
OBJECTIVE OF IAS 7
IAS 7 requires the presentation of Information about the historical changes in cash and cash
equivalents of an entity by means of a statement of cash flows (SOCF), which classifies cash
flows during the period according to operating, investing and financing activities.
It came to address the weaknesses of the SOPLOCI

DEFINITION OF CASH AND CASH EQUIVALENTS

Cash means cash in hand and deposits available on demand.
Cash equivalents means short term highly liquid investments that are readily convertible to
known amounts of cash and which are subject to an insignificant risk of changes in value.
Examples include; Treasury bills, Treasury notes, Commercial paper, Certificates of deposit,
Money market funds, Cash management pools, bank overdrafts.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the enterprise and other
activities that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of the
owners’ capital (including preference share capital in the case of a company) and borrowings of
the enterprise.

Although a business may make profit, it may lack cash for its operations due to the following
differences between profit and cash.
● Profit computed following the accrual concept.
● The profit represents an increase in net assets during the accounting period. The increase may
be in cash or it may be tied up in other assets like non-current assets purchased, increased
inventory, and increased receivables.

Therefore IAS 1 and 7 require all entities to present a SOCF as part of a complete set of financial
statements prepared in accordance with the international financial reporting standards (IFRS).

ANALYZING A STATEMENT OF CASH FLOWS

A key part of the Financial Reporting (FR) is the ability to analyze a set of financial statements.
The statement of cash flows is one of the primary financial statements, and one must be able to
explain the performance of an entity based on all the financial statements including the statement
of cash flows. To do this, one must understand the different sections of the statement and the
implications for the business.

One of the first things to note is to not simply comment on the overall movement in the total cash
and cash equivalents figure in the year. An increase in this figure does not necessarily mean that
the entity has performed well in the year. A situation could easily arise where an entity is
struggling to generate cash in a period and is forced to sell its owned properties and lease them
back in order to continue. This may mean that the entity’s overall cash position increases in the
period, but is clearly not a sign that the entity has performed well. This would be a significant
concern, as the entity cannot simply sell its properties again in the future. There will also be
fewer assets owned by the entity in the future, meaning that its ability to secure future borrowing
may be limited. Any financial analyst simply commenting that the entity has performed well as
the overall cash figure has increased is unlikely to have a poor analysis, as he or she has not
really understood the reasons behind the movement.

A good analysis will examine the statement of cash flows in detail and look for the reasons
behind the movement, commenting on how the entity has performed. The statement of cash
flows contains three sections: cash flows from operating activities, investing activities and
financing activities. Each of these sections gives us useful information about an entity’s
performance.

Operating activities
The first key figure to address is likely to be cash generated from operations. This shows how
much cash the business can generate from its core activities, before looking at one-off items such
as asset purchases/sales and raising money through debt or equity. The cash generated from
operations is effectively the cash profit from operations. The cash generated from operations
figure should be compared to the profit from operations per the statement of profit or loss to
show the quality of the profit.

The closer these two are together, the better the quality of profit. If the profit from operations is
significantly larger than the cash generated from operations, it shows that the business is not able
to turn that profit into cash, which could lead to problems with short-term liquidity. When
examining cash generated from operations, examine the movements in working capital which
have led to this figure. Large increases in receivables and inventories could mean problems for
the cash flow of the business and should be avoided if possible. The company may have potential
irrecoverable debts or a large customer with increased payment terms may have been taken on.
Either way, the company needs to have enough cash to pay the payables on time.

Look for large increases in payables. If a company has positive cash generated from operations,
but a significant increase in the payables balance compared to everything else, it may be that the
company is delaying paying its suppliers in order to improve its cash flow position at the end of
the year.

The cash generated from operations should be a positive figure. This ensures that the business
generates enough cash to cover the day to day running of the company. The cash generated from
operations should also be sufficient to cover the interest and tax payments, as the company
should be able to cover these core payments without taking on extra debt, issuing shares or
selling assets.

Any cash left over after paying the tax and interest liabilities is thought of as ‘free cash’, and
attention should be paid as to how this is spent. Ideally, a dividend would be paid out of this free
cash, so that a firm does not have to take out longer sources of finance to make regular payments
to its shareholders. Other good ways of using this free cash would be to invest in non-current
assets (as this should generate returns in the future) and paying back loans (as this will reduce
further interest payments).

Investing activities
This section of the statement of cash flows focuses on the cash flows relating to non-current
assets.

For example, sales of assets can be a good thing if those assets are being replaced. However, as
stated earlier, if a company is simply selling off assets to manage short-term liquidity
requirements, this makes the financial position significantly weaker, and banks will be less
willing to lend as there are less assets to secure a loan against.

The sale of assets should not be used to finance the operating side of the business or to pay
dividends. This is poor cash management, as a company will not be able to continue selling
assets in order to survive. This is an indication that a company is shrinking and not growing.

Whilst purchases or sales of non-current assets may be relatively irregular transactions, the
presence of interest received, or dividends received may well be recurring cash flows arising
from investments the entity holds.

Financing activities
The sources of financing any increases in assets should also be considered. If this can be
financed out of operations, then this is the best scenario as it shows the company is generating
significant levels of surplus cash. Funding these out of long-term sources (i.e. loans or shares) is
also fine, as long-term finances are appropriate to use for long term assets.
However, when raising long-term finance, it is also useful to consider the future consequences.
For example, taking out loans will lead to higher interest charges going forward. Higher levels of
debt will also increase the level of gearing in the entity, meaning that finance providers may
charge higher interest rates due to the increased risk. It may also mean that loan providers are
reluctant to provide further finance if the entity already has significant levels of debt.

Raising funds from issuing shares will not lead to interest payments and will not increase the
level of risk associated with the entity. However, issuing shares will lead to more shareholders
and possibly higher total dividend payments in the future.

In summary, a well-rounded answer will absorb all the information contained within a statement
of cash flows, using this to produce a thorough discussion of an entity’s performance. Candidates
who can do this should perform well on these tasks and are more likely to have demonstrated a
much greater understanding of performance than simply commenting on whether the overall cash
balance has gone up or down.

THE SOCF FORMAT

IAS 7 requires cash flows to be classified as relating to operating, investing, and financing
activities.

Cash flows from operating activities are the main revenue producing activities of the entity that
are not investing or financing activities. These include items that affect the entity's financial
performance or cash received from customers and cash paid to suppliers and employees.

Cash flows from investing activities relate to the acquisition and disposal of long term assets
and other investments that are not included in cash equivalents.
The Investing activities include:
● Cash payments to acquire property, plant and equipment, intangibles and other non-
current assets, including those relating to capitalized development costs and self-
constructed property, plant and equipment.
● Cash receipts from sales of property, plant and equipment, intangibles and other non-
current assets.
● Cash payments to acquire shares or debentures of other entities.
● Cash receipts from sales of shares or debentures of other entities.
● Cash advances and loans made to other parties.
● Cash receipts from the payment of advances and loans made to other parties.

Financing activities are activities that cause changes to contributed equity and borrowings of an
entity. These include:
● Cash proceeds from issuing shares.
● Cash payments to owners to acquire or redeem the entity's shares.
● Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or
long term borrowings.
 ● Principal repayments of amounts borrowed under finance leases.

NET INCREASE OR DECREASE IN CASH AND CASH EQUIVALENTS

The net increase or decrease in cash and cash equivalents is the overall increase (or decrease) in
cash and cash equivalents during the period from the three types of cash flows above. This is
added to the cash and cash equivalents at the beginning of the period, to get the final balance at
the end of the period.

THE INDIRECT METHOD

The indirect method adjusts profit or loss for the period (calculated using the accrual basis of
Accounting) to a cash flow for the effects of:
● Non-cash items like depreciation, provisions, accruals, unrealized foreign currency gains
and losses.
● All items of income or expenses affecting investing or financing activities like finance
cost, profit or loss on disposal of non-current assets.
● Changes during the period in inventories and receivables and payables.

DIRECT METHOD
The direct method shows direct actual trading cash flows for each major class of gross cash
receipts and gross cash payments.
Below is an example of the cash from operating activities section of the SOCF.

Shs Shs

Cash flows from operating activities

Cash received from customers X

Cash payments to suppliers (X)

Cash paid to employees (X)

Cash paid for other operating activities (X)

Net cash from operating activities X

Interest paid (X)

Income taxes paid (X)

Net cash from operating activities X

The sections for the investing and financing activities for the direct method are similar to those
of the indirect method above.
The direct method has an advantage of showing the true cash flows involved in the trading
operations on the entity. However, its main disadvantage is the higher cost of getting information
that is used as such Information is not elsewhere in the financial statements and control accounts
may have to be used to compute the cash flows.

