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Theories on Financial Analysis

Updated on March 14, 2010

The landmark study of financial analysis is “Security Analysis” by Benjamin Graham (an investment manager) and David Dodd (professor of finance at Columbia). The first edition was 1934, about the worst period in the financial history of America. Despite being in the middle of the Great Depression, their analysis and recommendations were professional and hard boiled. They distinguished investment from speculation, but considered most investments in common stock as speculative. The focus of financial analysis has changed substantially since then, but a historical foundation in financial analysis requires quite a bit of time with Graham and Dodd.

This research thesis is about the financial statement analysis of Pakistan Petroleum Limited one of the largest exploration and production company in Pakistan. Ratios are very helpful in this regard different ratio can be used for different industries to predict their performance. There have been many academic studies on the use of financial ratios to forecast financial failure and to forecast the financial position of the company in the future. Basically, these studies try to isolate individual ratios or combination of ratios that can be observed as trends that may forecast failure.

A reliable model that can be used to forecast financial failure can also be use by management to take preventive measure. Such a model can aid investors in selecting and disposing of stocks. Banks can use it to aid in lending decisions and in monitoring accounts receivable. In general, many sources can use such a model to improve the allocation and control of resources. A model that forecasts financial failure can also be valuable to an auditor. It can aid in determination of audit procedures and in making a decision as to whether the company will remain as a going concern.

Financial failure can be described in many ways. It can mean liquidation, deferment of payments to short-term creditors, deferment of payments, to interest on bonds, deferment of payments on principal on bonds, or the omission of a preferred dividend. One of the problems in examining the literature on forecasting financial failure is that different authors use different criteria to indicate failure. Where reviewing the literature, always determine the criteria used to define financial failure. Below are the two most important models that are used to forecast financial failure.

  1. Univariate Model

Univariate analysis assumes that a single variable can be used for predictive purposes. The univariate model as proposed by William Beaver which is published in The Accounting Review in October 1968, achieved a moderate level of predictive accuracy. Such a model would use individual financial ratios to forecast financial failure. William Beaver study classified a company as failed when any one of the following events occurred: bankruptcy, bond default, an overdrawn bank account or nonpayment of a preferred stock dividend. The Beaver study indicated that the following ratios were the best for the forecasting financial failure:

a)      Cash Flow / Total Debt

b)      Net Income / Total Assets (returns on assets)

c)      Total Debt / Total Assets (debt ratio)

Assuming that the ratios identified by Beaver are valid in forecasting financial failure, it would be wise to pay particular attention to trends in these ratios when following a company. Beaver’s reasoning for seeing these ratios as valid in forecasting financial failure appears to be very sound

These three ratios for Cooper for 1995 have been computed earlier. Cash flow/total debt was 35.69% which appears to be good. Net income/total assets (return on assets) was 10.33%, which appears to be good. The debt ratio was 34.53%, which is very good. Thus, Cooper appears to have minimal risk of financial failure.

  1. Multivariate Model

In the next stage of financial distress measurement, multivariate analysis (also known as Multiple Discriminant Analysis or MDA) attempted to overcome the potentially conflicting indications that may result from using single variables. The best-known, and most-widely used, multiple discriminant analysis method is the one proposed by Edward I. Altman. His model uses five financial ratios weighted in order to maximize the predictive power of the model. The model produces an overall discriminate score, called a Z score or zeta model.  Altman’s Z-score combined various measures of profitability or risk. The resulting model was one that demonstrated a company’s risk of bankruptcy relative to a standard.  So different authors use different ratios to know the financial position of the firms The trend analysis of the firm financial statement is also helpful in studding the financial history of the firm for comparison by looking at the trend of particular ratio one sees whether that ratio is falling, rising or remaining relative constant this help detect problem or observe good management in the research project the fixed base and moving base trend analysis is used. Further the common size analysis express comparison in percentage this is mainly used for making comparisons of firm of different size much more meaningful.

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      Tang Ven 

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