The Role of Financial Analysis on the Financial Performance of Microfinance Institutions in Rwanda. A Case Study of Inyongera SACCO/Cyuve from 2011 to 2015

Bachelor Thesis , 2017 , 113 Pages , Grade: 16.5

Business economics - Accounting and Taxes

This study’s is main objective was to analyze the role of financial analysis on the financial performance of microfinance institutions in Rwanda under three specific objectives. The first was to assess the indicators of financial analysis in Inyongera SACCO/Cyuve. The second was to analyze the determinants of the financial performance in Inyongera SACCO/Cyuve. The third was to measure the relationship between financial analysis indicators and the financial performance determinants in Inyongera SACCO/Cyuve.

The following research questions were used to test the above objectives: What are the indicators of financial analysis in Inyongera SACCO/Cyuve? What are the determinants of financial performance in Inyongera SACCO/Cyuve? What is the relationship between financial analysis indicators and the financial performance determinants in Inyongera SACCO/Cyuve? A descriptive research design was used. Data was collected from both primary and secondary sources using questionnaire, interview and documentation. The results of this research showed that financial revenues of Inyongera SACCO/Cyuve has generated more profit in the period of 2013 where it was 74%, and this year 2013 is experienced year profit where the Inyongera SACCO/Cyuve generated more profit. This was due to the decrease of operating expenses in this year within the reduction in personnel expenses compared to other years. And the 2011 is not more considered because it was the starting year. The recommendations given to Inyongera SACCO/Cyuve were to calculate its expenses, financial ratios to be able to assess the expenses incurred comparing to sales realized and gross margin obtained for a better control of production cost and other expenses. The institution should reduce its costs to maximize profit which is the common goals for all organizations in order to make efficient and effectiveness of its business.

TABLE OF CONTENTS

APPROVAL

DEDICATION

ACKNOWLEDGEMENTS

ABSTRACT

TABLE OF CONTENTS

LIST OF APPENDICES

LIST OF FIGURE

LIST OF TABLES

LIST OF ABREVIATIONS

CHAPTER ONE
GENERAL INTRODUCTION
1.1. Back ground of the study
1.2. Problem statement
1.3. Research questions of the study
1.4. Objective of the study
1.4.1. General objectives
1.4.2. Specific objectives
1.5. Hypothesis of the study
1.6. Choice of the study
1.7. Interest of the study
1.7.1. Personnel interest
1.7.2. Academic and scientific interest
1.7.3. Social interest
1.8. Delimitation of the study
1.8.1. Delimitation in domain
1.8.2. Delimitation in time
1.8.3. Delimitation in space
1.9. Methodology
1.10. Concept framework model
1.11. Subdivision of the study

CHAPTER TWO
LITERATURE REVIEW
2.1. Concept definitions
2.1.1. Financial analysis
2.1.1.1. Objectives of financial statement Analysis
2.1.1.1.1. Assessment of past performance and current position
2.1.1.1.2. Assessments of future potential and risks of a business
2.1.1.2. Users of financial analysis
2.1.1.2.1. Internal users of financial statement analysis
2.1.1.2.2. External users of financial statements analysis
2.1.1.3. Analysis and interpretation of financial statement
2.1.1.4. Methods of financial analysis
2.1.1.4.1. Comparative analysis/Horizontal Analysis
2.1.1.4.2. Common size analysis/Vertical Analysis
2.1.1.4.3. Trend Analysis
2.1.1.4.4. Ratio Analysis
2.1.1.4.4.1. Types of analysis using financial ratios analysis in decisions making
2.1.1.4.4.2. Predicting Financial Distress of Companies
2.1.1.4.5. Time series analysis
2.1.2. Financial statements
2.1.2.1. Types of financial statements
2.1.2.1.1. The balance sheet
2.1.2.1.2. Income statement
2.1.2.1.3. The cash flow statement
2.1.2.1.4. Statement of change in equity
2.1.2.2. Qualitative characteristics of financial statements
2.1.2.2.1. Understandability
2.1.2.2.2. Relevance
2.1.2.2.3. Reliability
2.1.2.2.4. Comparability
2.1.3. Performance
2.1.3.1. Financial performance
2.1.3.2. Determinants of financial performance
2.1.3.2.1. Profitability ratios
2.1.4. Microfinance institutions
2.2. Theoretical framework
2.2.1. Accounting theory
2.2.2. Positive accounting theory
2.2.3. Objectives of theories
2.3. Empirical studies
2.4. Partial conclusion on decision making and performance

CHAPITER THREE
RESEARCH METHODOLOGY
3.1. Description of the Inyongera SACCO/Cyuve
3.1.1. Location of Inyongera SACCO/Cyuve
3.1.2. History and evolution of Inyongera SACCO/Cyuve
3.1.3. The reason to be Umurenge SACCO
3.1.4. The vision of Inyongera SACCO
3.1.5. Mission of Inyongera SACCO
3.1.6. Objectives of Inyongera SACCO
3.1.7. The organization chart
3.2. Research methodology
3 .2.1 Research Design
3.2.2. The analytical research
3.2.3. Population of the Study
3.2.4. Sample size and selection
3.2.5. Source of data collection
3.2.5.1. Primary Data
3.2.5.2. Secondary Data
3.2.6 Data Collection Techniques
3.2.6.1. Documentary review
3.2.6.2. Document analysis
3.2.6.3. Interview guide
3.2.6.4. Questionnaire technique
3.2.7. Sampling technique
3.2.8. Data processing and analysis
3.2.8.1. Editing
3.2.8.2. Coding
3.2.8.3. Tabulation
3.2.8.4. Data analysis
3.3. Research limitations

CHAPTER FOUR
RESULTS AND DISCUSSION
4.1. Demographic characteristics of respondents
4.3. Analysis of financial performance of Inyongera SACCO
4.3.1. Net profit margin
4.3.2 Return on equity
4.3.3 Return on assets
4.3.4 Current ratio
4.4. Comparative analysis
4.5. Common-Size analysis
4.6. Trend analysis
4.7. Relationship between financial analysis and financial performance in Inyongera SACCO/ Cyuve

CHAPTER FIVE
CONCLUSION AND RECOMMENDATIONS
5.1. Conclusion

REFERENCES

APPROVAL

I, certify that this dissertation entitled “The contribution of financial analysis on the financial performance of microfinance institutions in Rwanda; A case study of Inyongera SACCO/ Cyuve (2011-2015)” is an original study conducted by Augustin MUDAKEMWA under my supervision and guidance. It submitted and presented to the Faculty of Economics, Social Sciences and Management in partial fulfillment of academic requirements for the award of Bachelor’s Degree in Enterprises Management at INES- Ruhengeri.