FORMAT OF THE DIRECT METHOD

Shs Shs

Cash flows from operating activities

Cash receipts from customers x

Cash paid to the suppliers (x)

CASH PAID TO THE EMPLOYEES (x)

Interest paid (x)

Taxes paid (x)

Net cash inflows/outflows from operating activities x/(x)

Cash flows from investing activities

Purchase of investments/ long term assets (x)

Cash receipts from sale of investments/ long term assets x

Net cash inflows/outflows from the investing activities x/(x)

Cash flows from financing activities

Proceeds from long term debt x

Long term debt payments (x)

Common stock issued x

Dividends paid (x)

Net cash inflows/outflows from financing activities x/(x)

Net increase/decrease in cash x/(x)

Opening cash as at the period x

Closing cash as at the period x

Net increase/decrease in cash x/(x)

FORMAT OF THE INDIRECT METHOD

Shs Shs

Cash flows from operating activities

Profit/loss before tax x/(x)

Adjust it for:

Finance costs x

Depreciation/amortization x

Impairment loss ( revaluation loss per IAS 16) x

Unrealized forex loss/ gain x/(x)

Fair value gain/loss (IAS 401 equity investments) x/(x)

Investment income/dividend income (x)

Cash flows before working capital xxx

Increase/decrease in inventories (x)/x

Increase/decrease in debtors (x)/x

Increase/decrease in payables x/(x)

Cash flows from operating activities xxxx

Less: interest expense paid (x)

Less: tax paid (x)

Net cash flows from operating activities xxxx

Cash flows from investing activities

Purchase of non-current assets (x)

Disposal/sale of non-current assets x

Investment income/interest/dividend x

Investment in shares (x)

Net cash flows from investing activities x

 Cash flows from financing activities

Issue of shares(share premium and capital) x

Loan acquisition/issue x

Loan redemption/payment (x)

Dividend paid (x)

Payment of lease obligation (x)

Net cash flows from financing activities x

Net increase/decrease in cash and cash equivalents x

Add: Cash and cash equivalents b/d x

Cash and cash equivalents c/d x

Working Notes
The working notes given below do not form part of the cash flow statement and, accordingly,
need not be published. The purpose of these working notes is merely to assist in understanding
the manner in which various figures in the cash flow statement have been derived.

1. Cash receipts from customers

Sales + debtors at the beginning of the period - debtors at the end of the period

2. Cash paid to suppliers and employees

Cost of sales + Administrative and selling expenses + creditors at the beginning of the period +
Inventories at the end of the period – (creditors at the end of the period + the inventories at the
beginning of the period)

3. Income taxes paid (including tax deducted at source from dividends received)

Income tax expense for the period (including tax deducted 300 at source from dividends
received) + Income tax liabilities at the beginning of the period – the income tax liabilities at the
end of the period)

4. Repayment of long-term borrowings

Long-term debt at the beginning of the period + Long-term borrowings made during the period -
Long-term borrowings at the end of period.
5. Interest paid
Interest expense for the period + Interest to be paid at the beginning of the period – Interest to be
paid at the end of the period

Example one
The following is the income statement for the year ended December 31st 2012.

Shs 000

Revenue 1,200,000

Cost of sales (840,000)

Gross profit 360,000

Distribution expenses (80,000)

Administration expenses (40,000)

Net profit before tax 240,000

The following is the extract from the Statement of financial position:

2012 Shs 000 2011 Shs 000

CURRENT ASSETS

Inventories 160,000 140,000

Trade receivables 259,000 235,000

CURRENT LIABILITIES

Trade payables 168,000 138,000

You are given the following information:

● Expenses include depreciation of shs 36,000,000 bad debts shs 14,000,000 and
employment costs of shs 42,000,000.
● During the year, the Co disposed of a non-current asset for shs 24,000,000 which had a
book value of shs 18,000,000, the profit of which had been netted off expenses.
You are required to calculate cash generated from operations for the period ended December 31st
2012 using both the indirect and direct methods.
Solution

Indirect method

Shs 000

Profit before tax 240,000

Adjustments for:

Depreciation 36,000

Profit on disposal of non-current assets

(24,000 - 18,000) (6,000)

Increase in inventories (20,000)

Increase in receivables (24,000)

Increase in payables 30,000

Cash generated from operations 256,000

DIRECT METHOD

Shs 000

Cash received from customers

(235,000 + 1,200,000-259,000-14,000) 1,162,000

Cash paid to suppliers

(840,000 + 160,000 - 168,000 - 140,000+ 138,000) (830,000)

Cash paid to EMPLOYEES (42,000)

Other cash PAYMENTS

(120,000-36,000-42,000+6,000-14,000) (34,000)

Cash generated from operations 256,000

BENEFITS OF A STATEMENT OF CASH FLOWS

The statement of cash flows shows:
● How the business spends and receives cash and allows the user to see the major types of
cash flows.
● The liquidity of the business- it helps in the assessment of the current liquidity.
● Whether the operating activities generate a positive cash flow.
 ● Whether the business has the ability to generate cash in future. Future cash flows are
regarded as a key determinant of the worth of a business and help in making proper
decisions.

DISCUSSION QUESTION
Below are the statements of financial position of Dickson as at 31 March 20X8 and 31 March
20X7, together with the statement of profit or loss and other comprehensive income for the year
ended 31 March 20X8.

20X8 $000 20X7$000

NON CURRENT ASSETS

PPE 825 637

Goodwill 100 100

Development expenditure 290 160

1,215 897

CURRENT ASSETS

Inventories 360 227

Trade receivables 274 324

Investments 143 46

Cash 29 117

TOTAL ASSETS 2,021 1,611

Equity

Share capital- $1 ordinary shares 500 400

Share premium 350 100

Revaluation surplus 152 60

Retained earnings 237 255

NON CURRENT LIABILITIES

6% debentures 150 100

Finance lease liabilities 100 80

Deferred tax 48 45
 CURRENT LIABILITIES

Trade payables 274 352

Finance lease liabilities 17 12

Current tax 56 153

Debenture interest 5 -

Bank overdraft 132 54

TOTAL EQUITY & LIABILITIES 2,021 1,611

Statement of profit or loss and other comprehensive incomes.

$ 000

Revenue 1,476

Cost of sales (962

Gross profit 514

Other expenses (157)

Finance costs (15)

Profit before tax 342

Income tax expense (162)

Profit for the year 180

Other comprehensive incomes:

Gain on revaluation of plant, property & equipment 100

Total comprehensive income for the year 280

NOTES
● Goodwill arose on the acquisition of unincorporated businesses. During 20x8 expenditure
on development projects totaled $ 190,000.
● During 20x8 items of ppe with a new book value of $103,000 were sold for $ 110,000.
Depreciation charged in the year on PPE totaled $57,000. Dickson purchased $ 56,000 of
ppe by means of finance leases, payments being made in arrears on the last day of each
accounting period.
 ● The current asset investments are government bonds and management has decided to
class them as cash equivalents.
● The new debentures were issued on 1 April 20x7. Finance cost includes debenture
interest and finance lease includes finance charges only.
● During the year Dickson made a 1 for 8 bonus issue capitalizing its retained earnings,
followed by a rights issue.

Required
(a) Prepare a statement of cash flows for Dickson in accordance with IAS 7 using the
indirect method.
(b) Prepare (In addition) net cash from operating activities using the direct method.

