Financial Statements Analysis

Financial Statements AnalysisSource: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)      

The purpose of financial statement analysis is to examine past and current financial data so that a company's performance and financial position can be evaluated and future risks and potential can be estimated.  Financial statement analysis can yield valuable information about trends and relationships, the quality of a company's earnings, and the strengths and weaknesses of its financial position.

Financial statement analysis begins with establishing the objective(s) of the analysis.  For example, is the analysis undertaken to provide a basis for granting credit or making an investment?  After the objective of the analysis is established, the data is accumulated from the financial statements and from other sources.  The results of the analysis are summarized and interpreted. Conclusions are reached and a report is made to the person(s) for whom the analysis was undertaken.

To evaluate financial statements, a person must:

1. be acquainted with business practices,
2. understand the purpose, nature, and limitations of accounting,
3. be familiar with the terminology of business and accounting, and
4. be acquainted with the tools of financial statement analysis.

Financial analysis of a company should include an examination of the financial statements of the company, including notes to the financial statements, and the auditor's report.  The auditor's report will state whether the financial statements have been audited in accordance with generally accepted auditing standards.  The report also indicates whether the statements fairly present the company's financial position, results of operations, and changes in financial position in accordance with generally accepted accounting principles.  Notes to the financial statements are often more meaningful than the data found within the body of the statements.  The notes explain the accounting policies of the company and usually provide detailed explanations of how those policies were applied along with supporting details.  Analysts often compare the financial statements of one company with other companies in the same industry and with the industry in which the company operates as well as with prior year statements of the company being analyzed.

Comparative financial statements provide analysts with significant information about trends and relationships over two or more years.  Comparative statements are more significant for evaluating a company than are single-year statements.  Financial statement RATIOS are additional tools for analyzing financial statements.  Financial ratios establish relationships between various items appearing on financial statements.  Ratios can be classified as follows:

1. Liquidity ratios.  Measure the ability of the enterprise to pay its debts as they mature.
2. Activity (or turnover) ratios.  Measure how effectively the enterprise is using its assets.
3. Profitability ratios.  Measure management's success in generating returns for those who provide capital to the enterprise.
4. Coverage ratios.  Measure the protection for long-term creditors and investors.

Horizontal analysis and vertical analysis of financial statements are additional techniques that can be used effectively when evaluating a company.  Horizontal analysis spotlights trends and establishes relationships between items that appear on the same row of a comparative statement thereby disclosing changes on items in financial statements over time.  Vertical analysis involves the conversion of items appearing in statement columns into terms of percentages of a base figure to show the relative significance of the items and to facilitate comparisons.  For example, individual items appearing on the income statement can be expressed as percentages of sales. On the balance sheet, individual assets can be expressed as a percentage of total assets.  Liabilities and owners' equity accounts can be expressed in terms of their relationship to total liabilities and owners' equity.

Financial statement analysis has its limitations.  Statements represent the past and do not necessarily predict the future.  However, financial statement analysis can provide clues or suggest a need for further investigation.  What is found on financial statements is the product of accounting conventions and procedures (LIFO or FIFO inventory; straight-line or accelerated depreciation) that sometimes distort the economic reality or substance or the underlying situation.  Financial statements say little directly about changes in markets, the business cycle, technological developments, laws and regulations, management personnel, price-level changes, and other critical analytical concerns.

Selected sources of information for financial analysis is appended.  Also appended are selected measures of financial condition 1975 or 1987 for FDIC-insured commercial banks.