Financial Management & Cost Accounting

Module 4. Financial statement analysis

Lesson 18
INTRODUCTION TO FINANCIAL STATEMENTS

18.1 Introduction

A financial statement (or financial report) is a formal record of the financial activities of a business, person, or other entity. A financial statement is often referred to as an account. In short financial statements are summaries of monetary data about an enterprise. For a business enterprise, all the relevant financial information, presented in a structured manner and in a form easy to understand, are called the financial statements. There are four basic financial statements:

18.1.1 Balance sheet

It also referred to as statement of financial position or condition, reports on a company's assets, liabilities, and Ownership equity at a given point in time. The balance sheet provides the user with data about available resources as well as the claims to those resources.

18.1.2 Income statement

It also referred to as Profit and Loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. Profit & Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state. The income statement provides the user with data about the profitability of the enterprise detailing sources of revenue and the expenses which reduce profit.

Analysis of financial statement means finding out the current position of the company through various tools like ratio analysis, fund flow analysis. It also involves comparing the company figures with regard to industry standards or over a period of time.

Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company. All financial statements are essentially historical documents. They tell what has happened during a particular period of time. However most users of financial statements are concerned about what will happen in the future. Stockholders are concerned with future earnings and dividends. Creditors are concerned with the company's future ability to repay its debts. Managers are concerned with the company's ability to finance future expansion. Despite the fact that financial statements are historical documents, they can still provide valuable information bearing on all of these concerns.

This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios.

18.2 Purpose of Financial Statements by Business Entities

The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities, equity, income and expenses are directly related to an organization's financial position.

Financial statements are intended to be understandable by readers who have "a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently." Financial statements may be used by users for different purposes:

a) Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders.
b) Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.
c) Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.
d) Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.
e) Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
f) Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business.
g) Media and the general public are also interested in financial statements for a variety of reasons.

18.3 Basis of Comparison

Comparison of financial statements forms the basis for much financial analysis. Four main types of comparison are made:

(1) Comparison of statements for the enterprise between successive years
(2) Comparison of a firm's statements with those of a specific competitor
(3) Comparison of a firm against an industry standard and
(4) Comparison with a target, such as a company's budget.

Comparisons between different organizations may be difficult or even meaningless because of differences in

(1) Size of the organization
(2) Type of organization and
(3) Accounting methods used by the organization.

Often, both the size and type of organization will dictate the kind of accounting methods used. Financial statement analysis is used to identify the trends and relationships between financial statement items. Both internal management and external users (such as analysts, creditors, and investors) of the financial statements need to evaluate a company's profitability, liquidity, and solvency. The most common methods used for financial statement analysis are trend analysis, common-size statements, and ratio analysis. These methods include calculations and comparisons of the results to historical company data, competitors, or industry averages to determine the relative strength and performance of the company being analyzed.

18.4 Users of Financial Statements

The Financial Statement information used by different decision makers differ based on the decision that they make. The major users of the said information are:

1) External users
2) Internal users

18.4.1 External users

The external users of Financial Statements primarily include the investors, creditors or short term and long term lenders. A potential investor is basically interested in his returns in the form of cash dividend as well as the capital gain that he can realize from eventually selling the stock. These returns depend upon how profitable is the company currently and how profitable it will be in future. Therefore, a potential shareholder is interested in the relationships within the company that indicate the present and future profitability of the enterprise and how such profitability could be translated into cash dividend.

A creditor, who supplies goods on credit, is interested in the recovery of the cash during the short period.

The long term creditors such as debenture holders are interested in getting the coupon rate of interest in the short run and recovery of their investment in the long run.

The other interested parties on the company’s performance include the Tax Authorities, Government Agencies,

18.4.2 Internal users

The internal management gets sizable information on the company from Financial Statements. Their interest comes from two sources. First decision s made by external users of financial statements significantly affects the firm in different ways.