Analysis of Financial Statement

Use of Financial statement

Manager and number of external parties regularly use a firm’s financial statements to evaluate the financial and operating performance of the business.

Sources of Financial Information

• Published Financial Reports

  The firm’s financial Statement contained in the annual report is the end products of the accounting process. To report on the progress of a firm during the year, most publicly held companies also issue interim reports each quarter. Interim reports focus primarily on the income statement and contain summary data rather than a full set of financial statements. Still, they provide additional information for evaluating the financial position and the profitability of the firm’s operations. Unlike the annual reports, however, interim reports are unaudited.

Annual and interim reports are two of the primary means by which management communicates information about the firm to interested parties. In addition to the financial statement. These reports generally contain the auditor’s report. Schedules and explanatory notes. And a discussion and analysis of the firms operation by management. An analysis of the published reports should include, at a minimum, a review of these components, for example the auditor’s report tells the reader that the statements were audited, and whether the statements are fairly presented in accordance with generally accepted accounting principles .Major concerns of the auditors will also be discussed in the report. A review of the notes will indicate the accounting policies followed by the company.

• Reports  filed With the SEC

Probably the most detailed information available on publicly held companies in contained in the reports that must be filled with Securities and Exchange Commission (SEC) .these reports include.

Form S-1 A report that must be filed when a firm wishes to offer securities for sale to public. From S-1 contain financial information about the company, its management and management’s plan for the use of the money received from the sale of the proposed securities.

Form 10-K. An annual report that is more detailed than the published annual report provided to stockholders.

Form 10-Q. A quarterly report of summarized financial information.

Form 8-k. A special report filed whenever any significant events occur such as a change in top management.

These reports are available to the public on request.

• Advisory Services And Financial Publications

Financial advisory services, such as Moody’s investors Services and standard and Poor’s Corporation, also Publish financial data about both publicly and privately owned companies; these are normally not as detailed as the SEC reports or the Company Reports. The advantages of advisory service reports are their accessibility since they are found at most public and university libraries.

 A comparison of the company under study with firms in a similar line of business and with industry norms is also useful. Industry data are available from a number of financial services. For examples, Robert Morris Associates Annual statement studies provide income statement and balance sheet data and 16 financial ratios for many industries. Dun & Bradstreet publishes an industry Norms and key business Ratios book that contains typical balance sheet, income statements and 14 selected financial ratios for over 800 different lines of business. The 14 ratios for the most recent year. By industry groups are also published in key business Ratios by Dun & Bradstreet. Individual company and industry analyses are also available from stock brokerage firms. An abundance of useful information is found in various economic and financial newspapers and magazines such as the Wall street Journal, Forbes, Fortune, Business week, and Barron’s.

In making comparisons with other companies, we must recognize that the company under review may not be similar to other companies because of diversification into other product lines .Also, because of diversification; industry data may not clearly resemble the company under study. In such cases, we attempts to identify the industry that the company best fits and uses that industry data and companies in that industry group for comparison.

The Need for Analytical Techniques

Information contained in the various sources of financial data is expressed primarily in monetary terms. When the absolute dollar amounts for most items reported in the financial statements are considered individually, they are generally of limited usefulness. Significant relationships may not be apparent from a review of absolute dollar amounts. Because no indication is given whether a particular item is good or bad for a firm. For example merely knowing that a company reported earnings of $100000 for the current year is of limited use unless the amount is compared to other information such a last year’s earnings, the amount is compared to other information, such as last year’s earnings, the amount of capital invested, the current year’s sales, the earnings of other companies in the same business or some predetermined amount budgeted by the firm.

 To simplify the identification of significant changes and relationships. The dollar amount reported in the financial statement is frequently converted into the percentages or ratios by the statement user. Some commonly recognized percentages are sometimes shown in supplementary schedules to the financial statement as part of the firm’s annual report. The analysis of relationship between dollar amounts of each item to same base amount is referred to as horizontal analysis and vertical analysis. Ratio analysis is the interpretation of the relationship between two items. Such as current assets to current liabilities.