DEDICATION

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ACKNOWLEDGEMENTS

I would like to thank the almighty God for the gift of life and guiding me throughout my education and this research for his mercy was always with me.

My Special thanks go to my supervisor Dr. Jean Bosco HARERIMANA for his guidance and time spent for me throughout this research to enable accomplishment of this work. My special thanks are addressed to the government of Rwanda through the ministry of education and INES Ruhengeri for promoting education. I worthwhile express my acknowledgement to all INES Ruhengeri administrative staff and all academic staff especially in the Faculty of Economics, Social Sciences and Management mostly in the Enterprise Management Department. I thank all my lecturers who have enabled me to acquire immeasurable knowledge, for their various contributions during my education.

I am very grateful to my entire family especially my uncle NKURUNZIZA Faustin and his wife NYIRABANGUKA Colette for their distinctive love and their constant encouragement as well as their advice, financial and material support all over my studies until to this achievement, may the God Lord reward your efforts. I would like to convey my warm thanks to my parents and relatives for their encouragement of different kinds that they extended to me during my studies.

I would like to thank all my friends and all colleagues for their encouragement in various ways, we shared the academic struggle are highly appreciated for their cooperation and combined efforts to help each other during our lectures courses. The friendly relationship that we enjoyed has been the best at the INES Ruhengeri.

Special thanks go to the employees of Inyongera SACCO/Cyuve who provided the information needed to come up with a successful report during the period I conducted this research.

Last but not least, thanks to individuals who have been involved either directly or indirectly in succession of my learning process; this research would not have been possible without you. Thank you, I acknowledge my indebtedness to them all. May God Bless you all!

Augustin MUDAKEMWA

ABSTRACT

This study is entitled “the contribution of financial analysis on the financial performance of microfinance institutions in Rwanda, a cases study of Inyongera SACCO/ Cyuve (2011 to 2015)’’. The main objective was to analyze the role of financial analysis on the financial performance of microfinance institutions in Rwanda. under three specific objectives; the first was to assess the indicators of financial analysis in Inyongera SACCO/Cyuve, the second was to analyze the determinants of the financial performance in Inyongera SACCO/Cyuve and the third was to measure the relationship between financial analysis indicators and the financial performance determinants in Inyongera SACCO/Cyuve. The following the research questions were used to test the above objectives: What are the indicators of financial analysis in Inyongera SACCO/Cyuve? What are the determinants of financial performance in Inyongera SACCO/Cyuve? What is the relationship between financial analysis indicators and the financial performance determinants in Inyongera SACCO/Cyuve? A quantitative and qualitative research design was used. Data was collected from both primary and secondary sources using questionnaire, interview and documentation. The results of this research showed that financial revenues of Inyongera SACCO/Cyuve has generated more profit in the period of 2013 where it was 74% , and this year 2013 is experienced year profit where the Inyongera SACCO/Cyuve generated more profit . This was due to the decrease of operating expenses in this year within the reduction in personnel expenses compared to other years. And the 2011 is not more considered because it was the starting year. The recommendations given to Inyongera SACCO/Cyuve were to calculate its expenses, financial ratios so as to be able to assess the expenses incurred comparing to sales realized and gross margin obtained for a better control of production cost and other expenses. The institution should reduce its costs so as to maximize profit which is the common goals for all organizations in order to make efficient and effectiveness of its business.

LIST OF APPENDICES

Appendix 1: A Letters and research questions requesting information addressed to the employees of INYONGERA SACCO in Cyuve sector

Appendix 2: Inyongera SACCO’s Horizontal Analysis/ comparative analysis based on Income Statement

Appendix 3: Inyongera SACCO’s horizontal analysis/ comparative analysis based on balance sheet

Appendix 4: Inyongera SACCO’s Vertical common size Analysis based on income statement

Appendix 5: Inyongera SACCO’s vertical analysis/common size based on balance sheet

Appendix 6: Inyongera SACCO’s Trend Analysis based on income statement

Appendix 7: Inyongera SACCO’s trend analysis based on balance sheet

Appendix 8: A letter requesting the data

Appendix 9: Inyongera SACCO ’s balance sheet as at 31st 12 (2015-2011)

Appendix 10: Inyongera SACCO’s income statement for the year ended 31st 12 (2015-2011) u Appendix 11: Diagram chart of Inyongera SACCO/Cyuve

LIST OF FIGURE

Figure 1: Concept framework

LIST OF TABLES

Table 1: The study population

Table 2: Respondents distribution according to gender

Table 3: Ages of respondents

Table 4:Respondent according to their marital status

Table 5: Respondent according to the level of education

Table 6: Respondent according to their position held

Table 7: Respondent according to the work experience

Table 8: Inyongera SACCO prepare financial statements

Table 9: The financial statements prepared in Inyongera SACCO

Table 10: The financial statements analysis is done in Inyongera SACCO

Table 11: Tools used for the financial statements analysis in Inyongera SACCO

Table 12: Financial statements analysis is useful for decision making in Inyongera SACCO

Table 13: The contribution of financial statements analysis on the financial performance

Table 14: Net profit margin

Table 15: Return on equity

Table 16: Return on assets

Table 17: Current ratio

Table 18: Inyongera SACCO’s comparative analysis based on income statement

Table 19: Inyongera SACCO’s comparative analysis based on balance sheet

Table 20: Inyongera SACCO’s common size Analysis based on income statement

Table 21: In yongera SACCO’s vertical anal ysis/c ommon size based on balance she et

Table 22: Inyongera SACCO’s Trend Analysis based on income statement

Table 23: Inyongera SACCO’s trend analysis based on balance sheet

Table 24: Measures of relationship between financial analysis determinants and financial performance indicators

Table 25: Model coefficients

Table 26: Coefficient of determination ( R2 )

LIST OF ABREVIATIONS

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CHAPTER ONE

GENERAL INTRODUCTION

The general introduction of this research topic focuses on the background of the study, the choice and interest of the study, problem statement of the study, research questions of the study, objectives of the study, hypothesis of the study, delimitations of the study, methodology, concept framework, and sub-division of the study.

