One of the major aspects of making the right investment decision is to analyze the financial statements of the company. The financial statement analysis is a process of selecting, evaluating and interpreting financial data. This is done in order to assess a company’s past and present financial performance, as well as forecasting its future performance.There are a number of questions that can be asked about the company to help give more of an insight into its financial health; these include questions about the company’s debt repaying capacity, its returns to shareholders, its revenue generating efficiency, its working capital management and whether it is financially sound or stressed, and if it has an apt financial mix. Although most of the information used is historical, the purpose of the analysis is to arrive at more accurate future forecasts and estimate the performance of the company.
One of the major aspects of making the right investment decision is to analyze the financial statements of the company. The financial statement analysis is a process of selecting, evaluatingand interpreting financial data. This is done in order to assess a company’s past and present financial performance, as well as forecasting its future performance.There are a number of questions that can be asked about the company to help give more of an insight into its financial health; these include questions about the company’s debt repaying capacity, its returns to shareholders, its revenue generating efficiency, its working capital management and whether it is financially sound or stressed, and if it has an apt financial mix. Although most of the information used is historical, the purpose of the analysis is to arrive at more accurate future forecasts and estimate the performance of the company.
Significance of Financial Analysis
The analysis of a financial statement helps the analyst know the financial information from the financial data contained in the financial statements and to assess the financial health (i.e. strengthsandweaknesses) of the enterprise. It also helps create a forecast for the future, which in turn helps us to prepare budgets and estimates. In short, the analysis of financial statements helps us to make a number of decisions within different areas of the firm. While there are multiple reasons why we might carry out a thorough financial analysis of a business, some of the key reasons arelisted below:
– To ascertain the short-term liquidity position of an enterprise.
– To evaluate the long-term solvency position of an enterprise.
– To assess the financial risk involved with the firm and detect any business risks.
– To assess the present earning capacity of the firm.
– To evaluate the efficiency of the firm for proper utilization of financial resources.
– To assess the intra-firm comparison within different areas of the firm.
– To assess the working capital management of the firm.
– To assess the overall performance of the firm.
FINTIBI empowers you to analyze complicated financial statements without the need for spreadsheets. It has designed a number of easy-to-use templates that make filling in financial statements and uploading them easier. When it comes to analyzing financial statements, FINTIBI focuses on what matters to ensure you get accurate results.
Besides the financial statement analysis, you will also be able to easily analyze financial ratios as well. FINTIBI features several tools, such as a variance analysis tool and graphs to support your analysis; it also helps to easily identify any material changes.
FINTIBI can conduct much more than just a variance analysis on a financial statement. It can leverage the power of its extensive library of financial ratios to analyze a financial performance and gain real insights into things that you can build on.
Steps Involved in a Financial Analysis
Academically, we are all aware of a common size analysis, which is restating the financial information in a standardized format. This could be done by a horizontal analysis, which compares two or more years of financial data in both currency and percentage form or a vertical one, where each category of accounts on the balance sheet is shown as a percentage of the total accounts. This can be complemented by the DuPont model (uses several financial ratios that are multiplied together to equal a return on equity, a measure of how much income the firm earns divided by the amount of funds invested),and also a ratio analysis. Furthermore, we also use relationships among financial statement accounts, forecasting the company’s future income statements, and balance sheets to see how the company’s performance is likely to evolve. This step is normally based on the guidance given by the company’s management. Basically, there are two major steps that are involved in a financial analysis which are as follows:
Step – 1 Methodical classification:
We know that financial statements are prepared usually in a traditional form which do not exhibit the information required by an analyst. Thus, an analyst rearranges the data and presents and prepares the same in a modified form to allow for making a proper interpretation and analysis.
The said data is modified in a vertical form for a particular purpose. This modification of the financial statement is not a compulsory requirement but only as a matter of convenience for understanding and analysis. That is why there is no standard form of its presentation which should be applied in all the cases. The financial statements used may also be prepared without modification; in this case, we cannot use them conveniently. While in the case of a methodical presentation, the information may be presented side by side for the purpose of making a proper comparison and understanding.
Step – 2 Usage of tools for a financial statement analysis:
Before explaining the tools we must remember that an application of a single tool is not at all sufficient to assess the financial position of an enterprise. As such, a combination of some tools should be applied in order to assess the financial position. For example, if an analyst desires to assess the liquidity position of a firm, he must consider the liquidity portion along with the Cash Flow Analysis, Funds Flow Analysis, Working Capital Analysis, and so on. This will, no doubt, help to assess the liquidity position of a firm. Thus, the tools of financial statement analysis are:
- Comparative Statement;
- Common-Size Statement;
- Trend Analysis;
- Working Capital Analysis;
- Funds Flow Analysis;
- Cash Flow Analysis;
- Cost-Volume Profit (CVP)/Break-Even Analysis;
- Ratio Analysis.