CASH FLOW STATEMENT:

Balance Sheet as at 31.12.2021
2021($ 000) 2020 ($ 000)
Assets
Cash on hand and balances with banks 200 25
Short-term investments 670 135
Sundry debtors 1,700 1,200
Interest receivable 100 -
Inventories 900 1,950
Long-term investments 2,500 2,500
Fixed assets at cost 2,180 1,910
Accumulated depreciation (1,450) (1,060)
Fixed assets (net) 730 850
Total assets 6,800 6,660
Liabilities
Sundry creditors 150 1,890
Interest payable 230 100
Income taxes payable 400 1,000
Long-term debt 1,110 1,040
Total liabilities 1,890 4,030
Shareholders’ Funds
Share capital 1,500 1,250
Reserves 3,410 1,380
Total shareholders’ funds 4,910 2,630
Total liabilities and shareholders’ funds 6,800 6,660

Statement of Profit and Loss for the period ended 31.12.2021

($ 000)
Sales 30,650
Cost of sales (26,000)
Gross profit 4,650
Depreciation (450)
Administrative and selling expenses (910)
Interest expense (400)
Interest income 300
Dividend income 200
Foreign exchange loss (40)
Net profit before taxation and extraordinary item 3,350
Extraordinary item – Insurance proceeds from earthquake
disaster settlement 180
Net profit after extraordinary item 3,530
Income-tax (300)
Net profit 3,230

The following additional information is also relevant for the preparation of the statement of cash
flows (figures are in $ 000).
a) An amount of 250 was raised from the issue of share capital and a further 250 was raised
from long term borrowings.
b) Interest expense was 400 of which 170 was paid during the period. 100 relating to interest
expense of the prior period was also paid during the period.
c) Dividends paid were 1,200.
d) Tax deducted at source on dividends received (included in the tax expense of 300 for the
year) amounted to 40.
e) During the period, the enterprise acquired fixed assets for 350. The payment was made in
cash.
f) Plant with original cost of 80 and accumulated depreciation of 60 was sold for 20.
g) Foreign exchange loss of 40 represents the reduction in the carrying amount of a short-term
investment in foreign-currency designated bonds arising out of a change in exchange rate
between the date of acquisition of the investment and the balance sheet date.
h) Sundry debtors and sundry creditors include amounts relating to credit sales and credit
purchases only
Required
a) Prepare a statement of cash flows for the period 31, December 2021 in accordance with IAS
7 using the direct method.
b) Prepare net cash from operating activities using the indirect method.
c) Prepare a statement of cash flows for the period 31, December 2021 using the indirect
method

Solution
a) Direct Method Cash Flow Statement
$ 000 $ 000
Cash flows from operating activities
Cash receipts from customers 30,150
Cash paid to suppliers and employees (27,600)
Cash generated from operations 2,550
Income taxes paid (860)
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
Cash flows from investing activities
Purchase of fixed assets (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 160
Net cash from investing activities 30
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Repayment of long-term borrowings (180)
Interest paid (270)
Dividends paid (1,200)
Net cash used in financing activities (1,150)
Net increase in cash and cash equivalents 750
Cash and cash equivalents at beginning of
period (see Note 1) 160
Cash and cash equivalents at end of period
(see Note 1) 910

b) Net cash from operating activities using the indirect method

$ 000 $ 000
Cash flows from operating activities
Net profit before taxation, and extraordinary item 3,350
Adjustments for :
Depreciation 450
Foreign exchange loss 40
Interest income (300)
Dividend income (200)
Interest expense 400
Operating profit before working capital changes 3,740
Increase in sundry debtors (500)
Decrease in inventories 1,050
Decrease in sundry creditors (1,740)
Cash generated from operations 2,550
Income taxes paid (860)
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870

Notes to the cash flow statement (direct method and indirect method)
1. Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand and balances with banks, and investments in
money-market instruments. Cash and cash equivalents included in the cash flow statement
comprise the following balance sheet amounts.

2021 2020
Cash on hand and balances with banks 200 25
Short-term investments 670 135
Cash and cash equivalents 870 160
Effect of exchange rate changes 40 -
Cash and cash equivalents as restated 910 160

2. Total tax paid during the year (including tax deducted at source on dividends received)
amounted to 900.

Working Notes
1. Cash receipts from customers

Sales 30,650
Add: debtors at the beginning of the period 1,200
31,850
Less :debtors at the end of the period 1,700
30,150

2. Cash paid to suppliers

Cost of sales 26,000

Administrative and selling expenses 910
26,910
Add: Creditors at the beginning of the period 1,890
Inventories at the end of the period 900 2,790
29,700
Less: Creditors at the end of the period 150
Inventories at the beginning of the Period 1,950 2,100
27,600

3. Income taxes paid (including tax deducted at source from dividends received)

Income tax expense for the year (including tax deducted at source
from dividends received) 300
Add : Income tax liabilities at the beginning of the period 1,000
1,300
Less: Income tax liabilities at the end of the period 400
900

Out of 900, tax deducted at source on dividends received (amounting to 40) is included in cash
flows from investing activities and the balance of 860 (900 – 40) is included in cash flows from
operating activities

4. Repayment of long-term borrowings

Long-term debt at the beginning of the period 1,040

Add : Long-term borrowings made during the period 250
1,290
Less : Long-term borrowings at the end of the period 1,110
180

5. Interest paid

Interest expense for the period 400

Add: Interest to be paid at the beginning of the period 100
500
Less: Interest to be paid at the end of the period 230
270

Note
Interest paid and interest and dividends received are usually classified as operating cash flows for
a financial enterprise. However, there is no consensus on the classification of these cash flows
for other enterprises. Some argue that interest paid and interest and dividends received may be
classified as operating cash flows because they enter into the determination of net profit or loss.
However, it is more appropriate that interest paid and interest and dividends received are
classified as financing cash flows and investing cash flows respectively, because they are cost of
obtaining financial resources or returns on investments.

INTERPRETATION OF STATEMENTS OF CASH FLOWS

The statement of cash flows should be reviewed after preparation. In particular, cash flows in the
following areas should be reviewed. Interpretation should be made in reference to the following
points during a given accounting period.
● Cash generation from trading operations.
● Dividend and interest payments.
● Capital expenditure.
● Financial investment.
● Management of financing ( loan repayments and acquisitions)
● Net cash flow.

COMPARISON OF THE STATEMENT OF CASH FLOWS AND STATEMENT OF PROFIT

OR LOSS
ADVANTAGES OF THE STATEMENT OF CASH FLOWS
● It may assist users of financial statements in making judgments on the amount, timing
and degree of certainty of future cash flows.
● It gives an indication of the relationship between profitability and cash generating ability,
and thus of the quality of the profit earned.
● Analysts and other users of financial information often, formally or informally, develop
models to assess and compare the present value of the future cash flow of entities.
Historical cash flow information could be useful to check the accuracy of past
assessments.
● A statement of cash flows in conjunction with a statement of financial position provides
information on liquidity, viability and adaptability. The statement of financial position is
often used to obtain information on liquidity, but the information is incomplete for this
purpose as the statement of financial position is drawn up at a particular point in time.
● Cash flows cannot be manipulated easily and are not affected by judgment or by
accounting policies.

LIMITATIONS OF THE STATEMENT OF CASH FLOWS

● Statement of cash flows are based on historical information and therefore do not provide
complete information for assessing future cash flows.
● There is some scope for manipulation of cash flows e.g. a business can delay paying
suppliers until after the year end.
● Cash flow is necessary for survival in the short term, but in order to survive in the long
term a business must be profitable. It is often necessary to sacrifice cash flow in the short
term in order to generate profits in the long term. (E.g. By investment in non-current
 assets). A huge cash balance is not a sign of good management if the cash could be
invested elsewhere to generate profit.
● The conclusion of cash equivalents has been criticized because it does not reflect the
way in which businesses are managed: in particular, the requirement that to be a cash
equivalent, an investment has to be within three months of maturity is considered
unrealistic.
● The management of assets similar to cash (i.e. cash equivalents) is not distinguished from
other investment decisions.
● It does not measure the real performance of the business due to ignoring transactions on
an accrual basis like Statement of profit or loss.

TOPIC 5: VALUATION OF COMPANIES

Company valuation is a process where the economic value of a company is determined. With the
help of the valuation, you would be able to determine the fair value of a company.

Explain the purpose of and circumstances that can lead to the valuation of a Co.

In case of Litigation: The need for a business appraisal arises in a variety of types of litigation
from domestic relations to minority shareholders suits, from disputes over the scale of a business
to taxation and estate litigation. In all of these instances, the basic issue is the same: how much is
the business or business interest worth?

Strategic planning: The true value of assets may not be shown with a depreciation schedule,
and if there has been no adjustment of the balance sheet for various possible changes, it may be
risky. Having a current valuation of the business will give you good information that will help
you make better business decisions.

Funding: An objective valuation is usually needed when you need to negotiate with banks or
any other potential investors for funding. Professional documentation of your company’s worth
is usually required since it enhances your credibility to the lenders.

Selling shares: For business owners, proper business valuation enables you to know the worth
of your shares and be ready when you want to sell them. Just like during the sale of the business,
you ought to ensure no money is left on the table and that you get good value from your share.

Buying a business: Even though sellers and buyers usually have diverse opinions on the worth
of the business, the real business value is what the buyers are willing to pay. A good business
valuation will look at market conditions, potential income, and other similar concerns to ensure
that the investment you are making is viable. It may be prudent to hire a business broker who can
help you with the process.

Selling a business: When you want to sell your business or company to a third party, you need
to make certain that you get what it is worth. The asking price should be attractive to prospective
purchasers.
Mergers. If your growth strategy includes buying or merging with another company, a business
valuation will help you determine if the price you are being asked to pay is a fair one.

