A company’s financial statements are a mirror to its financial health. Reading financial statements is like digging well into the sea. Analyst dig dipper and dipper to find and understand the different aspects of studying the same company’s financial data and come to a different conclusion. A simple look at financial accounts does not tell a picture because these data are raw and no conclusion could be made on these data while making decisions.
Therefore a proper analysis and interpretation need to be done to get important insights enabling investors and creditors to evaluate past, present and predict future financial health and performance of a company.
The second step in the process is to evaluate them efficiently, as in the first step financial statements are prepared to meet criteria so that potential performance and cash flows can be predicted.
John N. Myer once said ‘Financial Statement Analysis is largely a study of relationships among the various financial factors in a business, as disclosed by a single set of statements, and study of these factors as shown in a series of statements.’
Typically, managers are the one who manages the company. The owners of these businesses i.e. Shareholders are satisfied with independent assurance that the financial statements reasonably present the financial status and results of the business in all material aspects. The financial statement analysis is done on both sides internally (executives, managers, etc) and externally (investors, credit agencies, government agencies, creditors, etc.).
Analysts analyze the data in financial accounts to provide them with clearer information about such key factors for decision-making and ultimate business survival. Publicly traded companies worldwide need to file their financial statements with their appropriate authorities. For example, in America companies are required to report their financial statements to the Securities and Exchange Commission (SEC).
Firms also publish this into an annual report that they share with their stakeholders. The financial statement analysis consists of comparisons in a timeframe with the same company or different companies either in the same sector or in different sectors. Therefore, the board of directors and senior management also review these financial statements.
In brief, the goal is to collect essential information found in financial statements to understand the company’s weaknesses and strengths and to make a prediction of the company’s prospects, allowing investors to make decisions regarding investment activity.
The main Key aspects of financial statement:
Balance sheet: The balance sheet displays the assets that a corporation holds, the obligations it owes, and the funds that its shareholders contribute.
Assets = Liabilities + Owners’ equity (It is called Balance sheet equation)
The main items on the balance sheet are the following:
Current assets refer to cash and cash equivalents that can be easily converted into cash within 1-year and include marketable securities, inventory, and accounts receivable, etc.
Long-term assets include fixed assets like plant, equipment and machinery, and property, and is depreciated every year.
Current liabilities of the firm are obligations that need to be paid within 1-year and. include accounts payable, deferred expenses, etc.
Long-term liabilities financial payments or obligations (for example long term loans) due after one year is the company’s long-term liabilities.
Shareholder equity is also referred to as Share Capital, Shareholder Equity or Net Value. It is calculated by the difference between total assets owned by a firm and total liabilities outstanding.
Profit-and-loss statement/The Income Statement.
Profit (loss) = Revenue – Expenses.
An income statement aims to record a company’s revenues and expenses for a defined period. Sometimes it is also called profit and loss account. Along with communicating top-line sales, income statements unveil a variety of other indicators that can be valuable to analysts and investors.
Operating expenses include every expense made during the reporting period
Depreciation is the degree to which any assets is losing value over time (for example, ageing equipment or vehicles)
Net income, which subtracts the costs of the company from its gross income to calculate its overall level of gains or losses.
Earnings per share (EPS) is calculated by dividing net income by the total number of outstanding shares.
Cash-flow statement Cash flow statement analysis suggests how much cash is available to the company for acquisitions without external borrowing or cash diverting from important operational activities the free cash flow enables a business to pay dividends, repay its loans, buy back its stock and make fresh investments to encourage future growth
Cash Flow from Operating Activities is cash gained spent or day-to-day regular business activities money such as by selling products or services.
Cash flow from investment activities is cash received or generated from investing activities in the company’s assets or any other activities, such as buying equipment or investing in other businesses.
Cash Flow from Financing Activities mainly focus on inflow and outflow financing activities and it can come through either debt or equity e.g.: paying interest to service debt, raising fresh debt, or owner’s equity, etc.
METHODS OF FINANCIAL STATEMENT ANALYSIS
Horizontal and vertical analysis
Horizontal Analysis – It is described as percentage increases and decreases of related items in comparative financial statements. A base year is chosen as the beginning point for comparisons.
Vertical Analysis – A percentage analysis is done and a base is chosen to compare figures of the same years to show the relationship of each component to a total within a single statement.
Ratio Analysis Ratios help you gain insight into the health of a company by making relative comparisons with one another. Typically, these are divided into the following broad categories:
Profitability Ratios: Such ratios provide insights into the company’s ability to generate profits. Important examples are gross profit ratio, ROE, break-even point, ROA, and return on net assets.
Liquidity Ratios: These ratios offer insight into the liquidity nature of the company such as the company’s ability to stay in business. Some examples are the current ratio, Quick ratio, cash coverage ratio, and liquidity index.
Leverage Ratios: Leverage ratios offer insi
ght into the company’s dependency on debt to maintain its operations. Examples include debt to equity ratio, debt service coverage ratio, etc.
Activity Ratios: Activity ratios offer insight into how a company is managing and utilizing its resources. Examples include accounts receivable turnover rate, accounts payable, inventory turnover rate, etc.
This includes the study of three or more than three years of financial statements and is an extension of horizontal analysis also called pyramid analysis. The base year reflects the earliest year in the set results. Users test claims for gradual shift trends in trend analysis. The company’s financial statements are matched with each other for several years after the percentage has been converted.
A change in financial statements may mean that either increased revenue or reduced expenditure is available. However, there are also different methods of analyzing financial statement analysis like Fund Flow Analysis, Cash Flow Analysis and Cost Volume Profit Analysis, etc.
The understanding of financial statements is an important part of decisive management efficiency, business strategy, and plans. The balance sheet, income statement, and cash flow statement each provide an instrumental point of view on the success of the company.
Considerate what the various statements do and how they work together helps the reader to discover the narrative or tale of the business to build strong potential success goals and determine how different plan choices can influence future cash flows.
Therefore, the idea of reviewing financial statements is to use data about the company’s past success to anticipate how it will happen in the future.
The growth of the business depends on the detailed and timely review of financial statements. Analysis of financial statements is not an end in itself, but rather provide input that is beneficial in lending and investment decisions. It is suggested to consider the methodological approaches involved with the analysis of financial statements when reading and reviewing financial reports.
For many investment decisions, information useful in determining the quantities, timing, and uncertainty of prospective cash receipts from dividends or interest and proceeds from the selling, redemption, or maturity of securities or loans is important.
For several investment decisions, information such as cash receipts from dividends or interest and the proceeds from the selling, redemption, or maturity of securities or loans is fundamental. The advantages of getting information should outweigh the price of the data.
It takes years for an auditor to establish a good reputation and no one wants to risk checking an incorrect financial statement. You may argue or complain that the auditor does not verify 100% of the financial statement information. But it is his responsibility to recognize the most hazardous areas that could involve errors or data manipulation. It is always important to take into account inflation during the time under study.