1.1. Back ground of the study

According to Hamptons et al. (1996), the financial statement is an organized collection of data according to logical and consistent accounting procedures. Its purpose is to convey an understanding of financial aspects of a business firm. It may show a position at a moment of time as in the case of a balance-sheet or may reveal a service of activities over a given period of time, as in the case of an income statement. Provides useful information to both internal and external parties (Paramasivan & Subramanian, 2008).

The first causes of financial analysis can be traced back to the last stages of American’s drive to industrial maturity in the last half of the 19th century. As the management of enterprises management in the various industrial sectors transferred from the enterprising capitalists to the professional manager and as the financial sector becomes a more pre-dominate force in the economy, the need for financial statement increased accordingly. Both these changes were primary causes of financial statement analysis, but the shift in power to the financial institution was especially important. Although there was much overlap, the development paths of ratio analysis for creditors purposes and for managerial purposes were different (Horrigan, 1968).

Financial analysis (also referred to as financial statement analysis) is defined as the process of evaluating businesses, projects, budgets and other finance related entities to determine their suitability for investment. Typically, financial statements analysis is used to analyze whether an entity is stable solvent, liquid, or profitable enough to be invested in. And when looking at a specific company or entity, the financial statements analysis will often focus on the income statement, the balance sheet and cash flow statement (Peterson & Fabozzi, 2003).

Financial statement analysis is an evaluative method of determining the past, current and projected performance of a company. Several methods and techniques are commonly used as part of financial statement analysis including horizontal analysis/ Comparative Statement Analysis, which compares two or more years of financial figures expressed in currency or percentages, vertical analysis/common size analysis, Trend Analysis, and ratio analysis, which calculates statistical relationships between figures of past years (Bouwman et al., 1987).

The use of financial reporting is the main aspect in decision making. According to Gibson (1989), financial reporting is not the end in its self but it is intended to provide information that is useful in making business and economic decisions. It is in this regard the researcher was motivated in finding the extent to which management dealers may depend on financial ratios in decision making.

In consequences, managers had to look for the means of discharging their stewardship responsibility; this can be obtained through the use of accounting ratios. The use of accounting ratios is a time-tested method of analyzing a business. Wall Street investment firms, bank loan officers and knowledgeable business owners all use accounting ratio analysis to learn more about a company's current financial health as well as its potential (Vernmen, 2006).

Ratio analysis is the process of examining various financial statement items with the objective of assessing the success of past and current performance and, perhaps more importantly, of projecting future performance and financial condition (Kothari & Ball , 1994). Ratio analysis is a commonly used tool of financial statement analysis, where financial ratios are very powerful tools to perform some quick analysis of financial statements. There are four main categories of ratios: liquidity ratios (ratios that show the financial strength), profitability ratios (ratios that show profitability), activity ratios (ratios that show efficiency in the use of assets) and leverage ratios (ratios that show overall performance) (Smith, 1990).

The understanding financial ratio is a key business skill for any business owner because it illustrates the strengths and weakness owner of a business. By examining the financial information using different techniques especially ratios overtime, a business owner can notice any unusual changes in financial ratios and can note how the business is performing overtime. So ratios are also helpful tools in financial statements analysis. This useful of ratios allow owners to set specific goals and to easily tract progress toward those goals by knowing whether the business is profitable, whether they may continue its operations or to give up (Bull, 2007).

Ratios analysis simplified, summarizes, and systematizes a long array of accounting figures. Its main contribution lies in bringing out the inter-relationship which exists between various segments of business. Ratios are more of a diagnostic tool that helps to identify problem areas and opportunities within a company (Unegbu et al., 2011).

According to James et al. (2005) say «to evaluate the firm's financial condition and performance, the financial analysis needs to perform checkups on various aspects of a firm's financial health. A tool frequently used during these checkups is financial ratios».

Financial ratios are used almost universally by companies of all enterprises to provide numerical information on the business. Many companies are starting and close at early age because of poor decision making in their managerial, financial ratios provide useful analysis and can help drive management toward making better decisions if they are interpreted correctly in our days (Unegbu et al., 2011).

Accounting ratios are important tools in the management for decision making (Gupta et al., 2001), financial statements are prepared primarily for decision making, but the information provided in financial statements is not an end in itself and no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements. Thus, the proper use of accounting ratios assists management in communicating information which is pertinent and purposeful for decision makers to ensure the effectiveness of management in the enterprise.

1.2. Problem statement

The microfinance institution in Rwanda is quickly expanding, and institutions have increased their activities. The microfinance institutions can need to analyze the relationships of figures provided in the financial statement, we see this financial Statement Analysis as a useful technique, which is the process of reviewing and evaluating a company's financial statements particularly the balance sheet and income statement from past years, thereby gaining an understanding of the financial health of the company and enabling more effective decision making. Financial statements contains the financial information needed for decision making for users; however, this information must be evaluated through financial statement analysis to become more useful to investors, shareholders, managers and other interested parties (Ledgerwood et al., 2013). Possibly different ratios obtained can be analyzed then the results obtained can enhance decisions makers to know what course of actions is to be taken for future prospects.

The management of enterprise is depending on accounting information for taking various strategic decisions. Financial statements provide such information. This information is made useful by analyzing and interpretation of financial statements which help of financial analysis techniques among which the common and easy technique to use is financial ratios also known as accounting ratios (Lermack, 2004).

Financial statements analysis is relationships determined from a company’s financial information and used for comparison purposes (Brigham & Ehrhardt, 2013). The financial ratios can provide to small business owners and manager with valuable tools which used to measure their progress against predetermined the financial performance within Inyongera SACCO/Cyuve

The management of the company is responsible for taking decisions and formulating plans and policies for the future. A good financial statement is a key aspect to decision makers to take reliable financial decisions and many organizations in our days are failed through low level or capacity of understanding of the employees on financial principles that influence companies performance which leads to make wrong financial decision by decision maker, it is in that sense I come up with this topic entitled “the contribution of financial analysis on the performance of microfinance institutions in Rwanda; A case study of Inyongera SACCO/Cyuve (2011-2015).