Estate planning. Nobody wants to have the burden of paying heavy taxes on a business that was
undervalued. Knowing the value of your business is necessary in order to adequately fund a
future estate tax liability.

Liquidation and Shareholder Disputes. If in case of a decision to wind up the company, an

independent valuation is necessary to arrive at a fair settlement of ownership interest.

The purpose of company valuation is to give owners, potential buyers and other interested
stakeholders an approximate value of what a Co is worth. It is a process and a set of
procedures used to determine what a business is worth.

The real price may vary quite a bit depending on who determines the business value. The
selling price also depends on how the business sale is handled. E.g. going concern basis or on a
liquidation etc.

The choice of the method to be used in the valuation of a company depends upon the
specific business being valued. Explain the different methods of valuation.

The choice of the methods to be used depends upon the specific business being valued. For
example:

● A young start-up has little historical track record. Income business valuation methods
such as the discounted cash flow are an excellent choice to value such companies since
they require future business earnings forecast and risk assessment.
● For a well-established Co, the value of the business Goodwill may be considerable. In
this situation, the capitalized express earnings valuation method can be an appropriate
choice.
● For a business in the industry where similar companies sell often, use of market
business valuation methods. These methods let you estimate the business worth by
comparing the actual selling prices and the Financial Performance of similar sold
businesses.
● Asset rich companies such as manufacturing and real estate-driven firms can benefit from
using the asset accumulation Business valuation method. If the Co. Is sold, the business
valuation can be used to properly allocate the business purchase price in order to recover
the initial investment quicker and reduce taxes.

In detail

● Discounted Cash Flow Method – The Discounted Cash Flow Method is an income-
based approach to valuation that is based upon the theory that the value of a business is
equal to the present value of its projected future benefits (including the present value of
its terminal value).
 ● Capitalized Excess Earnings method determines the business value by summing the net
tangible value of the business assets with the capitalized value of the “excess” earnings.
● The market business approach is a valuation method used to determine the appraisal
value of a business, intangible asset, business ownership interest, or security by
considering the market prices of comparable assets or businesses that have been sold
recently or those that are still available.
● In the asset accumulation method, all the assets and liabilities of a business are
compiled, and a value is assigned to each one. The value of an entity is the difference
between the value of its assets and liabilities.

What are the assumptions considered in the process of Co. valuation?

The main premises/assumptions of value based experts.

● Value in continued use, as a going concern.

● Value in place, as an assemblage of assets.
● Value in exchange, as an orderly disposition.
● Value in exchange, as a forced liquidation.

Explain what asset based approach to company valuation entails including the 3 of its
components which are; the book value approach, net realizable value and the replacement
value.

The asset approach views the Business as a set of assets and liabilities that are used as building
blocks to construct the picture of the business value. The asset approach is based on the so called
economic principle of substitution which addresses this question: what will it cost to create
another business like this one that will produce the same economic benefits for its owners?

Since every operating business has assets and liabilities, a natural way to address this question is
to determine the value of these assets and liabilities. The difference is the Business value.

Basically, these Business valuation methods total up all the investments in the business. Here the
business is estimated as being worth the value of its net assets.

Asset based business valuations can be done on a going concern or on a liquidation basis.

A going concern asset based approach lists the business's net balance sheet value of its assets
and subtracts the value of its liabilities.

A liquidation asset based approach determines the net cash that would be received if all assets
were sold and liabilities paid off.
However, there are three common ways of valuing its net assets: book values, net realizable
values and replacement values.

The book value approach. The book value of non-current assets is based on historical (sunk)
costs and relatively arbitrary depreciation. Limitation: these amounts are unlikely to be
relevant to any purchaser (or seller). The book values of net current assets (other than cash)
might also not be relevant as inventory and receivables might require adjustments.

Note: The book value means the value of a business according to its books or accounts, as
reflected on its financial statements. Theoretically, it is what investors would get if they sold all
the company's assets and paid all its debts and obligations.

Net realizable values of the assets less liabilities. This amount would represent what should be
left for the shareholders if the assets were sold off and the liabilities settled.

● However, if the Business being sold is successful, then shareholders would expect to
receive more than the net realizable value of the net assets because successful businesses
are more than the sum of their net tangible assets. They have intangible assets such as
goodwill, know-how, brands, and customer lists - none of which is likely to be reflected
in the net realizable value of the assets less liabilities.
● Net realizable value therefore represents a worst case scenario because, presumably,
selling off the tangible assets would always be available as an option. The selling
shareholders should therefore not accept less than the net realizable amount - but should
usually hope for more.

Conditions appropriate for the application of the adjusted net asset method:

★ When valuing a holding Co or a capital intensive co.

★ When losses are continually generated by the Business; or valuation methodologies based
on a company's net income or cash flow levels indicate a value lower than its adjusted net
asset value.

Replacement values:

● The approach tries to determine what it would cost to set up the business if it were being
started now.
● The value of a successful business using replacement values is likely to be lower than its
true value unless an estimate is made for the value of Goodwill and other intangible
assets, such as brands.
● Furthermore, estimating the replacement cost of a variety of assets of different ages can
be difficult.
● It looks at how much will it cost if one is to replicate the same Business.

So, of the three approaches, net realizable value is likely to be the most useful because it
presents the sellers with the lowest value they should accept.
Illustration

Work out the following illustration of asset based approach to Co valuation:

Plant and equipment was valued at shs 180,000,000, there was a loss in value for the motor
vehicles amounting to shs 30,000,000; office equipment worth shs 5,000,000 was stolen towards
the end of the financial year and before the valuation exercise. Due to changes in the Co debt
management policy, amounts receivable amounting to shs 45,000,000 was exempted from the
debtors whereas inventories were valued at shs.10,000,000. Among the creditors shs 400,000 had
been omitted from the final accounts. Debt amounting to shs 130,400,000 was paid off in the
year prior to the end of the period.

Statement of Financial position extract:

Non-current assets Historical

Plant and equipment 300,000
Motor vehicle 85,000
Office equipment 50,000
435,000
Less accumulated depreciation 75,000
Current Assets 360,000
Cash 35,000
Accounts receivable 90,000
Inventories 15,000
140,000
Total assets 500,000
Liabilities and shareholder's equity
Share capital and reserves 265,000
Total 265,000
Long term liabilities
Debt 155,000
Current liabilities
Tax 45,000
Accounts payable 35,000
Total liabilities 235,000
Total liabilities and equity 500,000
Residual equity 265,000

As shown above, adjustments are made to the company's historical balance sheet in order to
present each asset and liability item at its respective fair market value. Examples of potential
normalizing adjustments include:
 ● Adjusting fixed assets to their respective fair market value;
● Reducing accounts receivable for potential uncollectable balances if an allowance for
doubtful accounts has not been established or if it is not sufficient to cover the potentially
uncollectable amount, and
● Reflecting any unrecorded liabilities such as potential legal settlements or judgments.

The most commonly utilized asset based approach to valuation is the adjusted net asset method.
This balance sheet-focused method is used to value a Co based on the difference between the fair
market value of its assets and liabilities. Under this method, the assets and liabilities of the Co
are adjusted from book value to their fair market value.

NON CURRENT ASSETS Historical Adjustments NRV

Plant and equipment 300,000 120,000 180,000

Motor vehicle 85,000 30,000 55,000

Office equipment 50,000 5,000 45,000

435,000 155,000 280,000

Less accumulated depreciation (75,000) (75,000)

360,000 80,000 280,000

Current Assets

Cash 35,000 0 35,000

Accounts receivable 90,000 45,000 45,000

Inventories 15,000 5,000 10,000

140,000 50,000 90,000

Total assets 500,000 370,000

Liabilities and shareholder's EQUITY

Share capital and reserves 265,000 265,000

Long term liabilities

Debt 155,000 130,400 24,600

Current liabilities

Tax 45,000 45,000

Accounts payable 35,000 400 35,400

Total liabilities 235,000 130,800 105,000

Total liabilities and equity 500,000 370,000

Residual equity 265,000 265,000

NRV / value of the Co. 370,000 - (45,000 265,000

+24,600 +35,400)

Example 2.

The following extract Information is got from ABBA co.

