Accounting Business Reporting for Decision Making

CHAPTER 8 Analysis and interpretation of financial statements 321

provided. Professionals who assess the credit status of entities are referred to as credit analysts. A financial

institution contemplating a loan to an entity would be interested in the ability of the entity to generate cash

flows to service the loan over the loan period, and the security that the entity could provide to the lender. They

are interested in assessing an entity’s credit risk. A shareholder or potential investor is interested in the ability

of an entity to generate profits that allow it to distribute dividends and/or retain the profits to invest, with the

expectation of capital appreciation in its share price. Professionals known as equity analysts provide invest-

ment recommendations on entities’ shares, and use financial analysis as part of their fundamental analysis

toolkit to derive what they believe to be the value of the entity. Employees are concerned about being paid

for services rendered and long-term job security, so they would be interested in the entity’s liquidity and

profitability. Although the rules for determining taxable income and accounting profit differ, the Australian

Taxation Office relies on financial numbers generated from the accounting information system in its assess-

ments of tax payable. Management also uses financial statements in its decision-making capacity, but man-

agers have the advantage of being able to command information from the accounting information system and

so do not need to rely solely on external financial statements when conducting financial analysis.

Statement users generally share a common objective: to evaluate past decisions and make informed

decisions about future events. In this sense, reported financial numbers have a role to play. The financial

statements depict historical information. When making predictions about future events, an evaluation of

past events is often the most useful starting point. For example, assessing the entity’s past profitability

(defined as the entity’s ability to generate profits from the available resources) will shape an investor’s

expectations as to the entity’s future profitability. Financial analysis involves expressing the reported

numbers in relative terms rather than relying on the absolute numbers, and can highlight the strengths

and weaknesses of entities. It is an important decision-making tool for evaluating the historical health of

an entity and predicting an entity’s future financial wellbeing.

The reality check ‘Weekly recommendation, target price, earnings forecast changes’ discusses the role

of financial analysis in share recommendation decisions.

REALITY CHECK

Weekly recommendation, target price, earnings forecast changes

FN Arena monitors recommendations for shares by eight leading stockbrokers on a daily basis. The

following are examples of the weekly reporting of share recommendation upgrades and downgrades.

Myer was upgraded to Buy from Hold, with Deutsche Bank lifting its call on the belief that the market

still had a steady appetite for discretionary retailer stocks. In this case, Myer represented the best oppor-

tunity, given a reasonable valuation and strong, free cash flow. The company was also delivering like-for-like

sales growth and was addressing structural issues, said Deutsche. Macquarie lifted its recommendation on

Qantas from Hold to Buy. Qantas was lifted on an improving capacity outlook, the broker having more confi-

dence in the industry outlook and believing that earnings margins were moving back to a more normal rate.

Virgin Australia was also upgraded, the broker suspecting that Virgin was increasingly challenging Qantas’s

position in the business class and regional markets. Sentiment was positive for both.

National Australia Bank was upgraded to Buy by Macquarie, but downgraded to Hold from Sell by

CIMB. Macquarie noted that institutional and corporate borrowing appeared to be improving in the

mining states, with signs of improving demand for equipment finance. Macquarie believed that access

to credit might become easier in the second half of the year, which would mean higher earnings. Mean-

while, CIMB was taking a look at bank sector net interest margins for FY13–15 and found that risks

remained skewed to the downside. While NAB’s dividend yield to the Australian government bond yield

was supportive, the broker thought that the more fundamental valuations, like NAB’s, looked stretched.

Orton Group (ORL) was cut to Hold from Buy by Credit Suisse. The half-year results were below

Credit Suisse’s forecasts and the outlook appeared more challenging than previously expected. The

earnings outlook was affected mainly by the loss of the Ralph Lauren licence. Credit Suisse estimated

an $18 million negative earnings impact in FY14. Sentiment moved to neutral on the downgrade.

Source: Nelson, A 2013, ‘Weekly recommendation, target price, earnings forecast changes’, FN Arena (Australia), 2 April.