1.3. Research questions of the study

According to this study the following questions will guide us to do this work;

1. What are the indicators of financial analysis in Inyongera SACCO/Cyuve?
2. What are the determinants of financial performance in Inyongera SACCO/Cyuve?
3. What is the relationship between the financial analysis indicators and the financial performance determinants in Inyongera SACCO/Cyuve?

1.4. Objective of the study

They are two kinds of objectives, which are general and specific objectives.

1.4.1. General objectives

The general objective of this study is to analyze the role of financial analysis on the financial performance of microfinance institutions in Rwanda.

1.4.2. Specific objectives

The specific objectives assigned to my work study are the following;

1. To assess the indicators of financial analysis in Inyongera SACCO/Cyuve.
2. To analyze the determinants of the financial performance in Inyongera SACCO/Cyuve.
3. To measure the relationship between financial analysis indicators and the financial performance determinants in Inyongera SACCO/Cyuve.

1.5. Hypothesis of the study

H1) Horizontal analysis/comparative analysis, Vertical analysis/common size, Ratio analysis, and trend analysis are the indicators of financial analysis in Inyongera SACCO/Cyuve. H2) Net profit margin, ROA, ROE, and current ratio are the determinants of the financial performance in Inyongera SACCO/Cyuve.

H3) There is positive relationship between financial analysis indicators and the financial performance determinants in Inyongera SACCO/Cyuve.

1.6. Choice of the study

I selected this study which will focus on the topic saying “the contribution of financial analysis on the financial performance of microfinance institutions in Rwanda; A case study of Inyongera SACCO/Cyuve”. This study will explained why I selected this topic.

1.7. Interest of the study

I interested and choose this topic because we want to know the contribution of financial analysis on the financial performance of microfinance institutions in Rwanda; especially in Inyongera SACCO/Cyuve. As researcher in management field, the more you study, the more the knowledge. In turn, the more familiar you are with certain subject of studying the more valuable you will be if you are learning a skill of a job. The outcome of this research study is of great importance on personnel interest, academic and scientific interest, and social interest in general.

1.7.1. Personnel interest

This research study will help us to increase our knowledge and skills of financial statements analysis techniques and interpretation of the available data for managerial decisions purposes by using financial analysis ratios regarding to the contribution of financial analysis on the financial performance of microfinance institutions in Rwanda especially Inyongera SACCO/CYUVE.

1.7.2. Academic and scientific interest

Regarding to the academic interest is due to INES Ruhengeri requirements, which precise that it is an obligation for all students to do a dissertation in partial fulfillment of academic requirements for the award of Bachelor’s Degree in Enterprises Management at INES-Ruhengeri. Regarding to the scientific interest, this dissertation documents will be used as sources of knowledge where it will be available in INES Ruhengeri library so that other researchers will consult it and used it by doing their own research in the similar fields.

1.7.3. Social interest

This study will improve the knowledge of the management of Inyongera SACCO/Cyuve regarding on the contribution of financial analysis on their financial performance of Inyongera SACCO/Cyuve.

This research study will also help the management of the Inyongera SACCO/Cyuve by facilitating them to identify its level of the decisions making for the performance on their solvency, liquidity, turnover and overall profitability.

The users of financial statements will be able to use the findings from this research to critically analyze the contribution of financial statements analysis on the decision making for the performance and take corrective measures to encounter any limitation identified.

1.8. Delimitation of the study.

They described the boundaries that I set for the study. This study was limited in domain, time and space.

1.8.1. Delimitation in domain.

Our study was limited in financial management domain.

1.8.2. Delimitation in time.

Our study was limited to the period of 2011-2015.

1.8.3. Delimitation in space.

Our study conducted within the Inyongera SACCO, is located in Musanze town, Kabeza cell, Cyuve sector, Musanze district, Near to wisdom primary and secondary school; there is 2km from Musanze town centre.

1.9. Methodology

A quantitative and qualitative research design was used. Data was collected from both primary and secondary sources using questionnaire, interview and documentation review and documentation analysis. The study population of 6 employees was selected. A sample size of 6 employees was selected by universal sampling.

1.10. Concept framework model

The following conceptual mode is going to establish the relationship between independent and dependent variables in our topic and intermediate intervening variables for both sides.

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Figure 1: concept framework Source: primary data, 2016.

The concept framework includes the independent and dependent variables. As the topic state the contribution of financial analysis on the financial performance of microfinance institutions in Rwanda. The independent variable is financial analysis which includes; comparative analysis/ Horizontal analysis, common size analysis/ vertical analysis, trend analysis and ratio analysis; the dependent variable is the financial performance of microfinance which includes net profit margin, ROA, ROE, and current ratio; the intermediate variables includes mismanagement, accounting errors, traditional analysis culture, principles of accounting and guidelines, and policies and procedures.

1.11. Subdivision of the study

The study is divided into five chapters; the first chapter is about general introduction which includes the back ground of the study, the choice and interest of the study, problem statement of the study, research questions, objectives of the study, hypothesis of the study, delimitations of the study and sub-division of the study; the second chapter is about literature review which includes the review of relevant applicable literature with reference to different sources of data’s definitions of terms, concepts and theoretical framework of the study; the third chapter is about research methodology; The forth chapter is about results and discussions; and the fifth chapter is about conclusion and recommendation.

CHAPTER TWO

LITERATURE REVIEW

A literature review in any field is essential as it offers a comprehensive overview and recapitulation on the given scholarship from past to present, giving the reader a sense of focus as to which direction your new research is headed. This involves with various reviews of text book, news papers, websites and other documents which present theories that are related to the topic. This chapter broadly aims to review the existing literature to arrive at conceptual understanding and this chapter contains the definitions of key words and terms used in this research and theories applicable to the study.

2.1. Concept definitions

Concepts analysis and definition of terms refers to the process of breaking down the key words used in the statement of the research problem, hypothesis or research questions, into specific ideas in order to clarify the scope of the study and meaning of the statement. A variety of points have been developed including the definition of key-terms which are: financial analysis, financial performance, and microfinance institution.

2.1.1. Financial analysis

Financial analysis (also referred to as financial statement analysis or accounting analysis or Analysis of finance) refers to an assessment of the viability, stability and profitability of a business, sub-business or project (Kieso et al., 2007).

