Financial Statement Analysis
Financial statement analysis is a process that examines past and current financial data for the purpose of evaluating performance and estimating future risk and potentials. Financial statement analysis is used by investors, creditor, security analysts, bank lending officers, managers, governmental agencies, suppliers, and many other parties who rely on financial data for making economic decisions about a company.
Analysis of financial statements focuses primarily on data provided in external reports plus supplementary information provided by management. The analysis should identify major changes or turning points in trends, amounts, and relationships financial statements are merely summaries of detailed financial information. Many different groups are interested in getting inside financial statements, especially investors and creditors.Their objectives are sometimes different but often related. However, the basic tools and techniques of financial statement analysis can be applied effectively by all of the interested groups. Financial statement analysis can assist investors in finding the type of information they require for making decisions to their interests in a particular company.
Financial statement analysis is an evaluative method of determining the past, current and projected performance of a company. Several techniques are commonly used as part of financial statement analysis including horizontal analysis, which compares two or more years of financial data in both dollar and percentage form; vertical analysis, where each category of accounts on the balance sheet is shown as a percentage of the total account; and ratio analysis, which calculates statistical relationships between data.
Financial reports are the primary means by which managers communicate company results to investors, creditors and analysts. These parties use the reports to judge company performance, to assess creditworthiness, to predict future financial performance, and to analyse possible acquisitions and take-overs. Users of financial statements must be able to meaningfully interpret financial reports, construct measures of financial performance and analyse the reporting choices made by companies. Also, since company managers choose accounting techniques when making their reports, users must learn to undo the effects of these accounting choices.
It is the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.
Financial statement analysis is a study of accounting ratios between various items in financial statements. Ratios are classified as profitability ratios, liquidity ratios, asset utilization ratios, leverage ratios and valuation ratios based on the indications they provide. Balance sheet, Income Statement and Cash Flow Statements are the most important financial statements and if properly analyzed and interpreted can provide valuable insights into a company’s business.
- Income Statement – a financial statement that shows the revenues, expenses and net income of a firm over a period of time
- Balance Sheet – a financial statement that shows the value of the firm’s assets and liabilities at a particular time
- Statement of Cash Flows – a financial statement that tracks cash coming into and flowing out of a firm over a period of time
A comprehensive financial statement analysis can highlight some of the more important issues and questions a savvy investor will usually ask such as-
- Does the company have enough liquidity to overcome any short-term market fluctuations?
- How was the performance relative to the industry it belongs to?
- How risky is it to invest in this company?
- How does the company handle its working
capital? - How did the company perform over the last couple of years and what were the returns it generated for the previous stakeholders?
There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.
Although financial statement analysis is a highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Comparison of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometime makes it difficult to compare the companies’ financial data. For example if one company values its inventories by the LIFO method and another firm by average cost method, then direct comparisons of financial data such as inventory valuations are and cost of goods sold between the two firms may be misleading. Some times enough data are presented in foot notes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.
In summary, financial statement analysis is concerned with balance sheet analysis and income statement analysis of a business to interpret the business ratios & financial ratios for financial modeling, financial forecasting and business valuation.
- The balance sheet, which summarizes what a firm owns and owes at a point in time.
- The income statement, which reports on how much a firm earned in the period of analysis .
- The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis.
Financial Statement Analysis Questions and Answers
Assets in Place
What are the assets in place?
How valuable are these assets?
How risky are these assets?
Growth Assets
What are the growth assets?
How valuable are these assets?
Equity
What is the value of the debt?
How risky is the debt?
Laibilities
What is the value of the equity?
How risky is the equity?