Using financial analysis and interpretation as a foundation to comprehend financial health

Abstract

The ability to measure the financial health of a company is becoming an increasingly serious issue. One only needs to think of the widely published irregularities in companies such as Enron, Parmalat and Macmed to grasp something of the magnitude of the losses and other problems that investors can face if they do not have the ability to “predict” possible problems. There are individuals who are constantly identifying new and ingenious ways to deceive their customers, investors, the government and others. It is important for parties with an interest in a company to devise new ways to identify how financial analyses can be used to protect their interests. Managers are primarily responsible for the prevention and identification of accounting irregularities. Unfortunately, at the same time, they may also be assumed to be the primary perpetrators of accounting irregularities, because they are in a position to manipulate accounting records and bypass control measures more easily than anyone else in a company. The main aim of this study is to determine whether financial analysis and interpretation can be applied by interested parties to measure financial health and by implication identify accounting irregularities. Proof that this is possible has the potential to be used in analyses, by all parties with an interest in a company, to determine financial health and to identify irregularities in the financial statements. The study begins with a literature review, which provides an explanation of accounting irregularities and related matters, as well as an overview of previous uses of financial analyses to determine whether such analyses are useful in the identification of irregularities in the financial statements. The objectives of the study are as follows: <ul> <li> An investigation into the characteristics, as identified by researchers locally and abroad, that are displayed by companies with a higher risk of or occurrence of accounting irregularities.</li> <li> A survey of the media by means of a literature review to identify case study companies that had allegations of accounting irregularities against them.</li> <li> The analysis of the case study companies in a quantitative and qualitative way to determine whether the characteristics that are identified as part of the first objective hold true in practice.</li> <li> Statistical analyses of the share price data of the case study companies in the form of an event study, a regression analysis and a structural break analysis to determine when and under what circumstances significant changes happened.</li> <li> Conduct a survey involving the creators and the users of financial statements in order to observe their experience regarding the usefulness of financial statements to reveal financial health. This is done by means of questionnaires that are analysed statistically, designed to derive conclusions of what practitioners tend to experience in practice and what their feelings are regarding the use of financial statements and accounting data in an analysis of the financial health of a company.</li></ul> On the basis of the case studies, nine of 18 identified characteristics were found to be useful in the identification of accounting irregularities by parties other than managers. They are: 1. company age; 2. company culture; 3. debt levels; 4. directors’ behaviour and character; 5. financial distress; 6. industry or sector; 7. liquidity; 8. management’s behaviour and character; and 9. remuneration policies. A further eight additional characteristics were also identified as useful in the identification of accounting irregularities. They are: 1. acquisitions, mergers and other restructuring; 2. dividends; 3. opposite movements from the industry or sector; 4. period before irregularities are detected; 5. “preparing” interested parties for the annual report; 6. share price changes; 7. significant changes; and 8. tax. The results of the review of the companies’ financial information are supplemented with a statistical analysis of the companies’ share price data as well as a questionnaire that are submitted to the users and compilers of financial statements. The aim of the first statistical analysis, consisting of event studies, regression analyses and structural break analyses, is to support the findings regarding the characteristics of companies with increased risk of accounting irregularities. The questionnaire set out to relate the subjective opinions of the users and compilers of financial statements with the findings of the study. The results of the study provide proof that interested parties have the ability to use the identified company characteristics to indicate increased accounting irregularity risk.