According to Kieso et al. (2007), it is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions.

2.1.1.1. Objectives of financial statement Analysis

According to Kieso et al. (2007), financial statement analysis is used to achieve two basic objectives:

2.1.1.1.1. Assessment of past performance and current position

Financial statement analysis helps in assessing or judging the past performance of a business by taking a look at the trend or historical sales, expenses, net income, cash flow, and return on investment.

2.1.1.1.2. Assessments of future potential and risks of a business

Information about the past and present performances is useful only to the extent that it bears on decision about the future. Financial statement analysis helps in assessing the riskiness of an investment or loan by making it easy to predict the future profitability and liquidity of a business.

According to the IASB (1989), the major objectives of financial statement analysis are providing information to the decision makers. Financial statement analysis is helping to understand all the financial consequences and the recent financial status of any business organization or corporation by the potential investors and financial decision makers in the forming expectation about corporation future financial performance.

Financial statement analysis provide basic information which is very useful for financial planning and financial control. It is very useful to predict, to compare and evaluate the firms earning ability. Financial statement analysis is also required to aid in economic decision making and investment and financing decision making (Agarwal & Jain , 1993). The purpose of financial statement analysis is to examine past and current financial data so that a company's performance and financial position can be evaluated and future risks and potential can be estimated. Financial statement analysis can yield valuable information about trends and relationships, the quality of a company's earnings, and the strengths and weaknesses of its financial position (Woelfel, 1988).

2.1.1.2. Users of financial analysis

Accounting is often described as the language of business because it is the medium of communication between a business firm and the various parties interested in its financial activities. Accounting provides information that is intended to be useful. This information can be used in decision making by different users (Henry, 2006). The users of financial statements include present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the financial. They use financial statements in order to satisfy some of their different needs for information. Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization (Mohammad et al., 2003). There are different users of financial statement analysis and these can be classified into internal and external users. Internal users refer to the management of the company who analyzes financial statements in order to make decisions related to the operations of the company such as manager, and employees. On the other hand, external users do not necessarily belong to the company but still hold some sort of financial interest. These include owners/share holders, investors, creditors, government, customers, donors, competitors, the general public, and Regulatory Authorities (Unegbu , 2007); (Messier et al., 2008).

2.1.1.2.1. Internal users of financial statement analysis

a. Management

In small businesses, management may include the owners. In huge organizations, however, management is usually made up of hired professionals who are entrusted with the responsibility of operating the business or a part of the business. They act as agents of the owners. The managers, whether owners or hired, regularly face economic decisions – the management would like to know how much they have performed? Have they been able to do better than they achieved in the previous years? How has their performance compared with budget and forecast? How well they have managed the firm’s resources? All those, and many other questions and business decisions, require analysis of financial statement (Angus et al., 2011).

b. Employees

Employees are interested in the company’s profitability and stability. They are after the ability of the company to pay salaries and provide employee benefits. They may also be interested in its financial position and performance to assess company expansion possibilities and career development opportuniti es (Omunuk, 1999).

2.1.1.2.2. External users of financial statements analysis

a) Owners/ shareholders

This groups interest in accounting information lies in fact that it is their money, which is invested in business. This ensures that they are getting a god return on their investments. This is assessed how much profit it the firm is making and whether their investment is increasing its value. For shareholders in companies, this means they will get good dividend and the market value of their shares will increase and they can make profit if they were sold. Management: board of directors and managers use accounting information for making decision and planning the business operations. They are responsible for owners/ shareholders in caring out policies and directives and running the business efficiently and effectively (White et al., 2003).

b) Trade creditors or suppliers

Like lenders, trade creditors or suppliers are interested in the company’s ability to pay obligations when they become due. They are nonetheless especially interested in the company's liquidity – its ability to pay short-term obligations (Mohammad et al., 2003).

c) Donors/ funding agencies Nonprofit making organization lie on non-governmental organizations (NGO’s) get funding from donors agencies abroad. These agencies are always interested in making sure that the money they donate achieves the objectives for which it was released. The most of their objectives are societal. Donors rigorously monitor utilization of their money by examining accounting records-financial report/statements, books, and documents of the organizations that they support (Omunuk, 1999).

d) Government

Governing bodies of the state, especially the tax authorities, are interested in an entity's financial information for taxation and regulatory purposes. Taxes are computed based on the results of operations and other tax bases. In general, the state would like to know how much the taxpayer makes to determine the tax due thereon (Mohammad et al., 2003).

e) Competitors

Competitors are interested in accounting information of firms in the same industry with them so as to judge whether they are doing badly or fairly in comparison with other players in the same business (Mohammad et al., 2003).

f) General Public

Anyone outside the company such as researchers, students, analysts and others are interested in the financial statements of a company for some valid reason (Omunuk, 1999).

g) Customers

When there is a long-term involvement or contract between the company and its customers, the customers become interested in the company’s ability to continue its existence and maintain stability of operations. This need is also heightened in cases where the customers depend upon the entity. The regular customers of the firm usually rely on of steady supply their merchandise for resale or of the raw materials in case of manufacturing companies. Therefore, they are interested to know if the company is able to continue in its operation on a long term basis and is capable of meeting of its customers demand for good (Omunuk, 1999).

h) Investors

For analyzing the feasibility of investing in the company, the Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company (Unegbu , 2007).

i) Regulatory authorities:

Regulatory Authorities for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set in order to protect the interests of the stakeholders who rely on such information in forming their decision (Omunuk, 1999).

2.1.1.3. Analysis and interpretation of financial statement

According to Koen & Oberholster (1999) , analysis and interpretation of financial statement is a treatment of the information contained in the income statement and balance sheet.

According to Maheshwari et al. (1993), a distinction here can be made between the two terms; analysis means methodical classification of the data given in the financial statements. Therefore, the term interpretation means and significance of data which have been simplified. However, both analysis and interpretation are complementary to one another.

2.1.1.4. Methods of financial analysis

There are several techniques or methods of analyzing the financial statements. The user must select the technique that may be most appropriate for his or her purposes (Agarwal & Jain , 1993). The methods of financial statements are horizontal analysis/comparative analysis, vertical analysis/ common size statements, trend percentages and ratio analysis.