Objectives of Financial Statement Analysis

Percentage analysis and ratio analysis have been developed to provide and effective means by which a statement user can identify.

1. Important relationship between items in the statements and
2. Trends in financial data percentages and ratio simplify the evaluation of financial conditions and past operating performances.

The information is used primarily to forecast a firm’s ability to pay its debts when due and to operate at a satisfactory profit level. However because the analytical techniques are almost limitless as are the user’s special interests and objectives the choice of Proper ratio and percentages must fit their specific purposes. For example some users of financial data are concerned with evaluating the firm’s ability to produce enough cash to pay its short term debts when they mature and still have sufficient cash left to carry out its other activities. The concern with a firm’s short-term debt-paying ability is called liquidity. The focus of this type of investigation is generally on the firm’s current assets and current liabilities.

 Other users, such a long-term creditors and stockholders. Want to know about a firm’s liquidity, but are also interested in the business ability to pay its long-term obligations. This long-term focus deals with a firm’s solvency. In this analysis the statement user assesses the financial structure of the firm and its use of financial leverage. The objective is to evaluate the prospects for operating at an earnings level adequate to provide sufficient cash for the payment of interest. Dividends and debt principal.

Percentage Analysis

1. Horizontal Analysis

An analysis of the change in individual financial statement items from year to year is called horizontal analysis; Horizontal analysis of the preceding year’s financial statement is generally performed as a starting point for forecasting future performance. Most firms’ annual reports include financial statements for the two most recent years and selected summary data for five to ten year. Financial statements presented for the same company for two or more years are called Comparative Statements.

In horizontal analysis, the individual items or groups of items on comparative financial statements are generally first placed side by side, as they are in the first columns of figures. Because it is difficult to compare absolute dollar amounts, the difference between the dollar amount of one year and the next is computed in both dollar amounts and percentage change. In computing the increase or decrease the earlier year is used as the base year. The percentage change is computed as follows:

Percentage Change= 100(Dollar Amount of change)                                                                                                Dollar Amount In previous year

For Example From 1990 to 1991 the cash account of ABC Corporation increased by 90 the percentage change is 30%.

 A percentage change can only be computed when a positive amount is reported in the base year. The amount of change cannot be stated as a percentage if the item in the base year was reported as a negative or a zero amount.

 We must also be careful when the dollar amount in the base year is small because a small absolute change can result in a substantial percentage change.For example, assume that net income was $100 last year and increased to $300 in the current year. This is an increase of only $200 in income. But is a 200% increase in percentage term such a large percentage change may create a misleading impression.

A review of the percentage increase or decrease will reveal those items that showed the  

Most significant change between the periods under study. Important and unusual changes such as a significant percentage change in sales should be investigated further by the analyst. The objective of the investigation is:

• To determine the cause of the change
• To determine whether the change was favorable or unfavorable.
• To attempt to assess whether a trend is expected to continue.

WE must also consider changes in other related items. For example when reviewing the percentage changes in the balance sheet accounts included in figure. Attention is directed to the change is in the plant and equipment because of the size and direction of the change 44.4% increase the cause of the  change is favorable or unfavorable, We must need to seek further answers to such question as how is the added investment being financed, is the expansion going to  cause  severe cash flow problems? Are sales markets adequate to support the additional output? What is the impact of Expansion on income? Answer To these questions and announcements made by management, will assist us in determining whether further expansion is expected to continue and to be effective. We may look to the balance sheet, the income statement. The statement of cash flow. And supplementary disclosures for additional data in answering these questions.

