The analysis of financial statements involves gaining an understanding of the financial situation of an organization by reviewing the organization’s financial statements. You can use three key financial statements - Income statement, Balance sheet and statement of cash flows. Analysis of these financial statements is often reported to the board of directors and senior management. They use this information as input in their decision-making process. External parties such as regulatory bodies and investors also use this analysis for gaining insight into the organization.
2.Users of Financial Statement Analysis
There are various users of the financial statement analysis. They include:
- Management of the company: The finance controller of the company does an ongoing analysis of company's financial statements, particularly operational metrics such as the profit by product, cost per distribution channel, cost per delivery etc. that aren’t seen by external entities.
- Investors: The current, as well as prospective investors, scrutinize the health of the organization by performing analysis of the financial statements. They do this to understand about the company's ability to continue as a going concern, issue dividends, generate cash flows and to ensure that the company continues to grow at least at the historical rate.
- Creditors: A creditor or anyone for that matter, who has provided funds to the company will be interested to know the ability of the company to pay back the debt and their several cash management measures.
- Regulatory authorities: In cases of publicly held companies, Securities and Exchange Board of India (SEBI) examines their financial statements to see if the statements conform to accounting standards as well as the SEBI rules and guidelines.
3.Performing analysis of financial statements
Note: It’s important to keep in mind that if you are using financial statements from more than one reporting period, each of the financial statements should be in a similar format so that you have all the relevant data in a comparable format to understand one period to other.
Each of the methods provided below gives visibility of variances, business trends, and also flags various issues. They raise questions about the company, which is required to be answered. Investigating the business, finding logical explanations for the variances and performing changes based on the positive or negative trends are the ultimate goals of the financial statement analysis.
There are various methods and techniques to perform Financial Statement Analysis. However, the most common methods of financial statement analysis include:
- Vertical analysis
- Ratio analysis
Horizontal Analysis: A horizontal analysis is a two-year comparison of analysis of the financial statements and its elements. It is also referred to as trend analysis, usually expressed in monetary terms and percentages. This comparison provides analysts with insight into the aspects that could contribute significantly to the financial position or profitability of the organization.
For instance, in 2015, a company earned INR 4 lakhs more than its previous year. This increase in turnover appears to be a positive development. However, examine closely, it reveals that the costs of the procuring goods and services increased by INR 4.5 lakhs. The wonderful picture of this additional turnover of INR 4 lakhs is now adjusted to the less positive picture.
Vertical Analysis: Vertical analysis is a financial statement analysis technique in which every line items of the financial statements are listed as percentages, based on a figure within the financial statement. The line items on the income statement could be stated as percentages of the gross sales, while the line items on the balance sheet could be stated as percentages of the total assets or liabilities. And in case of cash flow, every inflow or outflow of cash could be stated as a percentage of total cash inflows.
By doing this analysis, insight would be created about the changes in the allocation and distribution of the total assets. This method of analysis of financial statement is also used for comparing one company to another in the form of benchmarking. Example, by representing the different items as a percentage of the total turnover, it’s easy to get insight into every division’s costs, expenditures and profit.
Ratio Analysis: A ratio between two quantities is used for representing the relationships between different figures on the profit and loss account, balance sheet, cash flow statement or such other accounting records. It is a form of Financial Statement Analysis, used for obtaining a quick indication of the organization’s financial performance in various key areas.
Ratio Analysis as a financial analysis tool possesses many important features. The data provided by the financial statements are available readily. The ratios enable the comparison of firms that differ in size as well as compare an organization's financial performance with the industry averages. Additionally, ratios could be used in the form of trend analysis for identifying the areas within an organization where performance has deteriorated or improved over time.
Some of the key ratios include:
- Profitability Ratios: Profitability ratios measure the results of a company’s overall or day-to-day management performance and efficiency of management. Some of the commonly used profitability ratios include gross profit ratio, net profit ratio, return on equity capital, return on capital employed, operating ratio, earnings per share and dividends yield ratio.
- Liquidity Ratios: Liquidity ratios measure the current solvency of a firm’s financial position. These are calculated to ascertain out whether a firm has the ability to meet all of its existing business obligations. The most commonly used liquidity ratios are the current ratio and quick ratio.
- Solvency Ratio: Solvency ratios evaluate the organization’s ability to meet its long-term interest expenses and also the repayment obligations. Most common solvency ratios are equity ratio, debt-to-equity ratio and interest coverage ratio.
- Activity Ratios: Activity ratios indicate the quality of management as they reveal how well the management utilizes the company resources. Some of the key activity ratios include Accounts Payable Turnover Ratio, Accounts Receivable Turnover Ratio, Fixed Asset Turnover Ratio, Inventory Turnover Ratio and Working Capital Turnover Ratio.