An overview of financial statement analysis
Financial statement analysis is an important role that a business entity has to conduct in order to determine its strengths and weaknesses (Jago, 2002). To achieve this, a business entity has to prepare a number of financial statements from which the analysis can be made. Here, comparisons are done on financial statements that are prepared especially between various entries of the profit and loss account and the balance sheet. Financial reporting is essential internally since a business entity may use this information for decision-making and externally since shareholders, investors and other stakeholders can make appropriate decision with regards to investment, partnership and so on. Due to the vitality of these financial statements, a number of rules and regulations have been set to ensure that there is uniformity, consistency and reliability of financial information. These principles and standards referred to as Generally Accepted Accounting Principles (GAAP) (Jago, 2002). These principles govern and regulate the preparation of the profit and loss account, the balance sheet, statement of changes in equity and cash flow statements. These principles have been put in place to ensure that there is transparency, accountability and consistency in financial analysis and reporting.
Components of financial statements
It is essential for business entities, especially companies to report their performance to the public. This information is essential as it is used to earn new investors, shareholders and stakeholders and at the same time maintain the existing one. The process through which the organizations pass this information to the public is referred to as financial reporting (Bass, 2010). To achieve this goal, business entities need to prepare a number of financial statements. These include:
- The profit and loss account
- Statement of changes in equity
- The balance sheet
- Cash flow statements
The profit and loss account is also called the income statement. It represents the revenues and expenditure of a given financial period and in the end a net profit or loss for that period is reflected. This statement is used to show whether the business entity was profitable in a given financial period or not. A statement of equity shows the changes of equity within a specific financial period. This change could be either positive or negative. The balance sheet on the other hand shows the assets, liabilities and the equity of the business entity on a given time. The balance sheet normally adheres to the basic financial equation that is:
C=A+L
Where: C=Capital (Owners Equity), A=Assets and L=Liabilities
Finally, the cash flow statement represents the summations of cash inflows (revenues) and outflows (expenditures). It is essential for firms to maintain these financial statements as they assist in internal decision-making and give information to the public.
Ratio analysis
Ratio analysis is one of the most widely used methods of financial analysis (Bass, 2010). A ratio is used to show the relationship between one base figure and another figure or a variety of figure. In financial analysis, ratio analysis is the most efficient method that is used to show the relationship between different financial figures. The inferences that can be made from these ratios are of great importance. There are a number of financial ratios that can be used for financial analysis. These include:
- Profitability ratios
- Liquidity ratios
- Activity ratios
- Leverage ratios
Profitability ratios are used to measure the effectiveness of a business entity within a specific financial period. There are a number of profitability ratios. Examples include gross profit ratios, net profit ratios, operation ratios and expense ratios. Liquidity ratios on the other hand are used to determine the solvency of a business entity in the short run (James, 2010). Their main aim is to determine the ease at which entities can meet their short-term debts and payments. Examples of liquidity ratios include current ratio and quick ratio. Activity ratios are used to determine the ease at which the resources of a business entity are used to produce the desired output. These ratios are also referred to as turnover ratios since they represent the ease at which assets are converted into sales. An example of an activity ratio is the stock turnover ratio. Finally, leverage ratios are used to determine the ease at which organizations are able to endure their long-term debts and other financial obligations. Debt to equity ratio and equity ratio are examples of ratios in this category.
Short term and long-term debt payment ability
The short-term debt paying ability of a firm is determined with the help of liquidity ratios. As stated earlier, these ratios assist in determining the solvency ability of a business entity. Current ratio is an example of a liquidity ratio and it is calculated by dividing the current assets by the current liabilities. The resultant index is referred to as the margin of safety (Jago, 2002). If the margin of safety is huge, then the firm stands a higher change of meeting its short-term liabilities and vice-versa if the index is small. Acid ratio is another index that is used to calculate the short-term debt paying ability of a firm. It is calculated by dividing the liquid current assets by current liabilities.