 Sales in figure increase 7.7% by itself a favorable trend. However the rate of increase in cost of Goods sold was 10.7% and selling expenses increased by 30.1% thus during the period the firm was unable to maintain its profit margin percentage. It appears that the increase in sales is a least partially the result of an increased sales effort. These items warrant further investigation by us if we are concerned with the profitability and long term future of the firm. in this case the we should try to determine whether inventory cost are continuing to increase , the extent of competitive pressures on the revenues of the firm and the effect of the increased selling expenses on future sales.

Trend Analysis

Trend analysis is commonly employed when financial data are presented for three or more years. In this analysis, the base year is the first year that data are reported. Each financial statement item of the base year is set equal to 100.In subsequent years statement item are stated as a percentage of their value in the base year as follow:

Index=100(Dollar amount in index year)                                                                                               Dollar amount in base year

For Example, Assume that sales and net income were reported for the last five years as shown:

Now it can be seen that net income is increasing more slowly than sales.

 The relationship between sales and net income is only one trend to review. The trend in other accounts should also be investigated, particularly since the level of net income is affected not only by sales but also by the firm’s expenses. In this case, it is possible that the firms inventory cost are increasing faster than selling prices. Or the increase in sales may be the result of granting liberal credit terms. Which are resulting in larger bad debt expenses? The important point is that other related operating data must be also reviewed before drawing a conclusion about significance of one particular item. The overall objective is to evaluate various related trends and attempts to assess whether the trends can be expected to continue.

Vertical Analysis

Horizontal analysis compares the proportional changes in a specific item from one period to the next. Vertical analysis involves restating the dollar amount of each item on the same statement. This item is referred to as the base amount. For example, on the balance sheet, individual components are stated as a percentage of total assets or total liabilities and stock holder’s equity. on the income statement , net sales or total revenue are usually set equal to a base of 100%, with each income statement item expressed as a percentage of the base amount. Such statements are often called common size statement since all the items are presented as a percentage of some common base amounts.

 Vertical analysis is also an important tool for comparing data to other standards such as the past performance of the firm. The current performance of competing firms, and averages developed for the industry in which the firm operates.

Ratio Analysis

A financial statement ratio is computed by dividing the dollar amount of one item reported, the purpose is to express a relationship between two relevant items that is easy to interpret and compare with other information .for example the relationship of current assets to current liabilities. Called current ratio. is of interest to most financial statement users. For a firm reporting current asset of $210000 and current liabilities of $120000 the current ratio is 1.75. This means that the company has$1.75 in current asset for every $1 of its current liabilities.

 The relationship could be converted to a percentage, 175% by multiplying the ratio by 100.in ratio form, or as a percentage, the relationship between the two items can be more easily compared to other standards, such as the current ratio of other companies or an industry wide ratio.

 Relevant relationship can exist between items in the same financial statement or between items reported in two different statements; so many ratios can be computed. We must give careful thought to which ratios best express the relationship relevant to the area of immediate concern. The user must keep in mind that a ratio shows a significant relationship that may have little significance when used alone. Consequently, to evaluate the adequacy of a certain relationship, the ratio should be compared to other standards such as an industry average and the historical record of the company understudy.

 Ratios are classified according to their evaluation of a firm’s profitability, liquidity, and solvency.

Ratios To Analyze Profitability

Profitability analysis consists of tests used to evaluate a firm’s earning performance during the year. The result are combined with other data to forecast the Firm’s potential earning power, which is more important to managers, long-term creditors, and stock holders because , in the long run, the firm must operate at a satisfactory profit to survive. Potential earning power is also significant for other statement users. Such as suppliers and labor unions, who are interested in maintaining a continuing relationship with a financially sound company? A firm’s financial soundness depends on its future earning power.

 Adequacy of earnings is measured in terms of the relationship between earnings and either total assets or common stockholder’s equity, the relationship between earnings and sales, and the availability of earning to common stockholders. If earning appears to be inadequate, the next step is to determine why. Is the sales volume too low? Are the costs of goods sold and or other expenses too high? Is the investment in assets excessive in relation to the firm’s sales?

