What is Financial Statements Analysis?
Before you start analyzing financial statements, you must understand what the basic financial statements that companies usually prepare or report are. Financial statements provide information about your entity’s financial position, condition or standing, and its capability to pay off its obligations (i.e., balance sheet or statement of financial position). It also reflects your company’s financial performance or the amount of profit or loss it has generated from its operations (i.e., income statement or statement of comprehensive income). Lastly, it shows your cash flows or the ways the entity’s cash is generated or used (i.e., statement of cash flows).
Understanding the basic financial statements and its uses will guide you and your company what specific report or area to look into before making business decisions. Therefore, you must ensure that your financial statements are accurate and available on timely basis to help the stakeholders in their decision making.
Financial statements analysis means assessing and interpreting your company’s financial condition and performance based on the elements of information contained in the balance sheet, income statement, and statement of cash flows. It also involves evaluating the performance parameters or metrics of your company over a specified period. You can use different methods when analyzing your company’s economic performance, but the most useful techniques are financial ratios, horizontal analysis, and vertical analysis.
Financial ratios are one of the most powerful tools in analyzing your company’s financial statements. These ratios express the relationship between the line items in the balance sheet and the income statement. You can use financial ratios to evaluate your company’s profitability, liquidity, solvency, and efficiency.
In the succeeding sections, you will know how to compute some of the commonly used financial ratios and what these ratios tell about your company’s financial health and performance.
Profitability ratios indicate the inter-relationships between your company’s financial statements and major line items in a given calendar or fiscal year. These ratios measure your entity’s income-generation ability relative to its financial performance
(e.g., revenue and operating costs), assets and equity over a period of time.
One example of profitability ratio is the net profit margin ratio which can be computed by dividing your company’s net profit by the total revenue or sales for the given period. It indicates how a company converts its revenue or sales into profit. Other widely used profitability ratios are gross margin ratio, return on assets or investments (ROA or AOI), and return on equity (ROE).
Understanding profitability ratios will help you analyze the factors that affect your company’s financial performance, and will assist you in finding ways to improve your profitability and achieve set targets such as reducing costs or increasing sales. Higher profitability ratio means that your company’s operations are efficient, can absorb direct expenditures and various fixed expenses, while also generating positive financial results.
Liquidity ratios measure your organization’s capacity to settle currently maturing obligations. These ratios are useful to third-party stakeholders such as banks and other financial institutions in deciding whether to grant your company a loan or not. In short, these ratios indicate your company’s pool of cash and cash equivalents and its asset conversion capacity to pay currently maturing obligations.
One of the most common liquidity measures is the current ratio. It refers to your company’s ability to settle obligations and current debt due within one year, which can be computed by dividing your current assets by the current liabilities reported in the balance sheet. If your current ratio is greater than 1, it means that you have enough current assets to pay off your current debts or payables. On the other hand, when your current ratio is less than 1, current assets are inadequate to cover your currently maturing obligations. Another examples of liquidity ratios are quick ratio and operating cash flow ratio.
In general, your company is in a better position if it has a higher current ratio because it indicates that you have enough current assets to pay your short-term liabilities. However, it is essential to note that liquidity ratios vary per industry. Hence, to further evaluate liquidity, it is important to know the ideal current ratio in the industry you are involved in, as well as the current ratio of companies operating within your industry.
Solvency ratios indicate your company’s ability to settle both short-term and long-term obligations. It also assesses your overall financial and cash flow health in terms of principal and interest repayments associated with a long-term loan.
The debt-to-equity ratio is an example measure of solvency which shows the percentage of your company’s capital funded by creditors and capital from owners or shareholders. It signifies your company’s financial risk exposure in relation to its overall capital structure. You can also analyze other solvency ratios such as debt-to-assets ratio and interest coverage ratio.
As a general rule, you should target a higher solvency ratio because it indicates a more stable financial health and structure. However, just like liquidity ratios, companies have distinct solvency metrics. Therefore, your solvency ratio must be compared with other businesses within the same industry rather than viewed or analyzed separately.
Business ratios related to financial efficiency calculates your company’s efficient management of operations, assets and liabilities. These ratios also guide you and other stakeholders in assessing the processes and performance of a business.
An example of your company’s efficiency ratio is the total assets turnover ratio, which can be derived by dividing your average total assets indicated in the balance sheet from the net sales or revenue showed in your income statement. If you have a declining asset turnover rate, it means that your company is not maximizing the full potential of its assets in generating sales or revenue. It also means that you need to re-assess your production and operational practices and introduce new ways to improve efficiency.