NON CURRENT ASSETS Historical cost

( shs'000' )

Plant and equipment 300,000

Land 400,000

Furniture and fittings 150,000

Vehicles 185,000

CURRENT ASSETS

Debtors 88,000

Inventories 150,000

Cash at bank 102,000

LIABILITIES

Trade creditors 165,000

Other payables 70,000

Additional information

1) Plant and equipment had an accumulated depreciation of 205,000,000. The valuer of the
end of year period indicated a downward change in the current value of 5%
2) There was an appreciation of 15% in the value of land due to the high explosion in the
population and more so the location.
3) 10% worth of the furniture was sold before the end of the period. The total depreciation
for the category of furniture was shs 40,000,000. The depreciation for the sold off
furniture was shs 5,000,000
4) 15% of debt amount was reported to be uncollectable due to the after effects of Covid-19
pandemic lock down in 19/20.
5) The estimated net worth of the inventory is 165,000,000.
6) The value of trade creditors was valid to factor in a delay penalty of 5%. This
communication was made by the trade creditors one month to the end of the financial
year period.
7) All other items in the extracted Information stood at ease.
8) Long term debt amounting to 200,000,000 was fully settled before the end of the
financial year period.

Required: Generate the net worth of the Co using the most relevant asset based valuation
methods.

Valuation for ABBA co as at Dec 2020 (amounts in ‘000’)

Assets Historical cost Acc depn Adjustments NRV

Plant and 300,000 (205,000) =5%*95,000 =95,000- 4,750

equipment =4,750 =90,250

Land 400,000 =15%*400,000 =60,000 +

=60,000 400,000
=460,000

Furniture & 150,000 50,000 100,000

fittings

Vehicles 185,000 185,000

CURRENT
ASSETS

Debtors 88,000,000 13,200 74,800

Inventories 150,000 15,000 165,000

Cash at bank 102,000 102,000

 Liabilities

Trade creditors 165,000 8,250 =165,000 + 8250

=(173,250)

Other payables 70,000 (70,000)

NRV 933,800

NRV for furniture and fittings ( note 3)

150,000 * 10% = 15,000

Original b/f (cost) 150,000

Sold off (15,000)

Balance 135,000

Acc depreciation (40,000)

Depreciation of the 5,000

disposed off furniture

NRV 100,000

Adjustments

(Sold furniture + total depreciation for furniture) - Depreciation for the sold of furniture.

(15,000 + 40,000) - 5,000 = 50,000

Note 4

88,000 * 15% = 13,200

Note 6

165,000 * 5% = 8,250

Note 5

It means that there was an appreciation of inventories which is Shs. 165,000,000

Note
Net realizable value (NRV) is the value for which an asset can be sold, minus the estimated costs
of selling or discarding the asset. The NRV is commonly used in the estimation of the value of
ending inventory or accounts receivable.

Pros and Cons of asset based valuation method

Pros

• It is the most preferred method in a critical context like liquidation and M&A.

• It follows simple mathematical formulas and it is quick and easy to use.

• Consider off-balance-sheet items.

• Valid for loss making companies.

Cons

• Having innumerable assets does not point to the profitability of the business.

• Valuing the intangible assets requires attention to detail and making the overall process
complex.

• The method does not include the earnings of the company.

• Requires revaluation to derive the fair market value.

• Not forward looking.

• It also ignores the intangibles in most cases.

DISCOUNTED CASH FLOW METHOD OF SHARE VALUATION.

This method is most appropriate when one Co intends to buy the assets of another Co and to
make further investments in order to improve cash flows in the future. Discounted cash flow
(DCF) is a valuation method used to estimate the value of an investment based on its future cash
flows. DCF analysis finds the present value of expected future cash flows using a discount rate.
A present value estimate is then used to evaluate a potential investment. If the value calculated
through DCF is higher than the current cost of the investment, the opportunity should be
considered.

Discounted cash flow (DCF) refers to a valuation method that estimates the value of an
investment using its expected future cash flows. DCF analysis attempts to determine the value of
an investment today, based on projections of how much money that investment will generate in
the future.

The key issues to take note when using the discounted cash flow method and these are:

● Cash flows
● Discount rate and;
● Terminal value or the residual value. The DCF model also relies heavily on the terminal
value, which is the value of a company at the end of the forecast period. The terminal value is
usually estimated using a multiple of earnings or cash flow. However, these estimates can be
flawed and may not reflect the true value of the company because they are based on
assumptions.

Understanding the Components of the DCF Formula

There are three main components to the DCF formula: cash flows, the discount rate, and the
number of periods

Cash Flow (CF)

The cash flow that is being discounted can be from any source, such as earnings, dividends, or
even cash that will be generated from the sale of an asset. For example, if a company is looking
to invest in a new factory, the cash flow from that investment would be the revenue generated
from selling the products produced by the factory.

Discount Rate (r)

The discount rate is the rate at which future cash flows are discounted back to their present value.
The discount rate is often set at the investor’s required rate of return, which is the minimum
return that they require in order to invest in a company.

The discount rate can also be set at the weighted average cost of capital (WACC), which is the
average of a company’s cost of debt and cost of equity.

Number of Periods (n)

The number of periods is the number of years over which the cash flows are expected to occur. It
is often set at 10, which is the average life expectancy of a company.

Steps are:

● Need to forecast the cash flows.

● Determine the present value of the cash flows.
● Determine the terminal value and the present value of the terminal value.
● Then add the present value of the cash flows plus the present value of the terminal value to
determine the total value of the company.
Illustration 1:
Playing their role of stewardship, the top management of QUAT1 Co. a company dealing in
Telecom Services, presented its performance to the Board for the year ended June 30th 2022. The
Board was impressed with the performance achieved despite the fact that many companies had
suffered the negative economic impact of the Covid – 19 and aggravated more by the
inflationary effect of the war between Ukraine and Russia. One of the directors proposed that for
the coming financial period the situation may not be as is and required strategic decisions to
enable the company competitively keep afloat. It was further discussed that the closest
competing co to QT1 with unique product segment was PIA Co. Management was assigned the
task of interesting the shareholders PIA Co. to merge with QT1 and form one company proposed
to be named QUATIA Co. PIA co. welcomed the suggestion and suggested that since their Co.
had recently undertaken a valuation of their business, it was imperative that QUAT1 Co carries
out the same to establish its value as a going concern entity, which values for the companies will
form the net worth of the new company.
To facilitate the process, the following information was extracted and availed:
1. The Company generated a constant revenue amount of shs.165,000,000 for the last 3
years and it is anticipated that this could continue for the next 2 year ahead after which a
growth of 15% would be realized. The growth at this point will spur an increment in
revenue of 20% in the subsequent period of 3 years, after which growth will normalize at
17% into perpetuity.
2. The annual Operating costs are anticipated to be at the same level for the just concluded
FY at 60% of the generated revenue for the next 3 years and then reduce to 40% in the
subsequent years.
3. The depreciable assets of the Co. worth shs.62,000,000 are anticipated to have a
depreciation provision of 15,000,000 in year one, and this is to be reduced each
subsequent year by 20%. These assets are likely to serve only for the next 4 years after
which a disposal to an already identified buyer will be made at the carrying amount. The
depreciation amount is part of the operating costs percentage in note (2) above.
4. The Co has a running bank loan for which it is paying an annual interest of 0.5% of its
annual net income.
5. It is the intention of the co. to make an annual capital investment increment based on the
previous financial year. The capital investment for the year ended June 30th 2022 was shs.
25,000,000.
6. The co. has a very sound credit policy and therefore its working capital has been very
good. However, with the onset economic depression, it is anticipated that the Co. will
need to vary its working capital upwards every two years from year 2 to 110% and 130%
basing on the previous year position that stood at shs. 13,000,000.
7. The Co. is to pay off loans worth shs.50, 000,000 pear year; in year 2(2022/23) and
3(2023/24) and subsequently acquire a more cost effective loan of 85,000,000 in the year
4(2024/25), and shs.90,000,000 in 5(2025/26). The subsequent years will have no
additional loans and there will be no impact on the interest payable indicated in note (4)
above.
8. All companies in the industry pay income tax at the rate of 30%.
9. The risk-free rate for the industry is 12%. Whereas the inherent risk for such business is
7%. The Multiple rate for the residual value is estimated at 3 times.
Required:
Establish the total value of QUAT1 Co. to be presented to the Merger discussion Meeting with
PIA Co. indicate any other considerations to be made.

Solution
Note: the growth rate of 15% applies to year 3.

