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Financial Statement Analysis Techniques

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17 views3 pages

Financial Statement Analysis Techniques

Uploaded by

glenn.apon24
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

MODULE 12

FINANCIAL STATEMENTS ANALYSIS


Just looking at the financial statements will not give you a complete picture
of the company’s financial position and operating performance. You need to
convert the absolute amounts into ratios, turnovers and percentages after which
these are compared against the figures of the previous year ( intra-comparability)
or against the figures of a competitor (inter- comparability or bench marking).
Although it is important to study the new figures in the financial statements, it
also becomes more meaningful when the figures are “standardized” or reduced
into a common size by using ratios and percentages, especially when comparing
two companies which have different scale of operation.

An analysis of the previous year financial statements is a stepping stone in


forecasting the company’s future financial position and performance. The
financial data contained in the financial statements should be evaluated primarily
for two reasons:

1) Evaluate operating performance of the business based on profitability


2) Assess strength in financial position based on liquidity and solvency.

It is because of these reasons that financial statement analysis has been


recognized as a powerful tool assisting all users in obtaining meaningful
knowledge and in making informed judgment and decision.

Profitability

Profitability is the ability of the entity to obtain adequate profit for the
investors.

The relevant data are:

1. The revenues earned


2. The net income obtained
3. The assets used in the operation
4. The investment made by the owner.

The owners or investors will be interested in the following ratios:

Profit Margin : Net Income / Revenues

This shows the adequacy of the revenue to earn profit, the higher the
ratio the more profitable the business is.

Return on Total Assets: Net Income/ Average Total Assets

If the total assets of the previous period is given, get average total
assets: the sum of the total assets at the start of the year and at the end of
the year and divide by 2. You can consider the initial investment of the
owner as the beginning balance if this is the first year of the firm.

The rate of return shows the income earned by the business based
on assets invested. A high rate means the assets are being used profitably
by the business.

Rate of Return on Equity : Net Income/Average Owner’s Equity

This show the rate the owner earned from his investment.

LIQUIDITY

Liquidity is the ability of the business to pay for its short term obligations.
Short term creditors such as suppliers and lenders (banks) are interested in this
information. For liquidity, the relevant data are:

1. Current assets and


2. Current liabilities

Working Capital: Current Assets – Current Liabilities

Current Ratio: Current Assets/ Current Liabilities

The rule of thumb is a ratio of 2:1. This shows that the business is
liquid.
Quick Ratio or Acid Test Ratio: Quick Assets/ Current Liabilities

This is a stricter measurement of liquidity since only the quick assets


(cash, accounts receivable, and marketable securities) are in reality used to
pay for the firm’s obligations. There are two ways of assessing this ratio
which shows the business is highly liquid considering the rule of thumb is
only a ratio of 1:1.

1. If the company is going to use this for growth and expansion, then
it is wise to build up current assets or working capital.
2. If there is no plan for expansion, then it seems that the firm is
keeping idle funds. These funds must be moved and used
profitably else return on equity will be adversely affected.

SOLVENCY

Solvency is long term liquidity and is measured based on ability of the


business to pay for long term obligations when they fall due. This is determined
by computing for the debt ratio and the equity ratio. The debt ratio shows the
proportion of the assets provided by the creditors whereas the equity ratio shows
the proportion of the assets invested by the owner. A balanced financial structure
shows the creditors and investors contributed an equal proportion of assets to
the business.

Debt Ratio : Total Liabilities/ Total Assets

Equity Ratio: Total Owner’s Equity/ Total Assets

Take note that to facilitate interpretation of the financial statements one


must consider the following:

1) Use ratios, trends and percentages to standardize data.


2) Compare two or more periods
3) Compare your company against a competitor
4) Compare data in income statement (sales) against data in statement of
financial position.

Common questions

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Standardization of financial data affects comparative analysis by facilitating more accurate and meaningful comparisons between companies of different scales. By using ratios, trends, and percentages to standardize data, analysts can effectively compare financial performance and position across various periods, competitive companies, and industry benchmarks. This approach reveals underlying financial dynamics by removing size-related variances, enabling insightful analysis of relative performance and strategic positioning .

Considering both intra-comparability and inter-comparability in financial analysis is important because it provides a comprehensive view of a company's performance and market standing. Intra-comparability involves evaluating financial changes over time within the same company, which highlights trends and performance improvements or declines. Inter-comparability allows comparison with competitors or industry standards, offering context to the company's performance and identifying opportunities or threats relative to peers .

High asset turnover ratios are significant indicators of a company's operational efficiency as they reflect how effectively a company utilizes its assets to generate sales revenue. A high ratio suggests that the company is maximizing its asset use to produce goods or services, leading to better cost management and increased investor confidence. This efficiency can translate to a competitive advantage through improved profitability margins and market positioning .

Forecasting based on previous financial statements is crucial for business planning because it leverages historical data to anticipate future financial positions and performance. It aids in identifying trends, potential challenges, and growth opportunities. Doing so allows businesses to make informed strategic decisions, allocate resources efficiently, and prepare for future financial requirements or investments, ensuring sustainability and competitiveness .

Liquidity analysis plays a crucial role in evaluating a company's financial health by assessing its ability to meet short-term obligations. Important measures include the current ratio (current assets/current liabilities), with a rule of thumb of 2:1 indicating sufficient liquidity, and the quick ratio (quick assets/current liabilities). The quick ratio provides a stricter assessment by only considering liquid assets easily convertible to cash. Such analyses help creditors and investors understand the company's capacity to manage operational cash flow and financial commitments .

Financial statement analysis enhances understanding of a company's profitability operations by converting absolute financial amounts into ratios and percentages, which allow for better inter-comparability and intra-comparability. This involves assessing profitability through ratios such as the profit margin (net income/revenues), return on total assets (net income/average total assets), and rate of return on equity (net income/average owner's equity). Such analyses illustrate the efficiency with which revenue is converted into profit and the rates of return on investments and assets .

Comparing the income statement with the statement of financial position is critical in financial analysis because it provides a multidimensional view of financial performance. The income statement details revenues and expenses, reflecting operational effectiveness, while the statement of financial position outlines asset allocation, liabilities, and equity, indicating financial stability and capital structure. Analyzing both reveals correlations between operational results and asset utilization, enhancing strategic decision-making .

Debt and equity ratios contribute to the assessment of a company’s solvency by indicating financial structure and risk. The debt ratio (total liabilities/total assets) shows the extent to which creditors provide company assets. A high debt ratio may imply higher financial risk due to overwhelming creditor power. Conversely, the equity ratio (total owner's equity/total assets) indicates the level of asset investment by owners. A balanced ratio implies both stakeholders contribute equally, reducing financial risk .

Maintaining excessive liquid assets can negatively impact a company's return on equity if such funds are not utilized effectively for growth or expansion. Idle funds contribute little to earnings, thereby lowering the proportion of net income relative to equity. If not invested in profitable opportunities, it diminishes the efficiency of capital utilization, leading to suboptimal financial returns and reduced shareholder value .

Analysis of working capital, calculated as the difference between current assets and current liabilities, provides insights into a company's operational efficiency and short-term financial health. Positive working capital indicates that the company can meet its short-term liabilities, supporting uninterrupted operations and creditworthiness. Conversely, negative working capital may signal potential liquidity problems, requiring strategic management to ensure financial stability .

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