Financial Statement Analysis is a method of reviewing and analyzing a company’s accounting reports (financial statements) in order to gauge its past, present or projected future performance. This process of reviewing the financial statements allows for better economic decision making.
Globally, publicly listed companies are required by law to file their financial statements with the relevant authorities. For example, publicly listed firms in America are required to submit their financial statements to the Securities and Exchange Commission (SEC). Firms are also obligated to provide their financial statements in the annual report that they share with their stakeholders. As financial statements are prepared in order to meet requirements, the second step in the process is to analyze them effectively so that future profitability and cash flows can be forecasted.
Therefore, the main purpose of financial statement analysis is to utilize information about the past performance of the company in order to predict how it will fare in the future. Another important purpose of the analysis of financial statements is to identify potential problem areas and troubleshoot those.
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Here, we will look at 1) the users of financial statement analysis, 2) the methods of financial statement analysis, 3) key accounting reports (the balance sheet, income statement, and statement of cash flows) and how they are analyzed, 4) other financial statement information, and 5) problems with financial statement analysis.
USERS OF FINANCIAL STATEMENT ANALYSIS
There are different users of financial statement analysis. 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. On the other hand, external users do not necessarily belong to the company but still hold some sort of financial interest. These include owners, investors, creditors, government, employees, customers, and the general public. These users are elaborated on below:
The managers of the company use their financial statement analysis to make intelligent decisions about their performance. For instance, they may gauge cost per distribution channel, or how much cash they have left, from their accounting reports and make decisions from these analysis results.
Small business owners need financial information from their operations to determine whether the business is profitable. It helps in making decisions like whether to continue operating the business, whether to improve business strategies or whether to give up on the business altogether.
People who have purchased stock or shares in a company need financial information to analyze the way the company is performing. They use financial statement analysis to determine what to do with their investments in the company. So depending on how the company is doing, they will either hold onto their stock, sell it or buy more.
Creditors are interested in knowing if a company will be able to honor its payments as they become due. They use cash flow analysis of the company’s accounting records to measure the company’s liquidity, or its ability to make short-term payments.
Governing and regulating bodies of the state look at financial statement analysis to determine how the economy is performing in general so they can plan their financial and industrial policies. Tax authorities also analyze a company’s statements to calculate the tax burden that the company has to pay.
Employees need to know if their employment is secure and if there is a possibility of a pay raise. They want to be abreast of their company’s profitability and stability. Employees may also be interested in knowing the company’s financial position to see whether there may be plans for expansion and hence, career prospects for them.
Customers need to know about the ability of the company to service its clients into the future. The need to know about the company’s stability of operations is heightened if the customer (i.e. a distributor or procurer of specialized products) is dependent wholly on the company for its supplies.
8. General Public
Anyone in the general public, like students, analysts and researchers, may be interested in using a company’s financial statement analysis. They may wish to evaluate the effects of the firm on the environment, or the economy or even the local community. For instance, if the company is running corporate social responsibility programs for improving the community, the public may want to be aware of the future operations of the company.
METHODS OF FINANCIAL STATEMENT ANALYSIS
There are two main methods of analyzing financial statements: horizontal or trend analysis, and vertical analysis. These are explained below along with the advantages and disadvantages of each method.
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. For example, certain expenditures that are high currently, but were well under budget in previous years may cause the management to investigate the cause for the rise in costs; it may be due to switching suppliers or using better quality raw material.
This method of analysis is simply grouping together all information, sorting them by time period: weeks, months or years. The numbers in each period can also be shown as a percentage of the numbers expressed in the baseline (earliest/starting) year. The amount given to the baseline year is usually 100%. This analysis is also called dynamic analysis or trend analysis.
Advantages and Disadvantages of Horizontal 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 it’s doing based on past results.
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.
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.
Vertical analysis is also called static analysis because it is carried out for a single time period.
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. For instance, if the cost of sales comes out to be only 30 percent of sales each year in the past, but this year the percentage comes out to be 45 percent, it would be a cause for concern.
KEY FINANCIAL STATEMENTS & HOW THEY ARE ANALYZED
The main types of financial statements are the balance sheet, the income statement and the statement of cash flows. These accounting reports are analyzed in order to aid economic decision-making of a firm and also to predict profitability and cash flows.
I. The Balance Sheet
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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. The two sides of the balance sheet must balance as follows:
Assets = Liabilities + Shareholders’ Equity
The main items on the balance sheet are explained below:
Current assets held by the firm refer to cash and cash equivalents. These cash equivalents are assets that can be easily converted into cash within one year. Current assets include marketable securities, inventory and accounts receivable.