Year 0 1 2 3 4 5 6 7

Growth 165,000 165,000 165,000 189,750 227,700 273,240 327,888 383,629

rate

Less 99,000 99,000 113,850 91,080 109,296 131,155 153,452

operatin
g costs

EBIT 66,000 66,000 75,900 136,620 163,944 196,733 230,177

Less 330 330 380 683 820 984 1,150

Interest

EBT 65,670 65,670 75,520 135,937 163,124 195,749 229,026

Less tax 19,701 19,701 22,656 40,781 48,936 58,725 68,708

EAT 45,969 45,969 52,864 95,156 114,187 137,024 160,318

Add 15,000 12,000 9,600 7,680

DPN

60,969 57,969 62,464 102,836 114,187 137,024 160,318

Add 17,720
disposal

CFs 60,969 57,969 62,464 102,836 131,907 137,024 160,318

investm (25,000) (25,000) (25,000) (25,000) (25,000) (25,000) (25,000)

ent

Workin 13,000 14,300 14,300 18,590 18,590 18,590 18,590

g capital

Debt (50,000) (50,000) 85,000 90,000

mgt

ACFS 48,969 (2,731) 1,764 181,426 215,497 130,614 153,908

 DF 0.8403 0.7062 0.5934 0.4987 0.4190 0.3521 0.2959

PV-CF 41,149 (1,929) 1,047 90,477 90,293 45,989 45,541

Total 312,567

Note 3; we need to work out the depreciation

YEAR Shs 000
1 15,000
2 12,000
3 9,600
4 7,680
44,280

Therefore in the 5th period we have a disposal of 17,720 (62,000 – 44,280)

Note 6
YEAR Shs 000
0 13,000
1 13,000
2 (14,300)To be valued at 110%
3 14,300
4 18,590
5 18,590
6 18,590
7 18,590

Since there is no information about period 6 and 7, we don’t need to make assumptions but rather
get the shs 18,590 working capital for both periods 6 and 7.

Note 9
Our discount factor is; risk free rate + inherent rate which is 19% (12 + 7). We compute the
discount factor from the formula;

( )

Compute the terminal value

Perpetual cash flows 153,908
×3
461,724
Discount factor (19%) × 0.2959
136,624
Value of the Co.
PV of NCF 312,567
Add: terminal/ residual value 136,624
449,191

The 449,191 can go high due to the following considerations

a) Safe margin
b) Intangible asset.

Example 2

Diversification ltd wishes to make a bid for Tadpole Ltd. Tadpole makes an after tax profit of
ushs 40,000,000 a year. Diversification believes that if further money is spent on additional
investments, the after-tax cash flows (ignoring purchase consideration) would be as follows:

Year Cash flow '000'

( Net of tax )

0 (100,000)

1 (80,000)

2 60,000

3 100,000

4 150,000

5 150,000

The after tax cost of capital of diversity Ltd is 15% and the Co expects all investments to pay
back, in discounted terms, within five years.

Required: what is the maximum price that company should be willing to pay for Tadpole?

Solution:

The Maximum price is one which would make the return from the total investment exactly 15%
over the five years so that the NPV at 15% would be zero.

Year Cash flow shs'000' (net of tax) PV factor (15%) PV ushs '000'

0 (100,000) 1.000 (100,000)

 1 (80,000) 0.870 (69,600)

2 60,000 0.756 45,360

3 100,000 0.658 65,800

4 150,000 0.572 85,800

5 150,000 0.497 74,550

MAXIMUM PURCHASE PRICE 101,910

Limitations to companies and a sole proprietorship

Using the asset based approach to value a sole proprietorship is more difficult. In a corporation,
all assets are owned by the company and would normally be included in a sale of the business.
Assets in a sole proprietorship exist in the name of the owner and separating assets from business
and personal use can be difficult.

Foristance, a sole proprietor in a lawn care business may use various pieces of lawn care
equipment for both Business and personal use. A potential purchaser of the business would need
to sort out which assets the owner intends to sell as part of the business.

● There is a challenge of figuring out what assets and liabilities to include in the valuation.
● Choosing a standard of measuring their value, and;
● Determining what each asset and liability is worth.

For example, many Business balance sheets may not include the most important business assets
such as internally developed products and proprietary ways of doing business. If the Business
owner did not pay for them, they don't get recorded on the cost basis balance sheet.

But the real value of such assets may be far greater than all the recorded assets combined.

Indicate that the project cost would be more than the projected return. Thus, it might not be
worth making.

Dividend discount models, such as the Gordon Growth Model (GGM) for valuing stocks, are
other analysis examples that use discounted cash flows.

Advantages and Disadvantages of DCF

Advantages
Discounted cash flow analysis can provide investors and companies with an idea of whether a
proposed investment is worthwhile.

It is analysis that can be applied to a variety of investments and capital projects where future
cash flows can be reasonably estimated.

Its projections can be tweaked to provide different results for various what if scenarios. This can
help users account for different projections that might be possible.

Disadvantages

The major limitation of discounted cash flow analysis is that it involves estimates, not actual
figures. So, the result of DCF is also an estimate. That means that for DCF to be useful,
individual investors and companies must estimate a discount rate and cash flows correctly.

Furthermore, future cash flows rely on a variety of factors, such as market demand, the status of
the economy, technology, competition, and unforeseen threats or opportunities. These can't be
quantified exactly. Investors must understand this inherent drawback for their decision-making.

DCF shouldn't necessarily be relied on exclusively even if solid estimates can be made.
Companies and investors should consider other, known factors as well when sizing up an
investment opportunity. In addition, comparable company analysis and precedent transactions
are two other, common valuation methods that might be used.

TOPIC 6

PREDICTION AND PREVENTION OF COMPANY FAILURE

It's important to be familiar with failure prediction models based on both quantitative and
qualitative Information, and also to comprehend the underlying factors leading to the decline
and eventual demise of a Co.

It provides knowledge about the future on a subject of interest. However, accurate

predictions are the result of many analyses and the considerations of all sorts of probabilities.
These predictions help us make plans and decisions when we don't know what the future holds.

QUANTITATIVE

Quantitative models identify financial ratios with values which differ markedly between
surviving and failing companies, and which can subsequently be used to identify companies
which exhibit the features of previously failing companies. Commonly accepted financial
indicators of impending failure include:
 ● Low profitability related to assets and commitments.
● Low equity returns, both dividend and capital.
● Poor liquidity.
● High gearing.
● High variability of income.

Altman Z-score is one of the quantitative models used in the assessment of Co likely failure and
bankruptcy.

What is the Altman Z-score?

The Z-Score formula for predicting bankruptcy was published in 1968 by Edward Altman,
Assistant professor in the field of finance in the New York University. The Z-Score model is a
linear analysis, with weights attached to the five characteristics so that a cumulative result can be
reached to form the basis for classifying the Business in one of two groups - bankruptcy and non-
bankruptcy.

Altman added a statistical technique called multivariate analysis to the mix of traditional ratio
ANALYSIS techniques, and this allowed him to consider not only the effects of several ratios on
the predictiveness of his bankruptcy model, but to consider how those ratios affected each
other's usefulness in the model. The model is based on five financial ratios that can be calculated
from data found on a COMPANY'S annual financial reports. It uses profitability, leverage,
liquidity, solvency, and activity to predict whether a Co has a high probability of becoming
insolvent. The Altman Z-score is used to determine how far a value is from the mean. (For
example, it may show a student's performance in comparison to the average performance)

An Altman Z-score close to 1.8 suggests a Co might be headed for bankruptcy, while a score
closer to 3 suggests a company is in solid financial positioning.

Effect of becoming bankrupt:

When companies become bankrupt, many other challenges come up. If big companies become
bankrupt, an entire economy can be affected because of the many direct and indirect losses
suffered.

THE ALTMAN Z-SCORE Formula

The formula he came up with is shown below:

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

X1 - Working capital over total assets (WC/TA)

The working capital to total assets (WC/TA) ratio measures the company's liquid assets
compared to its size. We define working capital as the difference between current assets and
current liabilities. Typically, can Co experiencing frequent operating losses will see a contraction
of current assets compared to total assets. Of the three ratios for liquidity, this has proven to be
the most prized. The other two tested ratios for liquidity were the current ratio and the quick
ratio. However, these turned out to be less useful in Altman's model.

X2 - retained earnings over total assets ( RE/TA)

Retained earnings is a measure that represents a company's total reinvested earnings for its entire
lifecycle. We should note that retained earnings as a measure is susceptible to manipulation
through corporate reorganizations and dividends. The company's age is implicitly a part of this
ratio. For example, a relatively new Co would have a low RE/TA ratio because it did not have
time to accumulate profits. We can therefore argue that this analysis discriminates somewhat
against a new firm, and its chances of being classified in the bankrupt group are relatively more
substantial than those of another older Co. However, the risk of bankruptcy is much higher in the
early years of the company. Also, the ratio measures the leverage effect. Companies with high
retained earnings to total assets ratio funded their assets by retained profits and therefore, not
taken as many debts.