Rate of Return on Total Assets

Rate of return on total assets is determined by dividing the sum of net income plus after-tax interest expense by average total assets for the year:

Return on Total Assets= Net Income + Interest Expense (Net of tax)                                                                                        Average total Asset

 Interest expense (net of tax) is computed as:

   Interest Expense X (1.0- income tax rate)

Interest expense is added back to net income in the numerator to derive the total return earned on the total assets used, Regardless of how they were acquired. In other words, interest expense is a return to the creditors for the use of their money to finance the acquisition of assets. The net of tax interest expense is used because it is the net cost to the firm for using borrowed funds; Average total assets are used in the denominator because the earnings were produced by employing resources throughout the period. The sum of the beginning and ending total assets is divided by two to compute average total assets. If sufficient information is available, a monthly or quarterly average would be preferred to minimize the effects of seasonal fluctuations.

The management of XYZ Corporation produced a return on averaging total assets of 11.0% in 1991 and 13.5% in 1990 as computed below assuming the tax rate was 21 and 26% respectively:

During 1991, Management produced approximately 11 cents in profit for every dollar of asset invested, compared with 13.5 cents for every dollar in 1990.The decrease in the ratios between the two years is significant and result from decreased net income combined with an increased investment base. Such a decrease highlights the need for further investigation by us.

Rate of Return on Common Stockholder’s Equity

The return on total assets does not measure the return earned on the assets invested by the common stockholders. The return to the common stockholders may be greater or less than the return on total assets because of the firm’s use of financial leverage. Financial leverage is the use of borrowed funds or other financing sources, such as preferred stock, to earn a return greater than the interest or dividends paid to the creditors or preferred stockholders, If a firm is able to earn more on these funds than the amount that must to be paid to the creditors or preferred stockholders, the return to the common stockholders will be greater than the return on total assets. If the amount earned on the funds is less than the return on total assets. The rate of return to common stockholders may be computed as:

The preferred dividend requirement is subtracted from net income to yield the portion of net income allocated to the common stockholder’s equity. The denominator excludes the preferred stockholder’s equity in the firm.

The Computation for ABC Corporation are shown here:

Note that these rates are higher that the corresponding returns computed on total assets because the company earned a return on the assets financed by the creditors and preferred stockholders greater than the interest or dividends paid to them. However, the percentage decreased from 26 in 1990 to 17.1 in 1991 a decrease worthy of further investigation.

 Return on sales

 Return on sales-also called the profit margin is called during a vertical analysis of income statement, it reflects the portion of each dollar of sales that represents net income. Return on sales is computed by dividing net income by net sales.

For 1991, each Dollar of sales produced 5 cent in net income. Consistent with other ratios computed, this is measure shows a declining profitability trend for the firm. The ratio should, ofcource, be compared to other standards to be more useful. If the return on sales for competing firms is 4.5% for example, the 5% appears favorable. Even so, other data, such as increases in major expenses, should be investigated further because some problem areas or Poor management practices could be discovered to explain the decline between the two years.

Earnings Per Share

The Earning per share (EPS) of common stock is widely used in evaluating a firm’s financial performance; the ratio is commonly used to compile earning data for the press and for statistical services. It is a well-publicized ratio because its converts the absolute dollar amount of net income to a per share amount. That is, the EPS ratio is the amount of net income earned on one share of stock it is computed as follows:

 The average number of common shares outstanding is computed on a weighted average basis. The weighted average is based on the number of months that the shares were outstanding .The average number of shares for 1990 and 1991 is computed on the assumption that 120000, shares were outstanding during 1990 and that 30000 additional shares were issued at the beginning of 1991.

The EPS ratio means that for 1991 the firm earned $3.52 per share of common stock outstanding .current generally accepted accounting standards require that the EPS must be disclosed on the face of the income statement.

