In today’s post of our series on Financial Statement, we will try to develop a basic understanding of three major financial statement:
1) the Income Statement
2) the Balance Sheet and
3) the Cash Flow Statement
Why do we undertake financial statement analysis?
As the name suggests, Financial Statement provides information about an enterprise’s financial performance and position. It is the principal means of communicating accounting information and is used by management for making informed future decisions while also providing relevant information to parties external to the business.
However, to fully utilise these financial statements, Financial Statement Analysis is undertaken so that various parties with an interest in the enterprise can interpret and derive useful information..
Take for example,
Who are they?
They are suppliers to whom an enterprise owes money for goods and services that they provide.
What are they interested in?
As their claims are short term, they are primarily interested in the liquidity of a firm as the ability of the firm to pay these claims quickly is best judged by an analysis of the firm’s liquidity.
Similarly we can take another example of investors
Who are they?
An investor is any person or other entity who commits capital with the expectation of receiving financial returns
What are they interested in?
Investors usually focus on analyzing profitability apart from the firm's financial condition as it affects the ability of the firm to pay dividends and avoid bankruptcy.
Investors in a company’s common stock are principally concerned with present and expected future earnings as well as with the stability of these earnings.
Management itself undertakes financial analysis for the purpose of planning, implementation and internal control.
One should always keep in mind that the measures suggested above aren't the sole indicator and only form a part of different factors that are taken in account by an analyst.
It must be clear by now that the type of financial analysis undertaken varies according to the particular interests of the concerned parties. We will discuss more about this in our next post.
For now, we will move on to financial Statement
Overview of the Three Financial Statements
#1 Income statement
Often, the first place an investor or analyst will look is the income statement. The income statement summarises the activities of an enterprise in a period by disclosing the revenues earned and the expenses incurred. By measuring the net profit earned by the business, it indicates its degree of operating success.
Shows the revenues and expenses of a business
Express data over a period of time (i.e., 1 year, 1 quarter etc.)
In accordance with accounting principles such as matching and accruals
Used to assess profitability
#2 Balance sheet
The balance sheet displays an enterprise’ s assets, liabilities, and shareholders’ equity at a point in time. It summarises the resources, and the claims to those resources by owners and creditors, of the enterprise on a certain date.
Assets = Liabilities + Shareholders Equity
Shows the financial position of a business
Expressed as a “snapshot” or financial picture of the company at a specified point in time (i.e., as of January 31, 2021)
In accordance with given equation:
Assets = Liabilities + Shareholders Equity
#3 Cash flow statement
The cash flow statement describes the investments in assets made during the period and how those investments are financed and how much the owners took from the business. It reports the cash effects of not only the enterprise’s operations but also its investing(i.e. Buying assets) and financing ( i.e. cash received from or paid to owners and lenders) activities.
Shows the increases and decreases in cash
Express data over a period of time referred to as an accounting period (i.e., 1 year, 1 quarter etc.)
Has three sections: cash from operations, cash used in investing, and cash from financing
Shows the net change in the cash balance from start to end of the accounting period
Analyzing Financial Statements
The financial statements of a company record important financial data on every aspect of a business’s activities. As such they can be evaluated on the basis of past, current, and projected performance.
For the purpose of analysis, several techniques are commonly used as part of financial statement analysis.
Three of the most important techniques include:
Under financial statement analysis, Horizontal analysis is used to compare historical data, such as ratios, or line items, over a period of time.
Horizontal analysis can be used as an absolute measure or percentage measure, where the numbers in each succeeding period are expressed as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%. This is also known as base-year analysis.
Under financial statement analysis, Vertical analysis is a method in which each line item is listed as a percentage of a base figure within the statement.
line items can be stated as a percentage of gross sales
line items can be stated as a percentage of total assets or liabilities
Cash flow statement
cash inflow or outflow as a percentage of the total cash inflows.
To evaluate a firm’s financial condition and performance, the financial analyst often uses tools like financial ratio, or index, which relates two pieces of financial data by dividing one quantity by the other to gauge the financial health of a firm.
Computation of financial ratio is followed by the analysis of financial ratios involving two types of comparison.
1. Internal Comparisons.
The analyst can compare a present ratio with past and expected future ratios for the same company. When financial ratios are arrayed over a period of years, the analyst can study the composition of change and determine whether there has been an improvement or deterioration in the firm’s financial condition and performance over time.
