In every organization, financial analysis is a key part of operational activities. Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions. The essence is to determine the performance and suitability of a company.
Based on generally accepted accounting principles (GAAP), companies report their financial activities using financial statements. As managers, knowing how to work with the numbers in a company’s financial statements is an essential skill. The meaningful interpretation and analysis of financial statements is the basis for making significant decisions.
However, the structure of financial statement requires that we first become familiar with certain financial statement characteristics before focusing on individual corporate financials. In financial statements are financial results, financial position, and cash flows.
Advantages of Financial Statements
Financial Statements are useful for the following reasons:
- Determine the ability of a business to generate cash, and the sources and uses of that cash.
- Decided whether a business has the capability to pay back its debts.
- Track financial results on a trend line to spot any looming profitability issues.
- Derive financial ratios from the statements that can indicate the condition of the business.
- Investigate the details of certain business transactions, as outlined in the disclosures that accompany the statements.
- Statements are a key part of an annual report. These reports are made available to investors and the investment community.
Limitations of Financial Statements
There are few limitations to issuing financial statements.
- The figures are prepared on the basis of historical costs or original costs. The value of assets decreases with the passage of time current price changes are not taken into account. The statements are not prepared keeping in view the present economic conditions
- Statements are not adjusted for inflation. If the inflation rate is relatively high, the amounts associated with assets and liabilities in the balance sheet will appear inordinately low, since they are not being adjusted for inflation. This mostly applies to long-term assets.
- A lot of intangible assets are not recorded as assets. Instead, any expenditures made to create an intangible asset are immediately charged to expense.
- The statements only cover a specific period of time. A user of financial statements can gain an incorrect view of the financial results or cash flows of a business by only looking at one reporting period.
- Statements from different companies are not always comparable due to different accounting practices.
- Numbers presented could be wrong due to fraud. The management team of a company may deliberately skew the results presented. This situation can arise when there is undue pressure to report excellent results, such as when a bonus plan calls only if the reported sales level increases.
- It does not cover non-financial issues.
- The statement may not have been verified or audited.
- The values provided in financial statements are not predictive.
Types of Financial Statements
There are 4 + 1 financial statements used by entities to report business activities and financial performance:
- Balance Sheet or statement of financial position.
- Profit or Loss statement
- Statement of Changes in Equity.
- Statement of Cash Flow.
+1) Notes to the Accounts.