Financial statement analysis and misconceptions

Financial statements represent an aggregate total of the company’s business information during a certain time period.  This information can be evaluated on the basis of historical, current and projected performance. Financial statement analysis is a common technique that allows business owners to review their company’s operational performance. Business owners will need to create financial statements from their company business transactions before conducting a financial statement analysis. Financial statement analysis compares ratios and trends calculated from data found on financial statements. Financial ratios allow you to compare your business’ performance to industry averages or to specific competitors. These comparisons help identify financial strengths and weaknesses. Financial statement analysis involves examining a company’s financial statements to make informed decisions. External parties utilize this process to assess the general well-being of a company, evaluate its financial performance and determine its business worth. Internally, stakeholders use it as a means of monitoring and managing the organization’s finances.

Financial ratios are dominant tools to help summarize financial statements and the financial health of a company. Stanley Block and Geoffrey Hart explain in the ‘Foundations of Financial Management’ that financial ratios are classified into four types of financial measurements: profitability,  asset utilization, liquidity, and debt utilization.

Profitability ratios assess the profit generated from various financial sources. These include the profit margin, return on assets and return on equity. To determine any of these ratios, divide net income by sales, total assets or stockholders’ equity, respectively.

Asset utilization ratios evaluate how effectively a company manages its assets. These ratios include receivables turnover, average collection period, inventory turnover, fixed asset turnover and the total asset turnover. With the exception of the average collection period, each of these ratios is calculated by dividing sales by the asset category specified in the ratio’s name.

Liquidity ratios assess the amount of assets that can be quickly converted into cash. These ratios are commonly used alongside cash flow statements to evaluate a company’s capacity to meet its obligations to creditors. The primary liquidity ratios are the current ratio and the quick ratio, which are calculated by dividing current assets and quick assets, respectively, by current liabilities.

Like asset utilization ratios, debt-utilization ratios measure how efficiently a company uses its debt. These ratios are debt to total assets, times interest earned and fixed charge coverage. Debt to total assets is calculated as it is stated, while the others are a little different—income before interest and taxes divided by interest and income before fixed charges and taxes divided by fixed charges.

Trend analysis

Trend analysis allows for the comparison of a company’s performance over specific time periods. For instance, managers can assess changes in their profit margin over five years. A thorough analysis should also incorporate industry benchmarks for a more comprehensive evaluation. Financial analysis is an important part of business management. Business owners often review financial information to ensure their business is generating enough capital to pay for expenses and provide the owner with a profit. While different types of financial analysis exist in the business environment, financial statement analysis is a common management tool. Financial statement analysis usually involves a personal review by the business owner.

Financial statement analysis usually includes quantitative and qualitative reviews by business owners. A quantitative review includes the use of various financial ratios. These ratios measure the company’s ability to meet short-term financial obligations, profitability of goods or services sold to consumers, use of financial assets to generate income and other information. The qualitative review uses personal judgment or inferences when making decisions based on the information.

Financial ratios provide a limited analysis of the company’s financial statements. These ratios calculate numerical indicators or percentage values based on the financial information contained in the statements. However, these indicators mean very little if not compared to competing business or industry standards. Business owners may find it difficult to compare their information with another company, which has similar business operations or financial obligations.

Business owners using qualitative analysis on financial statements may be limiting their reviews to the final output of financial information. While financial statements usually indicate how much profit the company has generated during a certain accounting period, financial statements typically do not provide enough information about the efficiency of business operations. Small businesses often can turn a profit even though too much money was spent on generating this income.

Business owners with a limited knowledge of accounting or financial analysis may be unable to properly analyze their operations. Business owners also may create financial statements that do not accurately reflect the company’s financial situation. Analyzing financial statements with incorrect information can misrepresent the owner’s understanding and decision-making process. Incorrect financial statements also misrepresent the company’s historical financial information, creating a difficult process for measuring business trends.

Qualified finance and professional accountants assist small businesses with setting up and analyzing financial statements. These professionals can also prepare business tax returns and help prevent major financial errors in recording and reporting business financial data. Additionally, business owners may seek their advice when making business decisions.

Business owners can employ two utilizations of financial statement analysis: quantitative and qualitative. Quantitative analysis involves using formulas or ratios to break down financial statements into indicators, which serve as benchmarks for comparing the company's performance to industry standards. Qualitative analysis relies on personal judgment or inferences to evaluate financial statement information. Both types of analysis help business owners make informed decisions about their operations.

Quantitative analysis features different financial ratios for analyzing financial statement information. Ratios include liquidity, asset turnover, financial leverage and profitability. Liquidity ratios indicate how well the business can meet short-term financial obligations. Asset turnover ratios provide information on the company’s ability to use assets when generating sales. Financial leverage ratios determine the long-term solvency of the business. Profitability ratios help business owners calculate the amount of profit from consumer goods or services.

Businesses perform qualitative analysis by examining multiple financial statements simultaneously, a process known as horizontal or trend analysis. In this approach, business owners compile a document that includes the financial statement for the current month along with those from several previous months. By reviewing individual accounts or line items, they can identify trends in areas such as sales, cost of goods sold or expenses, helping to uncover insights into company operations.

A computerized accounting system is valuable for financial statement analysis, with many affordable accounting software options available. These programs can be customized to capture a company’s financial data based on pre-set instructions. Additionally, computerized systems help minimize calculation errors that business owners might make when reviewing financial statements.

Misconceptions

Financial statement analysis is not always the best management tool for measuring a company’s performance. Although financial statement analysis may indicate positive performance indicators, other issues may exist in the company. Business owners also should review production output, employee productivity and other internal business functions to avoid a myopic business decision-making process.