An analysis of financial statements of an ongoing concern is essential as it sheds the much needed light on the financial state of a firm and enables prudent decision making. Questions on the ability of a firm to meet its long-term obligations, use its assets efficiently, produce good returns to the shareholders or whether it possesses the optimal financing mix, can be answered through a financial analysis of the firm’s statements. Normally, the financial analysis is done using historical data and is aimed at depicting the future prospects of the firm. This is usually done through computation of ratios and analysis with a view to determining the performance of the firm and is carried out by both the internal management as well as external groups.
Financial statements remain an indispensable source of information and are presented to the Board of Directors. They aid greatly in management of a firm. They are audited by an independent team of auditors in compliance with regulations. These statements, prepared according to the standards set by GAAP, include the Balance Sheet, the Income statement, the Shareholders Equity Statement and the Cash flow Statement.
The balance sheet, also known as the statement of financial position, is a statement of the assets and liabilities of a firm. It paints a picture of what the firm owns, the debts the firm owes to its lenders, and the stake of the shareholders in the firm at a particular point in time. The information in the Balance sheet is presented in a conservative mode (prudence concept) in a bid to ensure that assets are neither overstated nor liabilities understated. The assets shown in the balance sheet are both current and long term. Current assets of a firm include inventory, cash in hand, cash in bank, debtors, marketable securities and prepaid expenses. Fixed assets on the other hand include equipment and land while intangible assets such as goodwill, patents and deferred charges also appear in the balance sheet.
Similarly, a statement of both short-term and long term liabilities including accrued expenses, creditors, bonds, capital leases, tax payable and bank overdrafts are provided therein. Also encapsulated is the Shareholder’s Equity which shows the share capital, paid-up capital, retained earnings as well as foreign currency translation adjustment. The equity in a firm is usually got by subtracting the total liabilities from the total assets. The net worth of a firm divided by the number of shares outstanding gives the book value of a share. In the usual course of business all assets with the exception of land (which appreciates over time), depreciate with time. This calls for this reflection of the loss in value to avoid overstating the assets. Fixed assets are said to depreciate, intangible assets are normally amortized over time while natural resources get depleted. All these need to be reflected in the proper statements of financial position. This notwithstanding, problems abound with the information as provided in the balance sheet. First, intangible assets such as goodwill are difficult to quantify. More so, since assets are valued at the original cost, they rarely represent the exact value especially with fixed assets whose values change with time.
Another important statement usually presented to the management is the income statement also known as the profit and loss account. It shows the revenue earned by a firm and the corresponding expenses incurred over the period. There is usually a discrepancy between the actual revenue as demonstrated by the Income statement and the actual cash flow in a firm. This is mainly due to the accruals concept applied whereby revenue is recognized as soon as it is earned and not when it is actually received. In the same matching concept, expenses are recognized in the statements the moment they are incurred and not when actually paid out. Even with the income statement, the downside lies wherein a number of items are subjectively determined such as depreciation of assets. This has the effect of understating the depreciation figure especially during inflationary periods while the revenue reflects the current market price. The net effect of this is a wrong presentation of figures depicting inflated earnings. Also, by the mere fact that the income statement only records transactions without taking into account the opportunities available means that an increase in value of say, land, may not be reflected in the income statement.
A statement of changes in shareholder’s equity is another of the statement that shows the remainder of retained profits after taking care of adjustments in current profits and dividends. Further, information on new shares issued by a firm, treasury stock as well as additional paid-up capital is also embodied in the statement.
The other crucial document is the cash flow statement that provides the cash inflows and outflows of a firm as emanating from operations, financing and investing. Cash flows from operating activities are those that directly relate to earning income such as cash collected after sales are made or salaries paid to workers. On the other hand, cash flows from investing activities include those concerning acquisition or sale of a firm’s assets. Cash flows from financing activities stem from receipt and payment of money to investors and lenders. Investors in a firm as well as the creditors are concerned with this information to determine whether to lend or invest in a particular firm. It also points to the management on what route to take in matters concerning investment and operations.
With the above financial statements, there arises the need for analyzing the information contained therein. This is normally done by computing ratios analysis. The ratios are a relationship of variables which test the liquidity, profitability, efficiency as well as the leverage degree of a firm.
Liquidity of a firm is usually assessed by calculating the current ratio and the quick ratio of a firm. Liquid assets are those that can be easily converted into cash. Higher liquidity ratios indicate greater liquidity and low risk for short-term lenders as they can be easily paid. This information is useful for the management in that they can know when to reinvest the surplus cash so as to provide better returns.
The extent to which a firm is relying on external sources to finance its operations is deduced from calculating the leverage ratios. This information is important to management in that default in servicing debts could lead to a firm being adjudged bankrupt. To this end, the information obtained is useful in ensuring proper credit management. Of much importance to the lender also is the ability of a firm to repay its borrowings in good time, a feat only achievable by working out the interest coverage ratio.
Performance indicators such as Return on Investment (ROI), Return on Equity (ROE), and Return on Assets (ROA) show the profitability of a firm. Real growth rate and nominal growth rate must be distinguished especially during a period of inflation since an impressive sales growth rate in such times, may not result in increased profitability.
The efficiency with which a firm’s assets are being used is obtained by working out the inventory ratios that show the turnover of stock. The debtor turnover ratio and the average collection period indicate the efficiency of a firm in collections of credit sales. A low ratio in this instance is good for the firm in terms of credit management, though it could also be indicative of a restricted credit policy which could scare away potential customers.
The ratio analysis is essential in evaluating the performance of a firm over a number of years as well as against other firms. It is necessary in setting the standards of performance and crucial in telling the investment potential areas of the firm. The information accruing from the analysis is also useful to external parties such as creditors and investors whose fortunes are usually at stake.
That being the case, the ratio analysis has not been without limitations. The subjectivity employed in telling the right ratios and the inability to draw the right inference where the ratios are favorable and not, make it difficult to determine the performance of a firm. Further, the different accounting policies employed by firms in different fiscal years also pose a challenge to comparison of such ratios. In addition, the very fact that a specific ratio is good does not necessarily mean that the rest of the industry is doing impressively. Since the ratios are based on historical data, it becomes difficult to make forecasts based on such past data especially in instances where there is no stability. The ratio analysis is static in form as opposed to the dynamic state of decision making process. The assessment of costs instead of value in the financial statements also provides a wrong impression in cases where the market value of items differs from the costs provided therein. There is also difficulty in linking the different ratios so as to ascertain the performance of a firm. It is with these limitations in mind that the management embarks on studying the analysis of the financial statements and seeks to come up with sound management policies.
Besides the ratio analysis, the data on financial statements is also used in cost-volume-profit analysis which equips management with understanding on how fixed and variable costs relate. Moreover, the analysis shows the volume of produce manufactured, sold and the consequent sales made. A component of this, the contribution margin analysis enables management to determine the pricing, mix and introduction of particular products into the market. It also helps managers to ascertain the amount of incentives to use for sales commissions and bonuses.
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