Chief Assist. Prof.

Krasimir Kulchev, PhD

AND AUDIT

THE INTERPRETATION OF FINANCIAL

STATEMENTS IN TERMS OF
CONTEMPORARY FINANCIAL ANALYSIS
Chief Assist. Prof. Krasimir Kulchev, PhD

Abstract: The evolution of financial analysis is accompanied by an extensive

use of indicators whose calculation is based on data provided both by entities in their
financial statements and by financial markets. The analysis of data and indicators
generated by the capital market is considered to be of primary importance when
studying the financial position of enterprises. This view is supported by a substantial
number of analysts and, although not applicable to all enterprises, it raises a number
of questions, two of them being whether the new analytical indicators are replacing the
classic indicators of financial statement analysis and whether financial statements
have retained their fundamental role as a primary source of data in studying the
financial position of enterprises. The objective of this paper is to answer these
questions by approaching the interpretation of financial statements within the context
of some unorthodox views about the evolution of financial analysis.
Key words: capital market; analytical models; economic value added;
interpretation of financial statements.
JEL: M 41.

Introduction

Financial analysis is an essential instrument for assessing the

financial position of enterprises. The findings of financial analysis are
primarily used by internal and external economic agents for making
managerial, investing and other decisions. The key areas of financial
analysis include revenue; business performance; inventory and capital

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THE INTERPRETATION OF FINANCIAL STATEMENTS IN TERMS …

structure; liquidity; indebtedness; turnover; profitability; and cash flow from

operating and financing activities and from investing operations.
To study these areas, the data provided in the financial statements
is made subject to comparative, structural, and factor analysis 1. We should
note, though, that the data presented in the financial statements might be
insufficient when an in-depth factor analysis is required. As C. Walsh points
out, the ratio between earnings before interests and taxes and revenue
from sales does not take into account the factor effects of such major
variables as selling prices and the product mix 2. The study of these values
requires further inside information and the application of advanced
dependencies to conduct a deterministic factor analysis3.
Financial statements are a primary source of data for studying the
financial position of enterprises. In addition to the interpretation of financial
statements, financial analysis also involves an extensive factor analysis
which requires wider data base. The full potential of contemporary financial
analysis, however, could only be deployed provided that analysts have
access to both inside and outside data resources, i.e. data obtained from
financial statements and from capital markets.
When studying the evolution of financial analysis, it is possible to
identify two models of assessing the financial position of enterprises – the
accounting analytical model and the financial analytical model 4. The major
differences between them are in terms of the indicators and data sources
they employ. The accounting analytical model employs absolute and
relative indicators whose computation is based on the information provided
in financial statements, whereas the financial analytical model employs
indicators whose computation also requires data obtained from capital
markets.
1
See: Mihaylov, M., Mitov, K., Koleva, R. Analiz na industrialniya biznes. V.
Tarnovo, Faber, 2013. p. 180.
2
See: Walsh, C. Klyuchovite koefitsienti v menidzhmanta (In English: Key
Management Ratios). Sofia, InfoDAR, 2008, p. 96.
3
See further: Mihaylov, M., Mitov, K., Koleva, R. Op. cit., p. 196-223.
4
See: Kasarova, V. Nov prochit na finansoviya analiz ot pozitsiite na
stoynostta (scientific manuscript deposited at the Central Research and Technical
Library No.169/2008). p. 17. Accessible at:
th
<http://www.eprints.nbu.bg/513/1/ANALIZ_DVA_MODELA.pdf> [Last access: 14 May
2016].

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 Chief Assist. Prof. Krasimir Kulchev, PhD

