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Using Psychology When Analyzing Financial Statements

  • By Karl Kern
  • Published: 5/16/2019

psych

Some of the more popular tools of financial analysis, if not most popular, are financial statement ratios. As finance professionals, we rely on these ratios to assess the profitability, liquidity and solvency of companies. But how can we add value to these ratios? One answer is to use psychology when analyzing financial statements.

“Thinking, Fast and Slow”

“Thinking, Fast and Slow” by Daniel Kahneman addresses how we make decisions—through thinking. Thinking comes in two forms: System 1 which is intuition (i.e., fast thinking), and System 2 which is contemplation (i.e.. slow thinking). These forms of thinking are addressed by the work of not only Kahneman, but also other psychologists, such as Paul Slovic.

Slovic is included in “Thinking, Fast and Slow” due to his work on making decisions when uncertainty (i.e., risk) exists. Kahneman describes a portion of Slovic’s work in chapter 13, which is titled “Availability, Emotion, and Risk.”  The last section of the chapter, “The Public and The Experts,” which covers pages 140 through 145, is the section that attracted my attention.

Slovic believes that there is no such thing as objective risk. His belief is expanded by indicating that there are nine ways to measure mortality risk associated with the release of toxic material in the air; according to him, one can measure death per million people while another can measure death per million dollars of product produced. His expansion of his belief leads to the conclusion that evaluation depends on the choice of measure and choice is based on preference.

How Slovic’s contribution applies to financial analysis

The second edition of “Financial and Managerial Accounting” by Jerry Weygandt, Paul Kimmel and Donald Kieso lists the following financial statement ratios by category on the inside back cover of the book:

Profitability

  1. Profit margin
  2. Asset turnover
  3. Return on assets
  4. Return on common stockholders’ equity
  5. Earnings per share (EPS)
  6. Price-earnings (P-E) ratio
  7. Payout ratio

Solvency

  1. Debt to assets ratio
  2. Times interest earned
  3. Free cash flow

Liquidity

  1. Current ratio
  2. Quick ratio
  3. Accounts receivable turnover
  4. Inventory turnover

We can conclude from the number of ratios within each category that people want to make assessments from different perspectives. We see within the profitability section that assessments can be made based on the firm’s revenue, assets, stockholders’ equity, market price of its stock, and dividend payments.  We can expand on the list provided by assessing profitability from the use of liabilities, current and/or long-term.

Applying Slovic’s contribution to a real-life example

Through the use of Yahoo! Finance, I conducted a liquidity assessment of two companies, Ford and General Motors. Ford and General Motors were selected because they are competitors and possess assets that affect their ability to pay bills when due. Financial statement data for fiscal years 2016 through 2018 was used.

Here is a chart containing statistics relevant to this assessment:

 

CURRENT RATIO

 

2018

2017

2016

Ford

1.19

1.23

1.20

General Motors

0.92

0.89

0.89

 

QUICK RATIO

 

2018

2017

2016

Ford

0.28

0.39

0.43

General Motors

0.35

0.36

0.36

 

AVERAGE COLLECTION PERIOD

 

2018

2017

2016

Ford

28.34

38.19

39.90

General Motors

28.39

32.05

31.04

 

AVERAGE AGE OF INVENTORY

 

2018

2017

2016

Ford

39.81

36.54

34.62

General Motors

42.81

47.13

54.23

                               

The first application of Slovic’s contribution to analyzing financial statements is my preference in using the average collection period and average age of inventory instead of accounts receivable turnover and inventory turnover. My preference is due to my belief that both turnover ratios do not provide a quick understanding of liquidity. I believe quickness is established when we use time to determine how long it takes for a company to collect cash from its receivables, i.e., the average collection period, and to determine how long it takes for a company to sell its products, i.e. the average age of inventory.

The second application of Slovic’s contribution to analyzing financial statements is the preference in using the current ratio or the quick ratio.

I call the current ratio a “quick and dirty” assessment because one can take the totals of current assets and current liabilities to make a liquidity assessment. This can provide immediate, as well as broad feedback, however this ratio has a flaw which is the inclusion of inventory. The inclusion of inventory is a flaw because inventory typically becomes accounts receivable before cash so the inclusion can create a false impression about a company’s ability to pay its bills when due.

How one can remove this flaw is through the use of the quick ratio. Since this ratio excludes inventory, it gives better information about a company’s ability to pay its bills when due. Some may dispute my statement about this ratio giving better information because it does not include all of a company’s current assets, so this dispute supports Slovic’s contribution.  Some people will measure liquidity through the current ratio because they prefer to include all of a company’s current assets while other people will measure liquidity through the quick ratio because they prefer to focus on current assets that exist as cash or “near cash.” This leads us to the third contribution from Slovic and that’s inferences about the liquidity of Ford and General Motors.

Here’s what we can infer from this chart:

  1. Based on the current ratio, Ford has been in a much stronger position than General Motors to pay its bills when due.
  2. Based on the quick ratio, Ford has been in a somewhat stronger position than General Motors to pay its bills when due until 2018.
  3. Based on the average collection period, Ford has been in a noticeably stronger position than General Motors to pay its bills when due however both companies in 2018 are in a similar position.
  4. Based on the average age of inventory, Ford has been in a significantly stronger position than General Motors to pay its bills when due. However, that strength decreased dramatically in 2018.

The art of financial analysis

Financial statement analysis can be seen as a science, but also can be seen as an art. The art of financial statement analysis is how profitability, liquidity and solvency can be assessed. The ability to assess has been provided by people like Weygandt, Kimmel and Kieso, however, there’s more than what people provide. The “more” is how people choose measurements, and these choices are based on preferences.  This “more” can be explained by the use of psychology.

Karl Kern is an accountant, lecturer and writer focused on economics and finance.

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