Ratio Analysis – Evaluating Past Performances and Predicting the Future
Amongst these tools, FINTIBI features a comprehensive library of financial ratios to perform ratio analysis for best practice. The financial ratios alone are not useful, but when we compare then with other ratio changes over time and compare them to other companies’ ratios within the same industry and size, the financial ratios then become very powerful tools.
A ratio analysis is used to evaluate various aspects of a company’s operating and financial performance, such as its efficiency, liquidity, profitability, and solvency, which are critical when evaluating the financial health of the company.
A sustainable business and mission requires effective planning and financial management. Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. Funders may also use ratio analysis to measure your results against other organizations or make judgments concerning management effectiveness and mission impact. For ratios to be useful and meaningful, they must be:
- Calculated using reliable, accurate financial information (i.e. Does your financial information reflect your true cost picture?);
- Calculated consistently from period to period;
- Used in comparison to internal benchmarks and goals;
- Used in comparison to other companies in your industry,
- Viewed both at a single point in time and as an indication of broad trends and issues over time;
- Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in assessing performance.
Ratios can be divided into four major categories:
– Profitability Sustainability: These are ratios that demonstrate how profitable a company is. A few popular profitability ratios are the break even point and gross profit ratios. The break even point calculates how much cash a company must generate to break even with their startup costs. The gross profit ratio is equal to gross profit/revenue. This ratio shows a quick snapshot of the expected revenue.
– Operational Efficiency: These are meant to show how well management is managing the company’s resources. Two common activity ratios are the accounts payable turnover and accounts receivable turnover.
– Liquidity: These are used to determine how quickly a company can turn its assets into cash if it experiences financial difficulties or bankruptcy; it is essentially a measure of a company’s ability to remain in business. A few common types of liquidity ratios are the current ratio and the liquidity index. The current ratio is current assets/current liabilities; it measures how much liquidity is available to pay for liabilities.
– Leverage: This depicts how much a company relies upon its debt to fund operations. A very common leverage ratio used for a financial statement analysis is the debt-to-equity ratio. This ratio shows the extent to which management is willing to use debt in order to fund operations.
The Ratio analysis is not just about picking different numbers from a balance sheet, income statement and the cash flow statement and then comparing them. Ratios compare facts against previous years, the industry, other companies, and even the economy in general. Ratios look at the relationships between values and relate them to find out how a company has performed previously and how they might perform in the future.
The echelon and chronological trends of these ratios can be used to make inferences about a company’s financial condition and its operations as well as the attractiveness as an investment. Financial ratios are calculated from one or more pieces of information from a company’s financial statements. They investigate thoroughly the financial condition of a business and can assist in making a decision about whether a company has the financial backup to support the console and achieve success or not.
Financial ratios are a suitable method of evaluating or assessing the current financial health and its related performance of a company relative to similar companies with in the same industry. Users of financial ratios use the traditional balance sheet and income statement to determine the liquidity,leverage, asset activity, profitability, and performance of companies. The companies and the basis of calculation of ratios need to be similar to one another because inter-firm comparisons provide a more meaningful, objective and controlled way of evaluation. Then these inter-firm comparisons can be used for helping to identify the strengths and weaknesses of a company related to a particular industrial sector. Either internal management or external users such as stakeholders, investors and creditors can then analyze these comparisons. There are several sources of getting inter-firm comparisons both internally and externally:
- They gather data from external published accounts.
- Those companies that confidentially and strictly survey for inter-firms comparisons.
Parties Involved in a Financial Analysis
The users of Ratio analysis are not only members of the top management;they include all levels of management. It depends on the firm which ratio it will use. The factors depend on both the firm’s size and nature. Nevertheless, the management always requires an analysis of the firm’s past data and its performance in order to maximize profits and prevent loss. Since management has to make decisions on a daily basis, an annual or quarterly analysis is not satisfactory. It requires up-to-date and meaningful financial information to be able to make such daily decisions. Since financial information is required and used at all levels, the management can decide what information is relevant for each level and therefore filter the unnecessary flow of financial information.
The questions that management asks include:
– Is the company in the growing sector of the economy?
– What are its trends regarding interns of profitability, liquidity and investment?
– How does the board perceive the past performance of the company and how do they intend to change their strategy for the future?
The profitability of a company is a major concern for the management as well as the stakeholders.The shareholders are concerned about the profitability of their company as well as the profit that they will earn upon investment in that company. The integrity of the financial information provided by the companies is also a vital concern for most external parties. In order to address the problem, governments and international organizations have created certain laws to prevent the“window dressing” of a company’s performance.
Financial ratios can also be used to assess the risk factor involved for an investor and to predict the bankruptcy of a company. The liquidity and non-bank credit ratio are used for assessing the companies going through a hard time. The non-bank ratio is used by a firm where the firm cannot afford to get more credit from banks. This ratio is assumed to be of greater risk.Since the firm may struggle to pay back the bank loan, it will probably be charged a higher interest rate. Interest payments are subject to the primary earnings of a firm (as regarded by some financial analysts), so the interest must be calculated as the percentage of sales of that firm or alternatively the total costs as the percentage of the previous year’s earnings.The result that an investor gets from these ratios affects the decision making of their investment into any firm associated.