Thus, for example, in the accounting analytical model for studying

business performance, earnings are employed in a number of indicators,
while the financial analytical model more frequently relies on the economic
value added (EVA). Another essential value is that of the weighted average
cost of capital (WACC) which is computed based on the cost of owners’
funds and long-term and short-term debt.5 We should point out that while it
is relatively easy to determine the cost of long-term and short-term debt,
establishing the cost of owners’ funds is a more difficult task. Two groups of
reasons might be identified behind this difficulty:
– underdeveloped capital markets, i.e. a large number of
enterprises which are not listed on the stock exchange and non-joint stock
companies;
– the subjective nature of determining the cost of owners’ funds– a
variety of approaches might be employed and the choice of a specific
approach is subject to the discretion of analysts 6.
Another shortcoming is the fact that in some cases data obtained
from capital markets may significantly lag behind the current financial
position of enterprises. Warren Buffett designed his investment strategy by
employing the lag in the information provided from financial markets as a
major source to maximize earnings. Buffet’s investment decisions are
primarily based on an in-depth analysis of financial statements. Buffett’s
investment decisions are primarily based on an in-depth analysis of
financial statements. This analysis involves identifying enterprises with a
durable competitive advantage in terms of growing earnings and a
subsequent increase in the economic value of the business. Although there
might be some delay in the acknowledgment of that growth by the stock
exchange, when this happens, the objective of the investment strategy 7 is
accomplished. The success of Buffett’s strategy proves that it is possible to

5
See: Kasarova, V. Novite metriki na korporativniya finansov uspeh. Sofia,
Evdemoneya Prodakshan EOOD, 2013, p. 24-33.
6
See: Todorov, L. Savremenni modeli za otsenka na biznesa. Sofia, Nova
zvezda, 2014, p. 84, 115 – 139.
7
See: Buffett, M., Clark, D. Warren Buffet i analiza na finansovi otcheti (In
English: Warren Buffett and the Interpretation of Financial Statements). Sofia, Iztok-
Zapad, 2011, p. 173.

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THE INTERPRETATION OF FINANCIAL STATEMENTS IN TERMS …

identify an existing durable competitive advantage through the inter-

pretation of financial statements.
The accounting analytical model is primarily focused on past
performance, whereas the financial analytical model deals with the future; it
would therefore be appropriate to approach them as complementary
models rather than as conflicting ones. We should emphasize that it is
possible to predict the future performance of a particular enterprise by
applying the accounting analytical model and Buffett is not the only investor
who has based his strategy on the interpretation of financial statements.
The proponents of this analytical model believe that ‘fundamental
accounting research is the most appropriate method of interpreting’8
financial statements. The opposite view is supported by analysts who are
primarily concerned with fluctuations in the prices of common shares, i.e.
those who base their investment decisions on a single indicator – the
market price per share.
Despite the possibility to make sound decisions based on the
interpretation of financial statements (including the design of a successful
investment strategy), this source of information has its shortcomings, too. A
balance sheet is a snapshot of the financial position of an enterprise at a
particular moment and the information presented in financial statements
(including the data about earnings) may be manipulated. Certain
approaches make it possible to mitigate or eliminate the impact of those
shortcomings upon the findings and assessments made through the
interpretation of financial statements. Depending on the objectives of the
analysis conducted, it might be appropriate to interpret several consecutive
financial statements to gain better awareness about the financial position of
a specific enterprise. It would thus possible to deal with the issue of the
‘snapshot’ nature of the balance sheet, while the employment of integral
indicators would help minimise the impact of misrepresentations in financial
statements.
An integral indicator provides a summary of the data presented
through several financial indicators. A specific integral indicator may be
employed to make a complex assessment of the financial position of an

8
See: Trifonov, Tr., Trifonova, V., Trifonova, S. Korporativni finansi. Sofia,
Trakia – М, 1999, p. 265.

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 Chief Assist. Prof. Krasimir Kulchev, PhD

enterprise, while each individual indicator may be approached as an

independent one. One of the most popular integral indicators is computed
through the Z-score model designed by Prof. Edward Altman in 1968 and
revised by Prof. Steven Skiena’s team in 2004. The model is employed
when studying the financial position of enterprises to predict the risk of a
bankruptcy within a three-year period. Although the Z-score model has not
been designed for the economic environment in Bulgaria, it can reliably
determine the odds of a bankruptcy with 80 % accuracy and gives
sufficiently good awareness about the financial position of enterprises and
the financial risk assumed 9.
The Z score model for assessing financial risk in public enterprises
uses the formula:
Z  X 1 1.2  X 2 1.4  X 3  3.33  X 4  0.6  X 5 ,
Where:
X 1 is the ratio between the net working capital 10 and total assets (a
liquidity indicator);
X 2 is the ratio between retained earnings and total assets (a self-
financing indicator);
X 3 is the ratio between earnings before interest and taxes and
total assets (a profitability indicator);
X 4 is the ratio between the market value 11 and debts (an
indebtedness indicator);
X 5 is the ratio between revenue from sales and total assets (a
turnover indicator).
When the value of the integral indicator is Z < 0.91, the enterprise is
likely to go bankrupt within two or three years. A value of Z > 2.07 indicates
good financial health. In terms of the ‘Z model’, there are several major
aspects which we should focus on:

9
Todorov, L. Op. cit., p. 200 – 208.
10
The net working capital is the difference between current assets and
current liabilities.
11
The market value (market capitalization) of an enterprise is the product of
the number of issued shares and the market price per share.

