There are various users of the financial statements of an organization. They include tax authorities, shareholders, employees, investors, and creditors. To make adequate use of the financial statements, they must be able to analyze it.
Creditors rely on the financial statement to determine if the company will be able to repay their debts. Tax authorities rely on the financial statements to determine the level of compliance of the company. Current investors rely on the financial statements to determine how well their investment is doing, while intending investors rely on the financial statements to determine if it will be profitable to invest in the company or not.
The financial statement is the medium through which the organization communicates with the various users of the information.
What is Financial Statement Analysis
It is the process by which an individual goes through the financial statements of an organization with the aim of making an informed decision about the business.
Types of Financial Statements
- Balance Sheet: The balance sheet shows the book value of a company. It accounts for all the company’s assets, liabilities and owners equity. It shows a snapshot of how the company is performing.
- Income Statements: The Income statement is a report that shows how much money the organization has made over a period.
- Cashflow Statement: This is a report that shows how a company receives and spends its cash. A typical cashflow statement is divided into three major sections namely: Operating activities, Investing activities and financing activities.
Advantages of Financial Analysis
- To determine the stability, solvency, liquidity, and profitability of an organization so as to make investment decisions.
- To evaluate trends ,so as to set policies and make future business decisions.
- To determine the value of an organization.
Methods of Analysis Financial Statements
- Vertical Method: This is used to determine how an individual line in the financial statement, relate to another item in the report. In the income statement, each line can be evaluated as a percentage of revenue.
- Horizontal Method: This is the process of comparing current financial data to similar data in previous periods. This is used to identify trends over time. As an example, to determine if revenue has increased from 2019 to 2020.
- Ratio Analysis: This is a process of comparing an information in the financial statement with another information in the same report. There are various types of ratios that can be used in analyzing the solvency, profitability, liquidity and the general health of the organization.
They are broken into broad categories:
- Liquidity Ratios: This ratio tells the user of the information how liquid the company is. Ratios used for determining liquidity include quick ratio and current ratio.
- Profitability Ratio: This ratio tells the user of the information how profitable the organization is. Ratios in this category include gross profit ratio, return on equity, and return on net assets.
- Activity Ratios: These ratios tell the user of the information, how well the company is utilizing its resources. Ratios in this category include account receivable turnover rate and inventory turnover rate.
- Leverage Ratios: These ratios tell the users of the information how much the company is dependent on debt to maintain its operations. Ratios in this category are debt to equity ratio and debt service coverage ratio.
Once the ratios are calculated, it can be compared to similar ratios in prior periods to determine how well a company is performing. It can also be compared to similar ratios of companies within the same industry to determine how well the company is doing compared to its peers in the industry. #EMBA28