Now let us talk about the hierarchical usage of ratios in the firms. The production manager in a firm is not required to have complete information about the firm;instead he or she is more concerned about the liquidity ratios, such as the repayment of debts, cost of raising long-term debts or an alternative to equity. His main focus is to maximize the efficiency of the production of the firm in order to maintain profitability. If today, for example, the management decides to sell 75% capacity of the production, he or she (Production Manager) would simply adjust the production accordingly.The management is responsible for gathering the reports of the current payments that the firm has made and the current income that the firm has received. It is different to the overall management, which requires the supervision of short-term and the long-term trends of the firm.Decisions at this level of management can project the equilibrium point between profitability and also assess the risk involved.
This same level of management will use the financial data to project the income of the company’s immediate future. If the data is from longer duration of time, such as the payment of loans or taxes by the end of the fiscal year, the projection can be stretched over this time and the management has to keep a high level of funds in the pool. Whereas if the management can predict that it can increase the firm’s income significantly then the level of funds kept in the pool can be lower. For example, a bank might give a company some leverage for its loan repayments so it can acquire a bank overdraft, which can be repaid over a longer period of time. Sometimes it seems that the information of the cash flows of a single firm is enough for the financial manager tomake future predictions and forecasts.
The general management has a job pretty much close to the Production Manager. Its role in predicting and projecting the future of the company is significant because it compares the current year’s ratios to the previous years’ratios to find out whether the overhead expenses have been increasing or not. It must be noted that over heads cannot only be caused by raw materials, for example, they can also occur from the machines or technological perspective.
The executive management is the one which requires almost all the information gathered for the financial analysis. It has to keep an eye on everything starting from what the production manager is doing to what the shareholders are getting. They get information about the previous years of the firm as well as the inter-comparison between firms similar to theirs. Its major role is to tweak the output and efficiency of the firm for profitability and portfolio.
I would like to say that different accounting policies restrict the use of ratios as they might distort the company comparisons. Companies should refrain from the“window dressing” of
their financial analysis and reporting. However,despite these limitations, financial ratios are still extensively used in evaluating the performance and profitability of a firm. Ratio analysis is required at all levels of management as a source of information for observing and learning about the company’s performance against its competitors or its previous years. Ratio scan also give information about the bankruptcy or the growth of that company over the past few years. If conducted in a mechanical thoughtless manner, ratio analysis is dangerous, but when used intelligently and with good judgment, it can provide useful insights into the company’s operations.
A financial analysis is carried out by investors, regulators, lenders and suppliers to decide whether to invest in a particular company or whether to extend its credit or not. The management of the company also carries out a financial analysis to evaluate the current performance and implement strategies for the future. A thorough financial analysis of a company examines its efficiency in putting its assets to work, its liquidity position, its solvency, and its profitability.
Firstly, the company’s annual reports from the last 3-5 years are needed. The various components of the annual report add to the final decisions about the company in question. The different parts of the financial statements need to be reviewed for abnormalities, and if any are found, they need to be highlighted.
People from different walks of life need financial analysis information for various purposes;the financial statements give this information. Some of the groups who use the information are listed below:
|Application of ratios
|Owners, Proprietors & Partners
|They are interested to know the rate of return on capital employed, the long-term solvency of the firm, and the rate of dividend among others.
|1. Return of capital employed
2. Net profit ratio
3. Debt-equity ratio
4. Capital gearing ratio
|Lenders, Lending institutions, Creditors, Bankers, etc.
|Their interest lies in the ultimate solvency and liquidity position of firms and in the interest cover.
|1. Current ratio
2. Liquid ratio
3. Cash ratio
4. Debt-equity ratio
|Investors use these analyses while determining the relative merits of various investment opportunities. They are interested to know the profitability and safety of their investments.
|1. Net profit ratio
2. Liquidity and solvency ratios
|Management is interested in the profitability and efficiency, which are supplied by financial statements.
|1. Gross profit ratio
2. Net profit ratio
3. Stock-turnover ratio
4. Debtors and creditors turnover ratio
|The Government is interested in the profit earning capacity and in the effective utilization of the firm’s capacity, which are also supplied by financial statements.
|1. Turnover ratios
2. Return on capital employed
|Various Government departments and agencies use financial analysis for the purpose of tax assessment and to evaluate business operations.
|1. Net profit ratio
2. Return on capital employed
3. Turnover ratios
|Employees are interested in the earning capacity and effective utilization of the firm.
|1. Profitability ratios
|Researchers and Academicians
|Research scholars and academicians are also using these analyses as per their area of study.
|1. Liquidity and solvency ratios
2. Profitability ratios