Long-term assets are also called non-current assets and include fixed assets like plant, equipment and machinery, and property, etc.
A firm records depreciation of its fixed, long-term assets every year. It is not an actual expense of cash paid, but is only a reduction in the book value of the asset. The book value is calculated by subtracting the accumulated depreciation of prior years from the price of the assets.
Total Assets = Current Assets + Book Value of Long-Term Assets
Current liabilities of the firm are obligations that are due in less than one year. These include accounts payable, deferred expenses and also notes payable.
Long-term liabilities of the firm are financial payments or obligations due after one year. These include loans that the firm has to repay in more than a year, and also capital leases which the firm has to pay for in exchange for using a fixed asset.
Shareholders’ equity is also known as the book value of equity or net worth of the firm. It is the difference between total assets owned by a firm and total liabilities outstanding. It is different from the market value of equity (stock market capitalization) which is calculated as follows: number of shares outstanding multiplied by the current share price.
Balance Sheet Analysis
The balance sheet is analyzed to obtain some key ratios that help explain the health of the firm at a given point in time. These metrics are as follows:
Debt-Equity Ratio = Total Debt / Total Equity
The debt-equity ratio is also called a leverage ratio. It is calculated to assess the leverage, or gearing, of a firm to show how much it relies on debt to finance its activities. This ratio has pertinent implications for the financial health of the firm and the risk and return of its shares.
Market-to-Book Ratio = Market Value of Equity / Book Value of Equity
The market-to-book ratio is used to reflect any changes in a firm’s characteristics. The variations in this ratio also show any value added by the management and its growth prospects.
Enterprise Value = Market Value of Equity + Debt – Cash
The enterprise value of a firm shows the underlying value of the business. It reflects the true value of the firm’s assets, not including any cash or cash equivalents, while unencumbered by the debt the firm carries.
II. The Income Statement
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The purpose of an income statement is to report the revenues and expenditures of a firm over a specific period of time. It was previously also called a profit and loss account. The general structure of the income statement with major components is as follows:
– Cost of goods sold (COGS)
= Gross profit
– Selling, general and administrative costs (SG&A)
– Research and development (R&D)
= Earnings before interest, taxes, depreciation and amortization (EBITDA)
– Depreciation and amortization
= Earnings before interest and taxes (EBIT)
– Interest expense
= Earnings before taxes (EBT)
= Net income
The net income on the income statement, if positive, shows that the company has made a profit. If the net income is negative, it means the company incurred a loss.
Earnings per share can be derived from knowing the total number of shares outstanding of the company:
Earnings per Share = Net Income / Shares Outstanding
Income statement Analysis
Some useful metrics based on the information provided in the income statement and the balance sheet are as follows:
1. Net profit margin: This ratio calculates the amount of profit that the company has earned after taxes and all expenses have been deducted from net sales.
Net profit Margin =Net Income / Net Sales
2. Return on Equity: This ratio is used to calculate company profit as a percentage of total equity.
Return on Equity = Net Income / Book Value of Equity
Price to earnings ratios (P/E ratio)
The P/E ratio is used to evaluate whether the value of a stock is proportional to the level of earnings it can generate for its stockholders. It assesses whether the stock is overvalued or undervalued.
(P/E) Ratio = Market Capitalization / Net Income = Share Price / Earnings per Share
III. The Statement of Cash Flows
The statement of cash flows shows explicitly the sources of the firm’s cash and where the cash is utilized. It is essentially a statement whereby the net income is adjusted for non-cash expenses and any changes to the net working capital. It also reflects changes in cash coming from, or being used by, investing and financing activities of the firm. The structure and main components of the cash flow statement are as follows:
Cash from operating activities = Net income + Depreciation ± Changes in net working capital
Cash from financing activities = New debt + New shares – Dividends – Shares repurchased
Cash from investment activities = Capital expenditure – Proceeds from sales of long-term assets
All three of the above determine the bottom line: changes in cash flows.
Cash Flows Statement Analysis
In order to measure how much cash is available to the company for investments without outside financing or money diverting from operations, it is useful to conduct a simple cash flow statement analysis. The free cash flow, as the name suggests, allows a company to be able to pay dividends, repay its debts, buy back its stock and also make new investments to facilitate future growth. The excess cash produced by the company, free cash flow, is calculated as follows:
– Changes in Working Capital
– Capital Expenditures
= Free Cash Flow
Some analysts also study the cash flow from operating activities to see if the company is earning “quality” income. In order for the company to be doing extremely well, the cash from operating activities must be consistently greater than the net income earned by the company.