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THE INTERPRETATION OF FINANCIAL STATEMENTS IN TERMS …

– The fact that the model has been updated nearly forty years after
it was first designed proves that it may be utilised in modern financial
analysis;
– The model allows predicting the future financial position of a
specific enterprise;
– Computing the value of the integral indicator Z requires mainly
data provided in financial statements; data obtained from financial markets
is solely used to compute the X 4 ratio which has the lowest weight.
Since each indicator has its advantages and shortcomings, we
believe that it would be more appropriate for external analysts to apply an
approach combining three groups of indicators when examining the
financial position of a public enterprise:
- Ratios based on the data presented in financial statements, i.e.
the liquidity, self-financing, profitability, indebtedness and turnover ratios;
- Straightforward ratios obtained from the capital market, i.e.
market capitalization, market price per share, etc.;
- Ratios whose computation relies on data provided in financial
statements and by capital markets, including the index of economic value
added; the economic added rate of return on invested capital; the Z-score
indicator; the market value added ratio; the standardized market value
added ratio, etc.
The advantage of a similar combined approach lies in the
opportunity it provides to study the financial position of enterprises from
several different perspectives. In this case, each indicator complements or
confirms the data provided through the other ratios and thus contributes to
a more detailed insight as to market assessment and the performance of
an enterprise over a particular period.
The application of the combined approach is illustrated with data
about Monbat PLC, Table 1 presenting the input data12 and Table 2
presenting output data.

12
The following sources have been accessed to collect input data:
– the financial statements of Monbat PLC: http://www.bse-
sofia.bg/?page=DownloadExtriFiles&EXTRI_ID=70201&lang=bg&year=2012&period=Q5;
http://www.bse-
sofia.bg/?page=DownloadExtriFiles&EXTRI_ID=79672&lang=bg&year=2013&period=Q5;

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 Chief Assist. Prof. Krasimir Kulchev, PhD

Table1
Input data in establishing the financial position of Monbat PLC

No. Indicators 2011 2012 2013 2014 2015

1. Owners’ funds (in BGN thousands) 120,086 120,321 141,184 145,994 158,598
2. Long-term loans (in BGN thousands) 12 ,677 9,663 6,649 33,819 9,198
3. Short-term loans (in BGN thousands) 28 ,207 26,652 20,138 8,680 25,214
4. Current assets (in BGN thousands) 57,224 60,656 80,493 93,153 100,767
5. Amounts payable which are due within 1 year
(in BGN thousands) 44,811 49,185 37,221 20,493 46,599
6. Total assets (in BGN thousands) 180,392 184,462 189,451 203,559 218,927
7. Liabilities (in BGN thousands) 60,306 64,141 48,267 57,565 60,329
8. Revenue from sales (in BGN thousands) 194,931 183,299 245,363 247,091 293,552
9. Retained earnings (in BGN thousands) 120,286 120,321 21,754 13,780 26,384
10. Earnings before interest and taxes (in BGN
thousands) 7,227 7,463 23,609 14,171 19,870
11. Net earnings (in BGN thousands) 6,250 9,051 21,754 13,780 18,454
12. Unlevered β 1.2 1.29 1.01 1.07 0.95
13. Market risk premium (%) 8.63 8.43 7.85 8.6 8.84
14. Risk-free rate of return (%) 519 3.85 3.52 3.37 2.5
15. Cost of long-term loans (%) 9.7 8.82 7.57 6.52 6.52
16. Cost of short-term loans (%) 7.2 6.84 7.03 5.96 5.35
17. Corporate tax rate (%) 10 10 10 10 10
18. Market capitalisation (in BGN thousands) 210,951 182,793 263,055 333,450 311,922
19. Market price per share (in BGN) 5.409 4.687 6.745 8.55 7.998