2.1.1.4.1. Comparative analysis/Horizontal Analysis

When figures are arranged in columns and studied, it is often referred to as horizontal analysis (Agarwal & Jain , 1993). Horizontal analysis is the comparison of financial information of a company with historical financial information of the same company over a number of reporting periods. It could also be based on the ratios derived from the financial information over the same time span. The main purpose is to see if the numbers are high or low in comparison to past records, which may be used to investigate any causes for concern. U nder the horizontal analysis, financial statements are compared with several years and based on that, a firm may take decisions. Normally, the current year’s figures are compared with the base year (base year is consider as 100) and how the financial information are changed from one year to another (Paramasivan & Subramanian, 2008). It is also called Comparative statement analysis which is an analysis of financial statement at different period of time. This statement helps to understand the comparative position of financial and operational performance at different period of time. Comparative financial statements classified into two major parts such as comparative balance sheet analysis and comparative profit and loss account analysis (Arthur, 1982).Where comparative balance sheet analysis concentrates only the balance sheet of the concern at different period of time. Under this analysis the balance sheets are compared with previous year’s figures or one-year balance sheet figures are compared with other years. And Comparative balance sheet analysis may be horizontal or vertical basis. This type of analysis helps to understand the real financial position of the concern as well as how the assets, liabilities and capitals are placed during a particular period (Paramasivan & Subramanian, 2008). And comparative profit and loss account analysis, under this analysis, only profit and loss account is taken to compare with previous year’s figure or compare within the statement. This analysis helps to understand the operational performance of the business concern in a given period. It may be analyzed on horizontal basis or vertical basis (Paramasivan & Subramanian, 2008).

- Advantages and Disadvantages of Horizontal Analysis/comparative analysis.

When the analysis is conducted for all financial statements at the same time, the complete impact of operational activities can be seen on the company’s financial condition during the period under review. This is a clear advantage of using horizontal analysis as the company can review its performance in comparison to the previous periods and gauge how its doing based on past results. This analysis indicates whether there is a trend, and if one is observed, it may quite useful in making predictions about the future (Agarwal & Jain , 1993).

A disadvantage of horizontal analysis is that the aggregated information expressed in the financial statements may have changed over time and therefore will cause variances to creep up when account balances are compared across periods.

Horizontal analysis can also be used to misrepresent results. It can be manipulated to show comparisons across periods which would make the results appear stellar for the company. For instance, if the profits for this month are only compared with those of last month, they may appear outstanding but that may not be the case if compared with the same month the previous year. Using consistent comparison periods can address this problem (Agarwal & Jain , 1993).

2.1.1.4.2. Common size analysis/Vertical Analysis

When figures from a particular statement are arranged in rows and then studied, it is often referred at vertical analysis (Agarwal & Jain , 1993). Vertical analysis is conducted on financial statements for a single time period only. Each item in the statement is shown as a base figure of another item in the statement, for a given time period, usually for year. Typically, this analysis means that every item on an income and loss statement is expressed as a percentage of gross sales, while every item on a balance sheet is expressed as a percentage of total assets held by the firm. U nder the vertical analysis, financial statements measure the quantities relationship of the various items in the financial statement on a particular period. It is also called as static analysis, because, this analysis helps to determine the relationship with various items appeared in the financial statement. For example, a sale is assumed as 100 and other items are converted into sales figures . Vertical analysis is also called static analysis because it is carried out for a single time period (Paramasivan & Subramanian, 2008). Another important financial statement analysis technique is common size analysis in which figures reported are converted into percentage to some common base. In the balance sheet the total assets figures is assumed to be 100 and all figures are expressed as a percentage of this total. It is one of the simplest methods of financial statement analysis, which reflects the relationship of each and every item with the base value of 100 % (Paramasivan & Subramanian, 2008).

- Advantages and Disadvantages of Vertical Analysis

Vertical analysis only requires financial statements for a single reporting period. It is useful for inter-firm or inter-departmental comparisons of performance as one can see relative proportions of account balances, no matter the size of the business or department.

Because basic vertical analysis is constricted by using a single time period, it has the disadvantage of losing out on comparison across different time periods to gauge performance. This can be addressed by using it in conjunction with timeline analysis, which shows what changes have occurred in the financial accounts over time, such as a comparative analysis over a three-year period (Paramasivan & Subramanian, 2008).

2.1.1.4.3. Trend Analysis

The financial statements may be analyzed by computing trends of series of information. It may be upward or downward directions which involve the percentage relationship of each and every item of the statement with the common value of 100%. Trend analysis helps to understand the trend relationship with various items, which appear in the financial statements. These percentages may also be taken as index number showing relative changes in the financial information resulting with the various period of time. In this analysis, only major items are considered for calculating the trend percentage (Paramasivan & Subramanian, 2008). Using the past history of a firm for comparison is called trend analysis. By looking at the trend in a particular ratio, one sees whether that ratio is failing, rising, or remaining relatively constant. From this, a problem is detected or good management is observed (Charles, 1989).

2.1.1.4.4. Ratio Analysis

Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a mathematical relationship between one numbers to another number. Ratio is used as an index for evaluating the financial performance of the business concern. An accounting ratio shows the mathematical relationship between two figures, which have meaningful relation with each other. Ratio can be classified into various types. Classification from the point of view of financial management is as follows: Liquidity Ratio, Activity Ratio, Solvency Ratio, and Profitability Ratio (Leach & Melicher, 2006) .

2.1.1.4.4.1. Types of analysis using financial ratios analysis in decisions making

According to NetMBA.com (2010), financial ratio can be classified according to the information they provide. The types of ratios frequently used are liquidity ratios, asset-equity ratios/leverage ratios, sales and profitability ratios, and efficiency ratios.

a) Analyzing liquidity

According to Emekekwe (2005) opined that liquidity ratio measures the level of a firm to meet its obligations in short notice liquid assets are those that can be converted into cash quickly. According to Reeve & Warren (2008) asserted that liquidity may be diagnosed into “current ratio” and “quick ratio”, quick asset are cash, receivables, and other current assets that can quickly be converted into cash. The short-term liquidity ratios show the firm's ability to meet short-term obligations. Thus a higher ratio (#1 and #2) would indicate a greater liquidity and lower risk for short-term lenders. The Rule of Thumb (for acceptable values): Current Ratio (2:1), Quick Ratio (1:1) While high liquidity means that the company will not default on its short-term obligations, note that by retaining assets as cash, valuable investment opportunities might be lost. Obviously, Cash by itself does not generate any return only if it is invested will we get future return. In quick ratio, we subtract the inventories from total current assets since they are the least liquid among the current assets (Sathyamoorthi, 2003).