In short, we are concerned not so much with one ratio at one point in time, but rather with that ratio over time.
2. External Comparisons and Sources of Industry Ratios.
The second method of comparison involves comparing the ratios of one firm with those of similar firms or with indus-try averages at the same point in time.
Such a comparison gives insight into the relative financial condition and performance of the firm. It also helps us identify any significant devi- ations from any applicable industry average (or standard) however any good analyst knows that the “rules of thumb” cannot be used indiscriminately for all industries.
One thing to keep in mind whenever you undertake analysis of any type is that you cannot compare apples to oranges.
Forgetting the above can lead to wrong interpretation and thus result in incorrect conclusions.
Let’s assume that we wish to compute liquidity of firm A belonging to industry X.
Rule of thumb: 1.5 to 1 current ratio is appropriate
Current Ratio of firm A: 1.1
Can we conclude that there are doubts over firm 1’s liquidity?
Obviously not because we don’t know whether the given rule of thumb is applicable for industry X,
The true test of liquidity is whether a company has the ability to pay its bills on time or not and this ability can vary depending upon the industry in which a form operates.
The analysis must be in relation to the type of business in which the firm is engaged and to the firm itself.. Many sound companies, including in the example given above, have this ability despite current ratios substantially below 1.5 to 1. It depends on the nature of the business.
Only by comparing the financial ratios of one firm with those of similar firms can one make a realistic judgment.
Van Horne’s Fundamentals of Financial Management
P.S. You can find more post going in depth about ratio analysis at Eduvantage Box
IMPORTANCE OF RATIO ANALYSIS
Ratio analysis is often employed to decode and possibly predict a firm’s present and future performance as it presents the facts contained in the financial statement on a comparative basis.
Its relevance in assessing the performance of a firm can be understood under the following categories:
(i) Liquidity Position
(ii) Long-term Solvency
(iii) Overall Profitability
(iv) Inter- Firm Comparison and
If a firm is able to meet its short-term liabilities it has sufficient liquidity.
For example the firm must have sufficient funds to pay the interest on its short-maturing debt usually within a year as well as to repay the principal.
Liquidity Ratio is computed to draw conclusions regarding the liquidity position of a firm. The firm’s ability to meet its current obligations when they become due is reflected in the liquidity ratio.
The liquidity ratios are particularly used by banks and other suppliers of short-term loans for credit analysis.
Ratio analysis reveals the strengths and weaknesses of a firm in this respect by
They indicate whether a firm has a healthy mix of various sources of finance or if it is heavily ridden with debt which can become a serious strain to its long- term solvency .
They would reveal the firm's capability to offer adequate return to its owners consistent with the risk involved.
Long-term creditors, security analysts and the present and potential owners of a business has keen interest in a firm’s long- term solvency
A firm’s management is constantly concerned about the overall profitability of the enterprise.Thus, unlike the outside parties, management is concerned about the ability of the firm to meet its short-term as well as long-term obligations to its creditors to ensure a reasonable return to its owners and secure optimum utilisation of the assets of the firm.
This is possible if an integrated view is taken and all the ratios are considered together.
Under Ratio Analysis, inter firm comparison and comparison with industry averages undertaken to ensure remedial measures, if needed, can be taken in time. Moreover, comparisons help us to come to a conclusion as a ratio by itself would be meaningless unless it is compared to some standard.
Comparison can be done with the help of:
One of the popular techniques is to compare the ratios of a firm with the industry average. This is based on the reasonable assumption that the performance of a firm should be more or less similar to the industry to which it belongs.
Inter- firm Comparison
It helps to compare a firm's position vis-a-vis its competitor.
If the results of Ratio Analysis are not in accordance with the above comparisons, the firm should seek to identify the probable reasons behind the anamolity and take remedial steps.
LIMITATIONS OF RATIO ANALYSIS
While Ratio Analysis has found an extensive use in financial analysis it too suffers from various limitations
In simpler words, one must always remember that while using ratios, the conclusions should not be taken on their face value.
Some of the limitations which characterise ratio analysis are
(1) difficulty in comparison
(2) impact of inflation, and
(3) conceptual diversity.
Applying a technique is one thing but understanding and making useful conclusions from the technique is another thing. Beginners extensively use Ratio Analysis for financial statement analysis but come to a wrong or a misleading conclusion because they forget to keep in mind its limitations.