http://www.bse-
sofia.bg/?page=DownloadExtriFiles&EXTRI_ID=97842&lang=bg&year=2015&period=Q5;
– Unlevered β in the branch of the researched company in the USA (Electrical
equipment) and market risk premium (including a premium for developed (American)
capital market and a premium for country risk in Bulgaria):
http://www.pages.stern.nyu.edu/~adamodar/;
– Risk-free rate of return (average annual value of ten-year government
securities):
http://www.pls.bnb.bg/bnb/dd/Yield_on_GSecurities_NEW.nsf/fsWebIndexBG;
– Cost of long-term loans (the average interest rate on loans due within 1 to 5
years for sector ‘Non-financial corporations’) and cost of short-term loans (the average
interest rate on loans due within 1 year for sector ‘Non-financial corporations’):
http://pls.bnb.bg/bnb/dd/IR_NBO_LOAN_NEW.nsf/fsWebIndexBG;
– Market capitalization and market price per share:
http://www.bse-
sofia.bg/?page=QuotesInfo&target=MarketInformation&code=5MB&compnum=116;
http://www.investor.bg/views/company/1212/2016-06-24/3/3/.

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Table 2
Output data in establishing the financial position of Monbat PLC

No. Indicators 2011 2012 2013 2014 2015

Invested capital (in BGN
20. thousands) р.1+р.2+р.3 160,970 156,636 167,971 188,493 193,010
Share of own capital in invested
21. capital (%)
р.1 / р.20 х 100 74.60 76.81 84.05 77.46 82.17
Share of long-term loans in
22. invested capital (%)
р.2 / р.20 х 100 7.88 6.17 3.96 17.94 4.77
Share of short-term loans in
23. invested capital (%)
р.3 / р.20 х100 17.52 17.02 11.99 4.60 13.06
Share of loans in own capital
24. (р.2+р.3) / р.1 0.34 0.30 0.19 0.29 0.22
Levered β
25. р.12 х (1+(1 – р.17 / 100) х
р.24) 1.57 1.64 1.18 1.35 1.14
Cost of own capital (%) р.14 +
26. р.25 х р.1 18.72 17.68 12.80 14.98 12.54
27. Weighted average cost of capital
(%)
р.21 х р.26 + р.22 х р.15 х (1 –
р.17 / 100) + р.23 х р.16 х (1 –
р.17 / 100) 15.79 15.12 11.79 12.90 11.21
Net operating profit after taxes (in
28. BGN thousands)
р.10 х (1 – р.17 / 100) 6,504.3 6,716.7 21,248.1 12,753.9 17,883
Profitability of invested capital
29. (%) р.28 / р.20 х 100 4.04 4.29 12.65 6.77 9.27
Economic value added (in BGN
30. thousands) (р.29 – р.27) х р.20 -18,909.3 -16,962.2 1,446.096 -11,570.2 -3,755.73
Economic added rate of return on
invested capital (%) р.30 /
31. р.20 х 100 -11.75 -10.83 0.86 -6.14 -1.95
32. Х1 net working capital/total assets
(р.4 – р.5) / р.6 0.07 0.06 0.23 0.36 0.25
33. Х2 retained earnings/total assets
р.9 / р.6 0,67 0.65 0.11 0.07 0.12
34. Х3 earnings before interest and
taxes/total assets р.10 / р.6 0.04 0.04 0.12 0.07 0.09

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 Chief Assist. Prof. Krasimir Kulchev, PhD

35. Х4 market capitalisation/total

liabilities р.18 / р.7 3.50 2.85 5.45 5.79 5.17
36. Х5 revenue from sales/ total
assets р.8 / р.6 1.08 0.99 1.30 1.21 1.34
37. Indicator Z
р.32 х 1,2 + р.33 х 1,4 + р.34 х
3,33+ р.35 х0,6 + р.36 4.33 3.83 5.41 5.44 5.21
38. Market value added
р.18. – р.1 90, 865 62,472 121,871 187,456 153,324
39. Standardised market value
added (р.38 t – р.38 t-1) / р.1 t-1
х 100 - -23.64 49.37 46.45 -23.38