Price –Earnings Ratio

The price-Earnings Ratio (P/E ratio) indicates how much investors are currently paying for each dollar of earnings. It enhances a statement user’s ability to compare the market value of one common stock, relative to earnings to that of other companies. The ratio is computed by dividing the current market price of share of common stock by the Earning per share.

The Common stock of ABC Corporation is said to be selling for 11.4 times its earnings.

P/E ratios vary widely since they represent investor’s expectations about the future earnings power of company. Thus high P/E ratios are associated with companies with prospects of high earning growth. Whereas more stable firms have lower P/E ratios. For example in the early part of 1988. Companies associated with high technology generally had high P/E ratios. Apple computer had a P/E of approximately 27. On the other hand, companies in the auto industry had low P/E ratio-Ford Motor Company and General Motors had P/E ratios of 5 and 7 respectively.

Dividend Yield

The dividend yield is normally computed by investors who are primarily investing in common stock for dividends, rather than for appreciation in the market price of the stock. The percentage indicates a rate of return on the dollars invested and permits easier comparison to returns from alternative investment opportunities. The dividend yield is computed as follows:

Dividend per share as follows

Dividend Per share= Dividend to Common stockholders                                                                                     Number of Common share outstanding 

Dividend Payout

Investors interested in dividend yields may also compute the percentage of common stock earnings distributed as dividends to the common stock-holders each period. This ratio is referred to as the dividend payout ratio.

The Ratio provides an investor with some insights into management’s Policy of distributing dividends as a percentage of net income available to common stockholders .A low payout ratio would indicate that management is reinvesting earnings internally. Such a Company would be desirable for someone interested in investing for growth in the market price of the shares. A Company with a consistently high payout ratio would appeal to an investor who depends on dividends as a source of current income (e.g. retired individual).

Ratios To Analyze Liquidity

Liquidity- that is, the firm’s ability to meet its short-term obligation-is an important factor in financial statement analysis, After all, a firm that cannot meet these obligation may be forced into bankruptcy and will not have the opportunity to operate in the long run. The focus of this type of analysis is on working capital or some components of working capital.

Current Ratio

Perhaps the most commonly used measure of a firm’s liquidity is the current ratio which is computed as follows:

The current ratio measure the Creditors Margin of safety in being paid. It indicates the relationship of current assets to current liabilities on a dollar per dollar basis. A low ratio may mean that the firm would be unable to meet its short-term debt in an emergency. A high ratio is considered favorable to creditors, but may indicate excessive investment in working capital items, such as holding slow selling inventory. That may not be producing income.

Analysts often contended that the current ratio should be at least two to one. In other words, a firm should maintain $2 of current asset for every $1 of current liabilities. Although such a rule is one standard of comparison, it is arbitrary and subject to exception and numerous qualifications in the modern approach to statement analysis. Deviations from 2:1 rule nevertheless indicate an area in which additional tests are needed to evaluate the time meeting its shot-term commitment therefore, to assess its liquidity the quick ratio and turnover ratios discussed below and the company’s cash flow should be carefully investigated.

The current ratios for ABC Corporation for 1991 and 1990 are:

Quick Ratio

One of the limitations of the current ratio is that it include inventory and prepaid expenses in the numerator, however, these items are not as liquid as cash, marketable securities, notes receivable, or accounts receivables. In the normal course of business. Inventories must first be sold and the cash must be collected before its is available, also most prepaid expenses, such as prepaid insurance, are to be consumed and cannot be readily converted into cash’s ratio used to supplement the current ratio that provides a more rigorous measure of liquidity is the quick ratio or acid test ratio. As it is sometimes called. The quick ratio is computed by dividing the sum of the most liquid current assets-generally cash, short-term marketable securities and net current receivable-by the current liabilities as follows:

A Ratio of 1.27:1 in both years shows that the firm is highly liquid. However, this observation is somewhat dependent on the collectability of the receivables included in the numerator.