X3-earnings before interest and tax over total assets ( EBIT/TA)

This ratio is a measure of the productivity of the company's assets, eliminating factors such as
taxes and leverage. Because the firm bases its whole existence on the return of its assets, this
ratio is particularly suited to analyze corporate bankruptcy.

X4-market capitalization over total liabilities (MVC/TL)

This ratio indicates how much company assets may be impaired if the value of the debt exceeds
the value of the assets. For listed companies, we use the market value of ordinary and preferred
shares or market capitalization. For private enterprises, we use the accounting value of the share
capital. This ratio also considers the market price, which is neglected by most bankruptcy
research models.

X5-Sales over total assets(S/TA)

The sales over total assets ratio is a standard Financial ratio illustrating the ability of company
assets to generate sales. This is a measure of the Management's ability to cope with competitive
conditions.

INTERPRETING THE SCORE

There are three ranges of numbers which show the financial status of the Co in regards to
bankruptcy.
 ● Score of 3 and above: a score of more than 3 indicates that the Co is in the safe zone.
This means that the Co's financial status is okay. It is financially healthy. If you are
investing, this would be a good company to invest in.
● A score from 2.9 and 1.8: this range is considered a gray area. Companies which have a
score lying in this range are not very safe. Their finances are not stable and the
companies may get into the danger zone if there are improvements.

If you are looking for an investment, this would not be a very good bet. If you already have your
money there, you will need to act fast.

Decide to either follow keenly everything affecting the company or just sell off your investment.

● Score of below 1.8. any score below 1.8 should scare you. Do not give it much thought
as the company is in the red area or distress zone. The lower the score, the more danger
there is in the Co soon becoming insolvent. A score below 1.8 means it's likely the Co is
headed to bankruptcy, while companies with scores above 3 are not likely to go bankrupt.
Investors can use Altman Z-scores to determine whether they should buy or sell a stock if
they're concerned about the Co's underlying Financial strength. Investors may consider
purchasing a stock if its Altman Z-score value is closer to 3 and selling or shorting a
stock if the value is closer to 1.8.

Illustration

Belta manufacturers in China produce car engines. They have been in the business for almost 20
years. They have been profitable enough to employ more staff and increase their production. But
with a recent loan taken to facilitate automation, investors want to know how the company is
doing.

Their total assets are worth $3,500,000 while they have a working capital of $4,200,000. Their
liabilities stand at $5,000,000 while retained earnings amount to $800,000. Earnings before
interest and tax come to $6,500,000. Sales total $8,300,000 while the market value of EQUITY
is $7,000,000.

Here is the calculation of Belta's Altman Z-score:

Altman Z-score=(1.2×A) + (1.4×B)+(3.3×C)+(0.6×D)+(0.999×E)

(1.2×(4,200,000/3,500,000))+(1.4×(800,000/3,500,000)) +
(3.3×(6,500,000/3,500,000))+(0.6*(7,00,000/5,000,000))+(0.999*(8,300,000 / 3,500,000))

=(1.2*1.2)+(1.4*0.229)+(3.3*1.857)+( 0.6*1.4)+(0.999*2.371)

=11.097

The investors can comfortably toss away their fears and relax, expecting higher returns. With a
score of 11.097, Belta is firmly in a safe zone.
Example 2

KLME Ltd is a manufacturer of school shoes with a number of distribution outlets in the East
African region. Their business commenced in 1985 and they have had no disruption since then.
Their profitability levels too have been good in that they have been able to employ more staff
and increase their production. However, KLME has approached their bankers to get a loan
facility to help them boost working activities since the schools were due to open; implying that
parents would be able to buy shoes for their students going back to school. But the bankers feel
that, with the recent prolonged closure of schools causing a very big impact on the company
profitability levels; and coupled with Covid -19 uncertainties for the immediate future, further
analysis regarding the survival of the company was required.

Additional information reveals that: Their total assets are worth $2,500,000 while they have a
working capital of $3,200,000. Their liabilities stand at $4,000,000 while retained earnings
amount to $700,000. Earnings before Interest and Tax come to $4,500,000. Sales total
$7,200,000 while the market value of equity is $6,000,000.

Compute the KLME Altman z-score as part of the quantitative analysis aiding decision making.

Altman Z score = (1.2 x A) + (1.4 x B) + (3.3 x C) + (0.6 x D) + (0.999 x E)

Example 3:

The following extracts relate to 5 manufacturing companies: The figures in the table are in US$
‘000.

CO.1 CO.2 CO.3 CO.4 CO.5

Net Sales 7,965 8,922 10,521 6,836 10,101

Retained earnings 1,195 1,338 1,578 1,025 1,515

Earnings before interest and Tax 1,673 1,820 2,105 1,308 2,075

Net working Capital 1,593 1,645 1,995 1,150 1,850

Asset 9,956 11,000 12,050 8,500 9,895

Long Term Loan 1500 1600 700 900 1200

Additional notes:

1. The market value of Equity for Co. 2 was $ 4,700,000; Co.4-C was $10,000,000, Co.1
was $ 4,400,000 whereas companies 3 and 5 had similar equity market value at $ 6,400,
000.

2. Additional short term loans for was as follows: Co 1: $600,000; Co.2: 460,000; Co.3:
350,000; Co.4: 500,000 and Co.5: 4,000,000.

3. The Formula for the Z score is given as: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 +1.0X5

Where; X1 = working capital/total assets, X2 = retained earnings/total assets, X3 =

earnings before interest and taxes/total assets, X4 = market value equity/book value of
total liabilities, and X5 = sales/total assets

Required:

a) Basing on the information given above compute the Z score for each of the company and
interpret the results in line with Altman’s performance guidelines.

b) Give advice on performance of the companies and which 2 best companies would best be
invested in and state why so.

LIMITATIONS OF THE ALTMAN Z-SCORE:

The Z-Score models have proven to be a reliable tool for predicting corporate failures in a broad
variety of contexts and markets. However, it should be noted that the Z-Score is not valid in
every situation, as the models have drawn several objections over the years.

The models should only be used for forecasting financial distress if the company being analyzed
is comparable to the firms in Altman’s samples (Altman 2000). The data that Altman used as the
basis of the models is now several decades old, which is evident in the original Z-Score, since it
uses data from relatively small firms with total asset values ranging between $1 million and $25
million. Thus, it is not particularly appropriate for small firms with total assets values less than
$1 million, since they may have different ratios than larger firms. Also, the Z-Score models are
generally not appropriate for small corporations with little or no earnings.

Furthermore, the models use unadjusted accounting data. For instance, one-time write-offs can
cause dramatic changes in the Z-Scores from quarter to quarter. In addition, the models have the
weakness of not being immune to false accounting practices.

Altman also states that retained earnings relative to total assets (X2) has shown a marked
deterioration in the average values of non-distressed firms in the past years. Therefore, he
reduced the ratio’s impact on Z”-Scores in the subsequent model for non-manufacturing firms.
EBIT may also be exposed to manipulation of accounting data.

Because the market value of equity is substituted by the book value, the Z”-Score for non-
manufacturers will not pick up bankruptcies caused by factors other than those that show up on
the Balance Sheet, like unexpected business disruptions for instance. This makes the Z”-Score
especially vulnerable to potential manipulation of accounting data, as it is unadjusted.

The score also relies on data directly from each company, so it’s only as good as the data the
corporation provides.

Additionally, some companies will perform a one-time write-off, potentially as part of a failed
acquisition. This can result in a very low Altman Z-Score for a particular year or quarter, which
might be unrepresentative of a company’s long-term position.

IN SUMMARY

Altman Z-Score: A tool to predict likelihood of bankruptcy

The Altman Z-Score is a measure of a company’s health and likelihood of bankruptcy. It was
developed by Edward Altman in 1968 when he was a finance professor at NYU. This is a
mathematical formula which uses financial data from a company's income statement and balance
sheet. It generates a number which tells you the likelihood of bankruptcy or financial
embarrassment. It has a reported 72% accuracy in predicting bankruptcies two years in advance.

1) Z-Score Formula for Public Companies:

T1 = Working Capital / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings before Interest and Taxes / Total Assets

T4 = Market Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Z-Score Bankruptcy Model:

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5

Zones of Discrimination:

Z > 2.99 -“Safe” Zone

2) Z-Score Formula for Private Firms:

T1 = (Current Assets-Current Liabilities) / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Book Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Z' Score Bankruptcy Model:

Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5

Zones of Discrimination:

Z' > 2.9 -“Safe” Zone

3) Z-Score for Non Manufacturer Industrials and Emerging Market Credits:

T1 = (Current Assets-Current Liabilities) / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Book Value of Equity / Total Liabilities

Z-Score Bankruptcy Model:

Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4

Zones of Discrimination:

Z > 2.6 -“Safe” Zone

CONCLUSION

The Altman Z-score is a good model which can accurately show the direction a company is
taking. If the alarm is raised in good time, then corrective measures can be taken.