OTHER FINANCIAL STATEMENT INFORMATION
Apart from the key financial statements, complete financial reporting statements also include the following:
Business and Operating Review
The business and operating review is also called “management discussion and analysis”. It serves as a preface to all the complete reporting statements in which the management talks about recent events, discloses essential information regarding expansion and future plans, and discusses significant developments in the business industry.
The business and operating review is a good place for the company to share any good news with the general public. They have room to elaborate on plans that would help enhance the company’s image and address any unpleasant events that may have occurred, to show the customers that they truly care about talking openly to their customers.
Statement of Change in Shareholders’ Equity
The statement of change in shareholders’ equity is also known as equity analysis. It provides information about all the changes in the company’s equity value over a certain time period. It reconciles the opening balances of the equity accounts with the closing balances. There are two types of changes expressed in the statement of change in shareholders’ equity:
- Changes arising from any transactions conducted with shareholders of the company. For example, issuing new shares, paying dividends, purchasing treasury stock, and issuing bonus shares, etc.
- Changes that are a result of alterations in the comprehensive income of the company. These changes might include revaluation of fixed assets, net income for the period and fair value of for-sale investments, etc.
Notes to the Financial Statements
Notes to the financial statements are basically additional information provided in a company’s financial statements. These notes provide details and information that are left out of the main reporting documents. They are important for the sake of clarity on many points as they outline the accounting methodology used for recording certain transactions. The notes to the financial statements are essentially footnotes because if included in the main statements, they would obscure the important information, as they are generally quite elaborate and detailed.
The following notes are usually used to impart important disclosures for explaining the numbers on the financial statements:
- Notes that show the basis for presentation
- Notes that advise on significant accounting policies
- Notes about valuing inventory
- Notes about depreciating assets
- Notes about intangible assets
- Notes that disclose subsequent events
- Notes about employee benefits
- Notes that reveal contingency plans
PROBLEMS WITH FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is a brilliant tool to gauge the past performance of a company and predict future performance, but there are several issues that one should be aware of before using the financial statement analysis results blindly, as these issues can interfere with how the results are interpreted. Some of the issues are:
Comparability between Companies
This is a big issue for analysts because they can seemingly compare financial statement analyses between different companies on the basis of ratios used, but in reality it may not paint an accurate picture. The financial ratios of two different companies may be compared to see how they match up against each other, but each company may aggregate all their information different from each other in order to draw up their accounting statements. This may lead to incorrect conclusions drawn about a company in relation to other companies in the industry.
Comparability between Periods
The change in accounts where financial information is stored may skew the results of the financial statement analysis, from one period to the next. For example, if a company records an expense in one period as cost of goods sold, while in another period, it is recorded as a selling and distribution expense, the analysis between those two periods would not be comparable.
Analysts do not take into account operational information of a company, as only financial information is analyzed and reviewed. There may be several indicators in operational information of the company which may be predictors of future performance, for example, the number of backlogged orders, any changes in licenses or warranty claims submitted to the company or even changes in the culture and work environment. Therefore, analysis of financial information may only relay half the story.
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The relationship of accounting ratios in Balance Sheet
It is said that Financial Management starts from the point, where Accountancy ends. In fact Accountancy forms the backbone of the financial management. According to the American Institute of Certified Public Accountants (AICPA), Accountancy is defined as
-the art of recording, classifying and summarising in a significant manner and in terms of money transactions and events which are, in part at least, of a financial character, and interpreting the results thereof-
If we interpret the definitions, we get some unique characteristics of accounting. The first one is the transactions, which are accounted for, must be of financial nature. That is Accountancy deals with quantitative data of the business transactions and not with the qualitative information. The second one is, Accountancy not only records the financial data but it also interprets data by finding out the profit/loss of the company as well as by giving the assets and liability status of the company at the end of the accounting period or the financial year. The Final accounts consists of the Income Statement and the Statement of Affairs of the company and provide valuable information about the operating profit/loss as well as the financial health of the organisation for the management and for the outsiders like shareholders, Government agencies, creditors and potential investors of the company. In fact the Balance Sheet of the company reflects the financial health of an organisation and, coupled with the Income Statement, forms the basis of almost all kinds of qualitative analysis on which the financial management of the company largely depends. One such tool for qualitative analysis is Ratio Analysis which gives an insight to a host of qualitative information for the management and plays a significant role in the deciding the future course of action of a company.
Before discussing the relationship of the accounting ratios and Balance Sheet, we will take a brief look at the roles played by the financial ratios in financial management.