 The current ratio and quick ratio measure the adequacy of the firm’s current assets to satisfy its current obligations as of the balance sheet date.However, these ratios ignore how long it takes for a firm to collect cash-an important aspect of the firm’s liquidity, since receivables and inventories normally makeup a large percentage of a firm’s current assets, The quick ratio and current ratio may be misleading if there is an extended interval between purchasing inventory, selling it, and collecting cash from the sale. Thus, the receivable turnover and inventory turnover ratios are two other liquidity measures that often yield additional information. These turnover ratios are sometimes called activity ratios.

Receivable Turnover

The receivable turnover ratio is a measure of how many times the average receivable balance was converted into cash during the year. It is also considered a measure of the efficiency of the firm’s credit-granting and collection policies it is computed as follows:

Receivable turnover = Net sales / Average Receivable Balance

The higher the receivable turnover ratio, the shorter the time period between recording a sale and collecting the cash. To be competitive, the firm’s credit policies are influenced by industry practicing. Comparison of this ratio to industry norms can reveal deviations from competitors operating results.

In computing this ratio, credit sales should be used in the numerator whenever the amount is available, however, such information is normally not found in financial statements, and so net sales are substituted. An average of monthly receivable balance should be used in the denominator. In the absence of monthly information, the year-end balance, an average of the beginning of the year and end of the year balances, or averages of quarterly balances are used in the calculation. The average of the receivable balance is used because net sales earned over a period of time. Therefore the denominator should approximate what the receivable balance was throughout the period.

During 1991, the corporation collected the average account receivables balance 7.51 times. Expressed another ways, it took an average of 48.0 days to collect sales on account, an improvement of one day over 1990.these measures are particularly useful if one knows the credit terms granted by the firm. Assuming credit terms of 60 days, the average 48-to -49 day collection period shows that the firm’s credit policy is effective and firm probably is not burdened by excessive amounts of noncollectable accounts that have not been written off. A collection period significantly in excess of 60 days indicates a problem with either the granting of credit, collection policies or both.

Inventory Turnover

The control of the amount invested in inventory is an important aspect of managing a business, the size of investment in inventory and inventory turnover depend on such factors as type of business and time of year, A grocery store has higher  turnover that an automobile dealership. The inventory level of a seasonal business is higher at certain times in the operating cycle that at others. The inventory turnover ratio is a measure of the adequacy of inventory and how efficiently it is being managed. The ratio is an expression of the number of times the average inventory balance was sold and then replaced during the year. The ratio is computed as follows:

Inventory turnover= Cost of Goods Sold/Average inventory Balance

Cost of Goods sold, rather than sales, is used in the numerator because (1) it is a measure of the cost of inventory sold during the year and (2) the cost measure is consistent with the cost basis of the denominator. Ideally, an average monthly inventory balances should be computed. But this information is generally not available to external parties in published reports. A quarterly average can be computed if quarterly interim reports are published by the firm.

The turnover ratio indicates that the average inventory was sold 4.08 times during the year, as compared to 3.84 times in 1990.in terms of days the firm held its inventory approximately 88 days in 1991 before it was sold, compared to about 94 days in 1990.

The increased turnover in 1991 is generally considered a favorable trend. Inventory with a high turnover is less likely to become obsolete and decline in price before it is sold. A higher turnover also demonstrates greater liquidity, since the inventory will be converted into cash in a shorter period.However, given the nature of the firm’s business, a very high turnover may indicate that the company in carrying insufficient inventory and is losing a significant amount of sales.

