Analyzing Methods Used In Financial Reporting - Free Essay Example

Nowadays, there are many different tools to help investor to analysis the stock market, but it can divided into two types which is fundamental analysis and technical analysis. Fundamental analysis is base on the corporation fundamental information, such as financial statement, balance sheet, cash flow statement, prospective of the industry and so on. Technical analysis is relying on many technical skills, for example, Bar chart, moving average line, rsi, macd etc. In this report, we will analysis the usefulness and benefits of financial reporting to share purchasing or sale decisions by using the methods of efficiency market hypotheses (EMH), behavioral finance and financial information Capital market efficiency and efficiency market hypotheses (EMH) Capital market efficiency can investigate the efficiency and performance of capital markets. When news information available about particular company, if the news is bad, then the prices will drop, and if the news is good the prices will rise, capital market efficiency will revaluate its and fully reflect on the share prices reasonably and speedily. In this theory, the shares do not overvalue or undervalue, hence, nobody can make a profitable return or outperform the overall market by buying a under price shares or beat the market except by chance. There are three types of efficiency: Operational efficiency This is refers to the outlay, velocity and dependability of transactions in securities on the exchange. It is desirable that the market carries out its operations to minimize the cost as possible, dependably and quickly which can decrease the risk of the transaction, it also identified as an internally efficient market. Second is Allocation efficiency This is refers to the optimal allocation of resource, a company or society has a scarcity of resource which means theresource is not unlimited, therefore, allocational efficiency is designed for better allocation of resource to maximize the benefits. Pricing efficiency The participants can expect to gain a risk adjusted return from an investment as prices move suddenly and in an impartial approach to any news in the pricing efficient market. The efficiency market hypotheses (EMH) can only apply to type of pricing efficiency. According to EMH nobody can make a profit more than the fair value or outperform than the market, expect by chance, because past and present information is instantly indicated in the current prices, just new information can change the prices but new information is unpredictable, hence changes of future prices are unpredictable. There are three levels of efficiency which is created by Fama(1970): Weak-form efficiency Current prices of shares is fully reflect all past price movement, thus it can not be used to predict the future situation. Semi-strong form efficiency It not only contain past price movement in the share prices but also include all public information such as rights issues, dividend announcements, resignation of directors and so on. This type of EMH implies that no benefit on analysis the public information that has been announce since the information is assimilated into share prices already, therefore investor can not gain a return higher than normal. Strong-form efficiency The present share price is reflected all information in the market including private and public held. In the strong-from efficiency market even is insider such as director who will know more than normal investor. They also do not have advantage to generate a profit that exceeding the normal returns. Behavioral finance There are many attacks on the EMH by finance experts using the human behavioral literature and the knowledge of market. Since 1980s, there has a movement tend to absorb more behavioral science into finance. Behavioral finance is a theory that explains the effect of psychology on the behavior of the investor such as illogical or irrational decisions and the respond of succeeding effect with different situation on individual and the whole market. Behavioral finance merges with two subject which are economic and psychology, it is disguised the characteristics of market investors and the information structure systematically influence individuals investment decisions as well as market outcomes. The two major types of behavioral finance are limits to arbitrage (when markets will be inefficient) and the cognitive psychology (how people think). The most popular cognitive biases in finance are that investor unwillingness to realize losses. Investors tend to not confess that they have been m ade an error and evade selling the securities at losses. There are some of the most common cognitive biases: mental accounting, representativeness, overconfidence, framing, conservatism and disposition effect. Usefulness of financial information Financial information has a lot of purpose. For examples, participants can use financial information which can help them to realize the overall financial position of the corporation and determine whether or not to invest in the corporation, furthermore, it can assist them to recognize whether they can receive a positive return on their investment. When a company after positive earnings news is issued the prices will likely to continue upward for weeks or months. Also, prices will keep rising after a stock split is released. In opposite, when negative news is announced the prices will continue decrease. There is some most popular aspect when concerning the financial information: Depreciation It can report the true value of items that after depreciate over time such as equipment, buildings and cars. It is the ways that record the residual value of the assets. Current Ratio It is a very popular tool of financial analysis because they provide indication and sign of underlyi ng conditions. The ratio can help the investors to discover the situation and tendency that difficult to detect by examining individual components. For example: acid-test ratio, inventory turnover, accounts receivable turnover, total asset turnover and so on. Working Capital Working Capital is current assets less current liabilities. A company needs enough working capital to settle the current debts, to obtain benefit of cash discounts, and to hold adequate inventories. If company is running lower working capitals which indicate that the company is not likely to meet the current liabilities or to continue operating. When assessing a companys working capital, investors can not just look at the amount of current assets less current liabilities, also have to look at the ratio. The current ratio is defined as current assets divide by current liabilities. If the ratio is less then one, it implies that the company has not enough cash to pay its current liabilities which is risky for investors. The Income Statement It provides vast data for who interested in the financial health of the corporation. It presents how much profits are made after minus all expenses. If the expenses are too high, then it will get a low profit margin. In order to get a net income, the following expenses are deducted from revenue: selling and administrative expenses, taxes, cost of goods and other income and expenses. Taking HSCB annual reports of 2008, 2009 and 2010 as an example, when the corporation announced annual report on March at 2009, 2010 and 2011, it was recorded a profits which is 66milliona, 59 millions and 131millions respectively, after the announcement the stock continue to raise a period of time. Some research finds that financial information is useful in predicting future stock returns. Ou and Penman (1989) and Holthausen and Larcker (1992) demonstrate that financial information come from public financial statements can be use to successfully predict st ock returns for the coming period. In general, financial analysts are less willing to follow poor performing, low- volume, and small firms (Hayes 1998; McNichols and OBrien 1997), Ou and Penman (1989) show that an array of financial ratios created from historical financial statements can accurately predict future changes in earnings, while Holthausen and Larcker (1992) show that a similar statistical model could be used to successfully predict future excess returns directly. Conclusion To conclude this demonstrate by quoting Statman, Meir (1999) People are rational in standard finance; they are normal in behavioral finance. Rational people care about utilitarian characteristics, but not value-expressive ones, are never confused by cognitive errors, have perfect self-control, are always averse to risk, and are never averse to regret. Normal people do not obediently follow that pattern. Standard finance asks for too much when it asks for market efficiency in the rational sense, and investment professionals ask for too much when they insist that the primary contribution of behavioral finance is its potential help in beating the market. Accepting market efficiency in the sense of beating the markets and rejecting it in the sense of rationality would allow finance researchers to ask questions about the roles of investment professionals that go beyond the role of beating the market. Investment professionals belong to many groups, and we need to understand the benefits, both utilitarian and value expressive, they provide. EMH required all investors are rational, logical and unbiased, but in the real world it is difficult to do that, because human has felling, they can not always be rational, logical and unbiased, also there are many investors that lack of knowledge, they just follow the others which is similar to crowd psychology. Refer to the question form Mr. Right, EMH state that the share prices has already contain all the public information, in fact is that, we can see the example above, when the public information is issued, the share price will fluctuation influence by the news information for a period of time, therefore, investors to study the report and account of companies is very important. Furthermore, the behavioral finance is more suitable in the real words. Words Count: 1574