Z SCORE:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + X5

• = 1.2 (X1 = Working capital / Total Assets) + 1.4( X2 = Retained Earning / Total Assets) +
3.3
(X3 = Profit before Tax and Interest / Total Assets) + 0.6 (X4 = Market value of equity /
Total long term debt) + 1 (X5 = Revenue / Total Asset)
• Qualitative models such as Z score use publicly available financial information and predict
whether a company is likely to fall within two year period.
• The model uses a financial model equation, into which various financial data is input and a
score is obtained.
• Advantage of this model is: it is easy to calculate and they provide an objective measure of
failure. Other advantage is:
• Disadvantage of this model is: it can be manipulated with creative accounting. If that
happens, it will appear as a sign of corporate failure anyways.
• Qualitative models actually fulfil the shortfalls/ complete the limitation in the financial ratio
measures. Financial measures are limited in describing actual status of a company.
• Prediction of failure for companies with score below 1.8 is just a probabilistic one, not a
guarantee. There is no detail analysis for the companies with performance score within the
grey area 1.8 – 3.0.
• The model or equation was developed with statistical data of some companies analyzing their
historical financial data. Hence the model should not be applicable to any other company
unless they are of same size, operating in the same market condition, economic condition and
with same resources.
• A score below 1.8 is dangerous and indicates bad performance or corporate failure WITHIN
NEXT TWO YEARS and a scope above 3 is generally good.
• Each component of the Z score formula is a variable for the Z score and they can individually
explain their contribution to the rise/fall of the Z score.
• Then the information from the question can explain why the variable is falling. For example:
debt level has been building up due to investment programs and share prices and market
value has fallen by 14% due to that.
• Once the reason for the performance has been figured out, we need to validate the relative
performance by comparing our results with that of the competitors or market standard or
benchmark data. This will confirm whether the problem is with the company itself or with
the current economic climate or general market condition.
• There could be issues with more than one variable components of the Z score formula. One
such variable is profit derived from the asset invested. It may so happen that the profit will be
realized from secondly year onwards, not from the year of investment and it will increase
gradually but the asset value will increase immediately as soon as investment is made.
ARGENTI’S MODEL

Elements of Argenti’s corporate failure prediction model

J. Argenti developed a model which is intended to predict the likelihood of company failure. The
model is based on calculating scores for the company based on 3 factors each of which is given a
“danger mark”.

Argenti Model (also referred as A-score) is a tool for understanding the causes of managerial
crisis at the company, which in its turn may lead to the firm’s bankruptcy.

ARGENTI MODEL is divided into three main areas, which are then subdivided into multiple
sub areas.

Each of the subareas is scored and if the addition of all scores is more than 25, then the company
is likely to fail. However most of the companies, which are failing or likely to fail; score very
high, around 60 or more. In addition to the total score; scores of the three main areas are also
checked and reviewed for the purpose of them to reveal something. For example a high score in
Mistakes made, will reveal poor management. Company should do all it can to avoid insolvency.

Defects are: Defects are divided into management defects and accounting defects.

● Management defects are about character or strength of senior management. Fault in

organization structure. CEO & MD positions are held by same person, an autocratic
CEO, a passive board of directors, top management leaving the company, poor skills and
experiences in management team and a poor record of responding to external/internal
changes by the organization.
● Accounting defects: lack of budgetary control system, lack of cash flow planning or a
proper costing system in place. These generic topics need to be then applied to the
specifics of the question.

Mistakes are: Mistakes happen because there were defects at the first place. They are
interconnected. If the management and accounting system is weak then mistakes are bound to
happen. High gearing (Debt/Equity ratio goes beyond previous gearing ratio), Overtrading (Rise
in revenue with the help of debt funding), failure of large and important projects. These areas are
under direct control of the managers and failures in these areas happen due to poor management
of the top management. These generic topics need to be then applied to the specifics of the
question.

Argenti suggests that the failure process of a business follows a predictable sequence:

1. DEFECTS OF THE COMPANY

1) Management weaknesses:

 Autocratic chief executive

 Failure to separate role of chairman and chief executive Passive board of directors
 Lack of balance of skills in management team – financial, legal, marketing, etc
 Weak finance director
 Lack of ‘management in depth’

2) Accounting deficiencies:

 No costing system

 No budgetary control
 No cash flow plans

3) Response to change:

• Slow or no response to changes in products, processes, markets, employee practices etc.

CONCLUSION FROM QUALITATIVE MEASURES:

• The qualitative models may imply or relay only bad points. However company may do well
at the same time with its financial results (Rise in revenue, rise in profit etc.). Increase in
revenue and profit means that the product of the company is being liked by the customer. But
that does not mean it is going to continue like this. Once the product is out of production and
is adopted by the customer, the financial ratios may change and it will tally up with the
opinion of the qualitative model measures.
• In order to confirm that the initial bleak results of financial measure are only temporary;
further data will be required; which are:

ISSUE WHY SOLUTION

INTEREST COVERAGE RATIO NO MONEY AVAILABLE IN THE CASH-FLOW PROJECTION TO

GOING DOWN. BANK. CURRENT RATIO IS CONFIRM THAT THE PRODUCT
LESS THAN 1. WILL PAY FOR INVESTMENT
GEARING RATIO IS GOING UP. WITH ITS MATURITY

DECLINE IN OPERATING THIS IS PURELY BECAUSE OF DETAILED ANALYSIS OF COST;

MARTIN NEED EXPLANATION MANAGEMENT CONTROL. COSTING SYSTEM – OR USING
OPERATING EXPENSES ARE IN MODELS SUCH AS ACTIVITY
CONTROL OF THE BASED COSTING OR KAIZEN
DEPARTMENT MANAGERS. MODEL OF COSTING; WILL
(GROSS PROFIT – OPERATING ANALYZE THE COST AT A
EXPENSES = OPERATING DETAILED LEVEL, IMPROVE
PROFIT). OPERATING PROFIT / THE COST CONTINUOUSLY
REVENUE = OPERATING AND HELP IN IMPROVING THE
 MARGIN. MARGIN.

SHARE PRICES GOING DOWN IT IS CONCERNING AS IT SHARE PRICE OF THE

AFFECTS CONSUMER COMPANY’S SHARE NEED TO
IMPRESSION OR EXTERNAL BE COMPARED WITH MARKET
IMPRESSION, SHAREHOLDER STANDARD, COMPETITOR’S
VALUES AND EQUITY SHARE PRICE AND REVIEWED
POSITION OF THE COMPANY IN LIGHT OF GENERAL
MARKET CONDITION. THIS IS
CONFIRM WHETHER THERE IS
A GENERIC MARKET
CONDITION OR ECONOMIC
CONDITION, WHICH AFFECTS
ALL COMPANIES IN THE
MARKET OR IT IS SOMETHING
SPECIFIC TO THE COMPANY
BEING ANALYZED.

IN THE EARLY STAGES OF THE NPV (NET PRESENT VALUE) &

PRODUCT/PROJECT LIFE- IRR (INTERNAL RATE OF
CYCLE; WHEN CAPITAL RETURN). NPV RETURNS AN
SPENDING IS HIGH AND ABSOLUTE PROFIT FIGURE,
RETURNS ARE YET TO BE WHEREAS IRR RETURNS A
REALIZED VARIOUS PROFIT PERCENTAGE. IN THE
FINANCIAL RATIOS MAY NPV METHOD, REVENUE AND
APPEAR BLEAK COST OF THE PROJECT ARE
CALCULATED, DISCOUNTED
TO PRESENT VALUE – AND
THEN THEY ARE COMPARED
TO THE INITIAL INVESTMENT
OVER THE ENTIRE LIFE CYCLE
OF THE PROJECT OR PRODUCT.
PROJECTS/PRODUCTS WITH
NEGATIVE NPV SHOULD BE
REJECTED, AS THESE MEANS
THAT THE PROJECTS/PRODUCT
CANNOT RECOVER ITS INITIAL
COST OF PROJECT.
Argenti and Z scope are the example of qualitative models

Argenti Score 25 or above is Subjective model/scoring

symptom of failure within based on qualitative analysis
next two years and analyst’s personal opinion

Z Score Score 1.8 or below is Based on absolute public’s

symptom of failure within available information used to
next two years. Score GE 3 is calculate the score. Hence
good Based on Objective score