After computing the analytical ratios, we could identify the following

major aspects in the financial position of Monbat PLC:
– Over the analysed period, the financial position of the enterprise
was good (Z > 2.07). The difference between the values of the Z score in
2013 and 2014 was minimum (0.03 points). The financial risk was the
lowest in 2014 when the highest value of the integral Z score was reported;
– Monbat PLC has the highest market assessment in 2014 (the
market capitalization of the enterprise reached BGN 333,450,000), the
market price per share being BGN 8.55 at the end of the year. If the
analysis had taken into consideration only the index market price per share
(as proposed by the advocates of the financial analytical model), then the
year 2014 would have been determined as the most successful one over
the period, which would be wrong;
– Over the analysed period, Monbat PLC had negative economic
value added, except for the year 2013 (BGN 1,446,000.096). The negative
value added over four years of the researched period indicates that the
company was not able to ensure the rate of return on capital which
shareholders had expected (the weighted average cost of capital). The
economic added rate of return on invested capital was a positive value only
in 2013. In that year, the return on invested capital exceeded the weighted
average cost of capital (12.65% > 11.79%) by 0.86%. Hence, 2013 was the
most successful year over the researched period, whereas the highest
price per share recorded in 2014 was a delayed positive assessment of a
past reporting period;

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THE INTERPRETATION OF FINANCIAL STATEMENTS IN TERMS …

– The conclusion made above is not based on the ratios of

economic value added or economic added rate of return on invested capital
only. In 2013, the values of a number of absolute and relative ratios
exceeded those reported in 2014, including the values of net earnings, the
Х3 ratio, and the standardized market value added, all of them being
computed based on data presented in the financial statements of the
company.

Conclusion

Based on our analysis of the findings of the combined approach, we

could draw the following conclusions:
First, financial statements interpretation is a major component of
the system of contemporary financial analysis. It may be approached as a
relatively independent component since the interpretation of financial
statements makes it possible to obtain the data required for sound
decision-making.
Second, the choice of an appropriate set of methods (a system of
analytical indicators, factor systems and technology models) is crucial to
the ultimate findings of the analysis.
Third, the evolution of financial analysis and the increasing
awareness about new analytical indicators should not be given priority
since these indicators still have their shortcomings, including the subjective
nature of their computation.
Fourth, the data obtained from the capital market might prove to be
a delayed consequence of a major economic situation observed earlier,
and thus the most appropriate moment for making related decisions might
be past, too (the reverse situation is also possible).
The summary of our research gives us grounds to claim that
despite the evolution of financial analysis, no universal single or integral
indicator has been designed so far to comprehensively describe the
financial position of a particular enterprise. It would therefore be more
appropriate to employ a balanced combination of the classic indicators
when interpreting financial statements, whose computation also requires

83
 Chief Assist. Prof. Krasimir Kulchev, PhD

data obtained from capital markets. A similar analytical approach, however,

should not underestimate the importance of financial statements due to the
other sources of data available. Hence, the major issue to be considered is
what would be the optimum combination of indicators that would describe
the financial position of enterprises both in terms of their economic situation
and their market valuation.

References

1. Buffett, M., Clark, D. Worren Buffett i analiza na finansovi otcheti

(In English: Warren Buffett and the Interpretation of Financial Statements).
Sofia, Iztok-Zapad, 2011.
2. Kasarova, V. Novite metriki na korporativniya finansov uspeh.
Sofia, Evdemoneya Prodakshan EOOD, 2013.
3. Kasarova, V. Nov prochit na finansoviya analiz ot pozitsiite na
stoynostta (scientific manuscript deposited at the Central Research and
Technical Library No.169/2008). Accessible at:
http://www.eprints.nbu.bg/513/1/ANALIZ_DVA_MODELA.pdf
4. Mihaylov, M., Mitov, K., Koleva, R. Analiz na industrialniya
biznes. V. Tarnovo, Faber, 2013.
5. Todorov, L. Savremenni modeli za otsenka na biznesa. Sofia,
Nova zvezda, 2014.
6. Trifonov, Tr., Trifonova, V., Trifonova, S. Korporativni finansi.
Sofia, Trakia – М, 1999.
7. Walsh, C. Klyuchovite koefitsienti v menidzhmanta (In English:
Key Management Ratios). Sofia, InfoDAR, 2008.
8. http://www.pls.bnb.bg/
9. http://www.bse-sofia.bg/
10. http:// www.forbes.com/billionaires/
11. http://www.investor.bg/
12. http://www.pages.stern.nyu.edu/~adamodar/

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