Ratios to Analyze Solvency

Another important use of financial statement analysis is to evaluate a firm’s solvency, or its ability to meet commitments arising from utilizing financial leverage, in the long run. A firm uses financial leverage whenever its finances a portion of its assets by borrowing or by issuing preferred stock. Issuing bonds to finance the purchase of plant assets is an example of using financial leverage. Debt of the firm carries two obligations: one to make interest payments on specified dates and the other to repay the principal when it matures. If a firm fails to meet these commitments, the bondholders can force the firm into bankruptcy, thus, borrowing increases the risk of default. The advantage to the common stockholders is that their return may be increased if the return earned on the funds borrowed is greater than the cost of the debt.AS a result, managers, long-term creditors, short term creditors and stockholders are all concerned with the amount of financial leverage a firm employs.

 Several ratios are used to analyze a firm’s solvency; one approach focuses on the firm’s ability to meet its interest commitments as indicated by the income statement, while second ratio considers the firm’s ability to carry debts as indicated by the balance sheet.

 Debt to Total Assets

The percentage of total assets financed by creditors indicates the extent to which the firm uses debt financing .The ratio of debt to total assets, also called the debt ratio. Measures the relationship between total liabilities and total assets and is computed as follows:

Debt to Total Asset= Total Liabilities/Total Assets

 A high debt to total assets ratio indicates a greater risk of default and less protection for the creditors, this percentage is important to long-term creditor and stockholders, since the creditor have a prior claim to assets in the event of liquidation. That is the creditors must be paid in full before assets are distributed to stockholders, the greater the percentage of assets invested by stockholders, the greater the protection to the creditors

Times Interest Earned

The times interest earned ratio is an indication of the firm’s ability to satisfy periodic interest payments from current earnings. The rough rule of thumb is that the company should earn three to four times its interest requirement. Since current interest charges are normally paid from funds provided by current operations, we frequently compute the relationship between earning and interest.

Limitations of Financial Analysis

 The analytical techniques introduced in this are useful for providing insights into the financial position and results of operations of a particular firm. Statement users must be careful in interpreting trends and ratios computed from reported financial statements, certain basis limitations and an explanation of each follow:

1. Financial analysis is performed on historical data primarily for the purpose of forecasting future performance. The historical relationship may not continue because of changes in:

• The general state of economy
• The business environment in which the firm must operate
• Management
• The Policies established by management

1. The measurement base used in computing the analytical measures in historical cost. Failure to adjust for inflation or for changes in fair value may result in some computations providing misleading analysis of trends and comparisons between companies. For example, the return on total asset includes net income in the numerator, which is affected by the current year’s sales and current operating expenses measured in current dollars. However, fixed assets and other nonmonetary items are measured in historical dollars, which are not adjusted to reflect current price levels, thus the ratio divides items primarily measured in current dollar amounts by a total measured primarily in terms of historical dollars.
2. Year-end data may not be typical of the firm’s position during the year. Knowing that certain ratios are computed at year-end, management may improve a ratio by entering into certain types of transactions near the end of the year, for example, the current ratio can be improved by using cash to pay off short-term debt. To illustrate, assume that a firm reported current assets of $200000 and current liabilities of $100000 before paying $50,000 on account payable. The payment will increase the current ratio as shown here:

Also, a firm usually establishes a fiscal year-end that coincides with the low point of activity in its operating cycle. Therefore, account balances such as receivables, payable, and inventory may not be representative of the balances carried in these accounts during the year.

4- Companies may not be comparable. Data among companies may not provide meaningful comparisons because of such factors as the use of different accounting methods, estimates made by company management the size of the companies, and diversification of product lines.

The selection of a particular accounting method or estimate can have significant effect on net income and financial position of a firm. Using accounting methods or making estimates that result in reporting the lowest net income In the current period is considered a conservative approach to income measurement. For example, in a period of increasing inventory prices, the last in, first out (LIFO) inventory method results in the lowest net income, so it is conservative. First in, first out (FIFO) is the least conservative inventory method when prices are increasing .To use a 5 year period to amortize an intangible asset rather than a 40-year period is another example of conservatism. As Financial analysts we carefully review such policies to assess what is called the quality of earnings. A firm that follows more conservative policies is considered to have a high quality of earnings.