The accounting data and the final accounts (Income Statement and the Balance Sheet) give only the quantitative figures about the various items of the Income Statement as well as the assets and liabilities. These data fail to convey the insight to the financial performance when act as standalone quantitative data. Ratio analysis helps to work out the relationship in between various items of the accounting data and reflect the interdependencies of those and the influence of one item on the other to affect the financial performance of the organisation. The financial ratios are really the first most significant tools in the hands of the strategic managers to take a stock of the financial situation of the organisation and to interpret the performance of the organisation in various fronts of the company activities. The financial ratios like the debtors’ turnover, the inventory turnover, the debt to equity ratio, the profitability ratios are all provide significant information to the management to identify the loopholes of the financial decisions and to decide on the financial strategies for the forthcoming years. The ratio analysis is also important tool for the inter-firm comparison in the same industry to have the idea how the organisation is performing in comparison to its competitors and what is the scope of development in various front of the operation of the company. Financial ratios depict the reasons for the precarious results of the organisation and when listed for several years, they also help the company for a trend analysis of the performance of the company indicating the changes in the financial performance and the reasons thereof over the years. This trend analysis helps a lot to predict and estimate the future performance of the company. However, financial ratios are not self sufficient to reflect all the cause and effect relationship in between the financial variables and it has its own limitations. The results that are reflected by the financial ratios should be corroborated by other analysis to get the best possible picture and to help the management to make the best possible financial strategy for the organisation.
The role played by the Balance Sheet in finding out the ratios is paramount. In fact most of the vital ratios are formed on the basis of the data given in the Balance Sheet of an organisation. As Balance Sheet reflects the financial health of the organisation, the financial ratios calculated using various figures of the Balance Sheet reflect provides most important information to the managers for proper analysis of the financial performance as well as for the future financial planning. To understand the relation between the financial ratios and the Balance Sheet it is better to look at the derivation of some ratios based on the Balance Sheet figures and their use in interpreting the financial situation of an organisation.
Debt to equity Ratio:defined as the ratio between the long term debts to total funds. Here total funds comprise of the shareholders’ fund plus the long term fund. This ratio shows how much of the total fund has been financed by debt. The financial leverage of the firm is very important in the sense that, it indicates the financial risk of the firm. The more the ratio, the more is the financial leverage and the more is the financial risk of the firm. In general, the debt capital should be used judiciously, and up to the extent it helps the management, to increase the wealth of the shareholders. Debt capital, if used beyond a certain limit, will act against the interest of the shareholders and will lead to an increase in the cost of equity as the shareholders will expect a higher return because of the increased financial risk of the company.
Ratio of long term funds to fixed assets:This one is calculated as the ratio of the long term funds to the fixed assets of the organisation. The long term fund means the shareholders’ fund plus the long term debt capital. This ratio indicates how much portion of the fixed asset has been financed by the long term funds. This is because of the fact that the fixed assets should preferably be financed by long term funds only. If the ratio is less than one the company is supposed to follow a faulty policy of using the short term funds to finance thefixed assets. However if the ratio is more than one, it reflects, the managementhas failed to use the longterm funds in a prudent manner as this means the long term funds have been acquired by the company and is being kept either idle or is unwisely using it to finance the working capital requirement of the company.
Current Asset ratio:One of the most important ratios to decide the short term solvency of the firm. It is calculated as the ratio of the current assets to current liabilities of the firm. If the current ratio is less than 2 (varies from industry to industry) then the company is said to be suffering from the short term solvency to honour its short term obligations. However, a higher current ratio, than is warranted by a particular industry, signify poor working capital management, as in that case the short term fund gets locked up in current assets thereby raising the cost of short term fund for the company. This ratio, therefore gives an insight to the management about how to deal with the various items of current assets and current liabilities, which have a direct bearing on the working capital management of the firm.
There are other ratios for which the various items of Balance Sheet are required. The ratios like Inventory turnover, debtors’ turnover, creditors’ turnover, fixed asset turn over, Return on capital employed are calculated on the basis of the information given in the Income Statement and the Balance Sheet of the firm. When the debtors’ turnover ratio gives an indication, how quickly the debtors of the company are being converted into cash and whether the credit policy of the receivables management of the company is at the best interest of the company, the return on capital employed indicates the performance of the company in generating the return as a percentage of the capital employed and whether the capital employed is being used efficiently to generate the best possible return for the company.
The above accounts of various financial ratios have been cited as an example to clarify how Balance Sheet items are used to find important ratios and why the ratios are found. Balance Sheet provides the platform wherefrom various accounting ratios are calculated and these ratios together with the quantitative information provide the management an insight to the performance of the company as well as the efficiency and effectiveness of various policies and the impact of those policies on the financial performance of the organisation. The result of the financial ratios when coupled with the Balance Sheet information provides the foundation, on which the entire financial analysis of the organisation starts and leads the way to form a sound financial planning for the company for the coming years.