Since the cash is the most liquid asset, a financial analyst may examine the ratio of cash and its equivalent to current liabilities. Trade investment and marketable securities are equivalent of cash therefore they may be included in the computation of current ratio (Pandey, 1995).

1. Current Ratio = Total Current Assets/Total Current Liabilities
2. Quick or Acid-test Ratio = Total Current Assets - Inventories /Total Current Liabilities
3. Cash ratio = Cash + Marketable securities/Current liabilities.

These ratios show the extent to which a firm is relying on debt to finance its investments/operations and how well it can manage the debt obligation. Obviously, if the company is unable to repay its debt or make timely payments of interest, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides valuable tax benefits to the firm. Note total debt should include both short-term debt (bank advances + current portion of long-term debt) and long-term debt (such as bonds, leases, and notes payable) (Altman, 1968).

b) Asset-equity ratio or leverage ratio

According to Unegbu et al. (2011), it is of the view that “financial leverage” refers to the degree of a business relying on debt instead of equity to finance its operations. This shows firm's reliance on external debt for financing (or the degree of leverage). Any number above 100% shows that the company relies on external debt for financing some of its assets. If the number equals 100%, it implies that the assets are fully financed by the shareholders. Some analysts tend to use the Debt ratio (given by total Debt/total assets) or Debt/Equity ratio given by total long-term debt/equity). These ratios also show company's reliance on external sources for financing its assets (Altman, 1968).

1. Total Debt ratio = Total Debt/Total assets
2. Debt to Equity Ratio = Total Debt/Equity
3. Long-term Debt to capital = Debt/Debt + Equity
4. Interest coverage= Profit before interest and tax/Total interest charges

For a lender, more important than the degree of leverage is the firm's ability to service the debt and this is captured in the following ratio.

c) Analyzing sales and profitability

According to Unegbu & Kishore (2007), writing on profitability asserted that profitability ratios help to assess the adequacy of profit earned by the company and also to discover whether profitability is increasing or declining. Profitability is a relative term. It is hard to say «what percentage of profits» represents a profitable firm as the profits will depend on the product life cycle, competitive conditions in the market, borrowing costs, expense management. Analysts will be interested in the (historical and forecasted), the set of ratios here include some of the traditional earnings based performance measures such as net profit margin, ROA, and ROE. For a better understanding of growth rates, it will be useful to know the «real growth rate» as opposed to «nominal growth rate». For example, it is quite possible that the sales growth rate figures are impressive due to inflation (rather than an increase in the number of items sold) (Abor, 2005).

The following are ratios selected to analyze profitability and sales;

1. Sales Growth Rate = {(Current year sales - last year sales)/last year sales} * 100
2. Expense analysis = various expenses /Sales
3. Gross Margin/Sales = Gross Profit/Total Sales
4. Operating Profit/Sales = Operating Profit/Net Sales
5. EBIT to Sales = EBIT/Net Sales
6. Return on Sales (ROS) or net profit ratio = Net Income/Net Sales
7. Return on Investment (ROI) = Net Income/Total Assets
8. Return on Assets (ROA) = Net Income/Total Assets
9. Return on Equity (ROE) = EAT/Shareholders' Equity
10. Payout ratio = Cash Dividends/ Net Income
11. Retention ratio = Retained Earnings/Net Income
12. Sustainable growth rate (SGR)= ROE * Retention Ratio It is useful to disaggregate the ROE figure into three elements as follows to get a better insight
13. ROE = {Net Income/Sales} * {Sales/Assets} * (Assets/Equity)

The above formulation clearly shows that if management wishes to improve their ROE, they need to improve profitability, efficiently use the assets, and optimize the use of debt in their capital structure.

SGR shows how much the company will grow in the future if some of the key ratios remain the same as in previous years. It is useful to disaggregate the sustainable growth rate (SGR) as follows.

SGR = f (Profitability, Asset Efficiency, Leverage, Dividend policy) SGR = Return on Sales * Asset turnover ratio * Leverage * Retention ratio SGR= (Net income/sales) * (sales/assets) * (assets/equity) * (RE/net income)

d) Analyzing Efficiency

According to Ross et al. (2002), explained this ratio as the ratio that shows the ability of the firm to control its investments in “assets”. It measures how effectively the firm’s assets are being managed. This ratio reflects how well the firm’s assets are being managed. The inventory ratio show how fast the inventory is being produced and sold. These ratios reflect how well the firm's assets are being managed. The inventory ratios show how fast the inventory is being produced and sold. Ratio #1 shows how quickly the inventory is being turned over (or sold) to generate sales higher ratio implies the firm is more efficient in managing inventories by minimizing the investment in inventories. Thus a ratio of 12 would mean that the inventory turns over 12 times or the average inventory is sold in a month. Some High ratio by itself does not mean high level of efficiency as high ratio could also mean shortage. Ratio #2 is referred to as the «shelf-life» i.e. how many days the inventory was held in the shelf. Ratio #3 shows how much sales the firm is generating for every currency unit of investment in assets, naturally, higher the better. However, note that this ratio is biased (as assets are listed at historical costs while sales are based on current prices). Ratios #4 and #5 show the firm's efficiency in collecting from credit sales. While a low ratio is good it could also mean that the firm is being very strict in its credit policy, which may drive away some customers. Ratios #6 and 7 focus on efficiency in making payments (Cummins & Weiss, 2013).

1. Inventory Turnover = Cost of Goods Sold/Average Inventory
2. Days in Inventory = (Average Inventory/Cost of Sales)*365
3. As sets turnover = Net Sales/Total As sets
4. Receivables Turnover = Credit Sales/Accounts Receivables
5. Average Collection period = (Accounts Receivable/Net Sales)*3 65
6. Accounts Payable turnover = Purchases/Accounts Payable
7. Days AP outstanding = (Accounts Payable/Cost of Sales)*3 65
8. Asset utilization ratio = Total Revenues / Total assets
9. Operating Efficiency= Total operating Expense / Total operating Income

2.1.1.4.4.2. Predicting Financial Distress of Companies

To predict financial distress, different criteria are weighted and combined for each time period to determine whether a company has a bright or break future.

