Financial statement analysis is the process of analyzing an organisation’s financial reports for decision-making purposes. Stakeholders like shareholders/equity owners, business analysts, regulators and creditors amongst others, use financial statements to understand the overall well-being of an organisation and to evaluate its performance and business value. Suppliers of financial information, as the managers of an organisation use it as a monitoring tool for managing its affairs.
Organisations use four financial statements to report on their business activities. These statements are the statement of financial position, also known as the balance sheets, the income statement, the statement of cash flow, and the statement of stockholders’ equity.
The statement of financial position reports on the organisation’s financial position at a particular point in time whilst the income statement, statement of cash flow, and statement of stockholders’ equity, report on the organisation’s performance over a period of time.
The statement of financial position reports on an organisation’s financial worth. It is broken down into three parts: assets, liabilities and shareholder equity. Assets are what the organisation owns, its resources and it must be paid for. There are two ways an organisation gets to finance its assets or own its resources. It could be from raising funds through its shareholders, which is known as owner financing; or it could be from creditors, such as the banks, which is nonowner financing. From this, it is safe to infer that both shareholders and the organisation’s creditors lay claim to the organisation’s assets. The shareholders’ claim over the organisation’s assets is known as equity while the creditors’ claim is known as liability. Meaning investing equals financing. This equality is known as the accounting equation which is represented thus:
Assets(Investing) = Liabilities (nonowner financing) + Equity (owner financing)
The statement of financial position must balance liabilities and equity to equal assets and if you want to know the shareholders’ equity then you would subtract the organisation’s liability from its assets.
The second financial statement is the income statement. An income statement provides a breakdown of an organisation’s revenue against its expenses to provide the bottom line, its net profit or loss. To analyse the income statement, it is broken down into three parts. Beginning with revenue, direct costs (also known as cost of goods sold) associated with the revenue are deducted from the revenue generated to give the gross profit. Then to get the operating profit, you subtract indirect expenses like general cost, depreciation and marketing cost from the realised gross profit. Lastly, the net income is calculated by deducting interest and taxes. In summary, to understand the income statement, it is represented as:
revenue- direct cost=gross profit then gross profit- expenses (other than the direct cost of goods sold) = net income or loss as the case may be.
Analysing the income statement involves the calculation of gross profit margin, operating profit margin, and net profit margin and then dividing profit by revenue. Profit margin enables the stakeholder reviewing the financial statement to know where the organisation’s costs are low or high. It provides insight into the organisation’s efficiencies.
We would be looking at the statement of cash flow and the statement of stockholders’ equity in the next post. Until then, have a great week!
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