Other common examples of ratios that you can use in analyzing the efficiency of your company are accounts receivable and inventory turnover ratios, average sales and collection periods, and fixed assets turnover ratio. Understanding these ratios will give you an idea of whether your company is efficient or not in utilizing revenue-generating assets, and accordingly implement measures to improve your efficiency and profitability.
In summary, financial ratios are useful tools for analyzing your financial statements. However, it does not consider your company’s reputation in providing products or supporting services, changes in the management structure, and other non-financial information. All these factors can affect a company’s overall value, even if these are not measurable or quantifiable in terms of ratios. In short, it is also essential that you analyze non-financial information to have a complete analysis or evaluation of your company’s financial health and performance.
Horizontal analysis, otherwise known as trend analysis, is used by companies to evaluate the accounts of the financial statements over a period of time, to determine the movement or increase and decrease between the accounts. Usually, under this analysis, current financial statements are compared with prior-year results to assess and evaluate how the accounts have changed over a period of time.
You can use the horizontal analysis in evaluating both the balance sheet and income statement accounts. Below is an example of trend analysis for significant balance sheet accounts of an electronics company, using the year 2016 as the base year:
The table above indicates an increasing trend for both total assets and total equity. It is an indication that the company is growing in terms of its operations. Hence, it also needs more assets and capital to sustain its growth. Meanwhile, the total liabilities showed an increasing trend from 2016 to 2018 but slightly decreased in 2019. This increase was due to loans entered by the company to finance its operations, while the decrease (2019) was due to the significant loan repayments.
Meanwhile, below is an example of trend analysis for significant income statements accounts of an electronics company, using the year 2016 as the base year:
Based on the table above, the revenue and net income showed an increasing trend from 2016 to 2018. Still, the company suffered a significant decline in 2019 due to lower revenue contracts from customers and non-adjustments of contract prices. Meanwhile, the operating expenses continued increasing for the last four years. Despite the decline in revenue for 2019, the operating cost still increased since these expenses pertain to general and administrative expenditures which are not directly related to the revenue.
Horizontal analysis is also useful in comparing the growth trends or patterns between different companies within the same industry.
Vertical analysis, also known as common-sized financial statements, shows the relationship or percentage of the financial statements line items with some major accounts. Usually, in the income statement, the line items are presented as a percentage of the total sales or revenue. Meanwhile, for balance sheet accounts, these are reflected as a percentage of total assets, and total liabilities and equity.
Continuing from the example above, the table below shows a sample of vertical analysis of the significant balance sheet accounts of the same electronics company:
Based on the table above, accounts receivables accounted for the majority of the company’s total assets, which is related to the revenue of the company. Due to the lower revenue in 2019, the percentage of receivable also decreased. Meanwhile, in terms of liabilities and equity, the accounts payable and retained earnings account for its significant portion, respectively. The accounts payable significantly reduced in 2019 due to payments made to the vendors. Meanwhile, the lower retained earnings percentage in 2019 is also affected by the low revenue and net income for the year.
Meanwhile, below are the relevant percentages for the electronics company’s major income statement accounts or line items:
|Cost of Sales||91.8%||90.0%||88.1%||88.0%|
Based on the table above, the cost of sales accounts for the majority of the company’s revenue at over 90% for the last two years, while the net income remained steady until 2018. Meanwhile, the operating expenses showed a fluctuating rate as a percentage of revenue over the previous four years, which is understandable since this account is not directly related to the revenue activities of the company.
After having a glance at your company’s financial performance and position by analyzing the financial statements trends and patterns, the next step will be to conduct substantive procedures or detailed examination for each significant accounts. You can do it by collecting reports and explanations, especially for the accounts with material changes or variances.
Consequently, you must verify the responses by examining corroborating evidence and reports. Lastly, you need to prepare and present a management report to the key decision makers (e.g., top management and department heads) as to the reasons for the trends and the corresponding recommendations on how to improve the company’s performance and economic position.
With the complexities of business operations nowadays, coupled with more stringent regulations and never-ending updates in the standards, the preparation and interpretation of financial statements seemed an impossible task to do, particularly for non-accountants.
Thankfully, with the help of outsourced accountants in Singapore and with the help of accounting software and other internally-developed programs, the heavy load of completing and analyzing financial information can be lessened. But one thing that will not change is the usefulness of financial statements in making the right decisions, regardless of who the users are.