Multiple Discriminant Analysis

The following is a Multiple Discriminant Analysis (MDA) and the use of MDA helps to consolidate the effect of a set of ratios by looking at a number of separate clues (ratios to sickness or failure).It would be more useful to combine the difference ratios into a single measure of the probability of sickness or failure (bankruptcy). According to Altman (1968) as the first man to apply Discriminant analysis in finance for studying bankruptcy, his study helped in identifying five ratios that were efficient in predicting bankruptcy. The model was developed from a sample of 66 firms half of which went bankrupt. He derived the following Discriminant function:

Z = 0.012X1+0.0 14X2+0.033X3+0,006X4+0.999X5 Where Z= Discriminant function score of a firm; X1= net working capital/total assets (%); X2= retained earnings/total assets (%); X3= EBIT/total assets (%);

X4=market value of total equity/book value of debt (%); X5= sales/total assets (%);

Using the above ratios and weight Altman established two indicators values for the Z score; Altman (1968) established a guideline Z score which can be used to classify firms as either financially sound a score above 2.675 or a headed towards bankruptcy a score below 2.675. The lower the score, the greater the like hood of bankruptcy and vice versa.

Current researcher found that, Above 3% [0.03] there is a high probability that the company would not fail, Below 1.8% [0.018] failures was very likely and would probably happen within two years and Obviously there is a grey area between these two values but any value below 3% should be cause for serious concern for the firm in question (Alterman & Edward, 2000).

2.1.1.4.5. Time series analysis

This is the way used to evaluate the performance of a firm by comparing its current ratios with the past ratios. It gives an indication of the direction of change and reflects whether the firm's financial performance has improved, deteriorated or remained constant over time (Pandey, 1995).

2.1.2. Financial statements

A financial statement is an official document of the firm, which explores the entire financial information of the firm. The main aim of the financial statement is to provide information and understand the financial aspects of the firm. Hence, preparation of the financial statement is important as much as the financial decisions (Paramasivan & Subramanian, 2008). Financial Statements represent a formal record of the financial activities of an entity. These are written reports that quantify the financial strength, performance and liquidity of a company. Financial Statements reflect the financial effects of business transactions and events on the entity. Financial statements are periodic reports published by the company for the purpose of providing information to external users (Richard et al., 2004).

2.1.2.1. Types of financial statements.

In short, the firm itself as well as various interested groups such as managers, shareholders, creditors, tax authorities, and others seeks. Financial analysis involves the use of financial statements. A financial statement is an organized collection of data according to logical and consistent accounting procedures. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show a position at a moment of time as in the case of a Balance Sheet, or may reveal a series of activities over a given period of time, as in the case of an Income Statement. Thus, the term ‘financial statements’ generally refers to two basic statements: the Balance Sheet and the Income Statement (Metcalf & Titard, 1976).

2.1.2.1.1. The balance sheet

The Balance Sheet shows the financial position (condition) of the firm at a given point of time. It provides a snapshot and may be regarded as a static picture. Balance sheet is a summary of a firm’s financial position on a given date that shows (Metcalf & Titard, 1976).

According to Henry (2006),the balance sheet is organized into three parts: assets, liabilities, and stockholders’’ equity at a specified date (typically, this date is the last day of an accounting period). The balance sheet shows the current financial position of the firm, at a given single point in time. It is also called the statement of financial position. The structure of the balance sheet is laid out such that on one side assets of the firm are listed, while on the other side liabilities and shareholders’ equity is shown (Paramasivan & Subramanian, 2008).The two sides of the balance sheet must balance as follows:

Assets = Liabilities + Shareholders’ Equity

2.1.2.1.2. Income statement

According to Henry (2006), the Income statement reports a company’s profitability during a specified period of time. The main components of the income statement are revenues, expenses, gains, and losses. Revenues include such things as sales, service revenues, and interest revenue. Expenses include the cost of goods sold, operating expenses (such as rent, utilities, advertising), and no operating expenses (such as interest expense).The income statement (referred to the profit and loss statement) reflects the performance of the firm over a period of time. Income statement is a summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period (Henry, 2006).

2.1.2.1.3. The cash flow statement

A statement of cash flows is required by generally accepted accounting principles to be included in a complete set of financial statements. A cash flow statement must be included for each year for which an income or operating statement is included. Thus, the annual reports of most organizations include cash flow statements for either two or three years for comparative purposes (Laura, 1998).The purpose of the cash flow statement is to report how an organization generated and used its cash. Knowing where the cash comes from is important in projecting whether cash will be generated from those sources in the future. Knowing where the cash goes is important in assessing the organization’s future cash needs. When presenting cash flow statements, most companies combine cash and cash equivalents because short-term investments classified as cash equivalents are used primarily as a substitute for cash (Laura, 1998).

2.1.2.1.4. Statement of change in equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the movement in owners' equity over a period (Laura, 1998).

2.1.2.2. Qualitative characteristics of financial statements

FPPFS identify four qualitative characteristics that make information useful however it gives primary importance to relevance and reliability. It also states the applications of the principle qualitative characteristics and of appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view of, or a presenting fairly such information (Agarwal & Jain , 1993).

2.1.2.2.1. Understandability.

The information must be readily understandable to users of the financial statements. This means that information must be clearly presented, with additional information supplied in the supporting footnotes as needed to assist in clarification (Agarwal & Jain , 1993).

2.1.2.2.2. Relevance.

The information must be relevant to the needs of the users, which is the case when the information influences the economic decisions of users. This may involve reporting particularly relevant information, or information whose omission or misstatement could influence the economic decisions of users (Agarwal & Jain , 1993).

[...]

• College: INES Ruhengeri Institute of Applied Science
• Course: Accounting
• Grade: 16.5
• Author: Augustin Mudakemwa (Author)
• Publication Year: 2017
• Pages: 113
• Catalog Number: V584227
• ISBN (eBook): 9783346189004
• ISBN (Book): 9783346189011
• Language: English
• Tags: analysis, sacco/cyuve, rwanda, role, performance, microfinance, inyongera, institutions, financial, case, study