Leverage ratios are used to determine the ability of a firm to meet its long-term obligations. The debt-to-equity ratio for instance is a reliable index for this function. It is calculated by dividing the external funds by the internal equity (funds from shareholders). This ratio is used to represent the external claims against the firm versus its assets. It is thus a clear indicator as to whether a firm can meet its long-term obligations given its current assets.
Profitability analysis
Gross profit ratio and net profit ratios are used measure the performance of firms with regards to their profits. Gross profit ratio is calculated by dividing the gross profit by the total sales and expressing the index as a percentage. Net profit ratio on the other hand is calculated by dividing the net profit by the total sales and expressing the index as a percentage. These ratios are used to determine the extent to which the selling price of goods and services can be reduced to without affecting the profitability of the company and ensuring that the company is still able to attain a desirable return on investment.
Importance of cash flow statement analysis
A cash flow statement is a financial statement that represents the cash inflows (incomes) and outflows (expenditures) of a business entity within a certain financial period. This statement represents all the current transactions of a firm and corresponding changes in the balance sheet. A cash flow statement represents operation, investment and financial transactions of an entity. It is essential for a business entity to maintain a cash flow statement for every financial period as it is a good tool to give out information with regards to the firms ability to meet its short-term obligations such as payment of bills.
Leveraging and its effects on business entities
Leverage is a means through which a business entity applies specific techniques to increase their gains and reduce their losses. There are a number of techniques that can be used to improve on the financial status of a firm. This includes borrowing money, purchase of fixed assets and the use of derivatives. The main aim of leveraging is to increase the financial base of an entity so that it can stand a better chance to meet is short-term obligations. A company can for instance leverage by borrowing money from the public. This can be achieved through the issue to shares to the public. A share is a claim against the company by an investor. Once the public has purchased the shares, the money that has been acquired can be used to improve on the operations of the entity in a bid to boost production and increase their sales. As a result of borrowing, the company will be able to maximize on its profits without increasing its equity. In addition, if losses may arise, they will be shared proportionately among all the shareholders thus minimum impacts shall be felt by the company (James, 2010). A firm can also purchase fixed assets. This will have an overall effect of increasing the base if their fixed asset in comparison to its variable operating costs. As a result, any change that may be experienced in revenue shall result in an even bigger change in the operating income of the firm. This means that the entity shall enjoy more profits that it would have if it did not purchase the additional assets.
However, it should be noted that the impacts that leveraging has on multiplying profits have the same effects in multiplying losses. Therefore, an entity that borrows huge sums of money or purchases a lot of assets may face bankruptcy if in case of a financial downturn. In such an event for example, a shareholder who had invested at 60% may suffer a 50% loss if the share value declines to 20%. Given the same situation, a firm that was less leverage may survive a financial downturn and in some cases, it may even be profitable. Therefore, certified public accountants should ensure that a desirable level of leveraging is maintained to guarantee the operations of the firm is effective and efficient even in harsh economic times.
Importance of financial statement analysis on specialized industries
Financial analysis provides insights that are essential in the process of decision making in all business entities. Banks for example rely on the information gathered from financial analysis to determine their profitability, strengths, and weaknesses. It is also through financial analysis that banks monitor the financial market and adjust their lending rates. With this set of information, banks develop strategies that will make them to be sustainable in the short run and in the long run. The oil and gas industry on the other hand rely on financial analysis to determine their performance in a given financial period, determine market trends such as demand and supply that will be used to adjust the fuel price accordingly. The real estate industry solely relies on financial analysis to determine the viability of the market, value properties and project their short term and long-term operations. Financial analysis is thus a useful tool of analysing the performance of an organization and determining its short term and long-term prospects.
References
Bass, B. (2010). Financial Analysis: Learning to Share the Vision. Organizational Dynamics, 18 (3), 19-31
Jago, A. (2002). Perspectives in Theory and Research. Management Science, 28 (3), 315-336
James, B. (2010). From Transactional to Transformational Leadership: Learning to Share the Vision. Organizational Dynamics, 18 (3), 19-31