Financial Statement Analysis Explained Notes

Financial Statement Analysis Explained Notes

Organization obtains input from the environment, processes (value addition) it and then produces out someoutput back in environment. At each level some persons are interested about the organizations performance; they need to know about the organization and primary source for them is the financial statements produced by the organization.

Contents for Financial Statements

The coming pages describe in detail about

• Particular Information each user (employees, shareholders, lenders etc) of financial statements is interested in and how to extract that information from financial statements.
• Financial Statement Analysis Techniques
• Horizontal Analysis
• Vertical Analysis
• Ratio Analysis (the most commonly used analysis technique)
• Limitations / Weaknesses of Financial Statement Analysis

Step by step approach has been used so that even a person having very limited knowledge of financial accounting can understand and use this guidance in his real life. For the complete easy and understandable notes.

Financial Statement Analysis

Organization obtains input from the environment, processes (value addition) it and then produces out some

output back in environment. At each level some persons are interested about the organizations performance; they need to know about the organization and primary source for them is the financial statements produced by the organization. 

Extracting the particular information from financial statements requires the skills thus the knowledge of “Financial Statement Analysis” comes into play. In my opinion every person should have basic ideas of interpreting financial statements since everyone is in interaction with organizations either in the form of shareholder, lender of money to companies or (in the most obvious form of) being an employee.

Users of Financial Statements

Below diagram shows the key persons interacting with an organization at different levels (described in detail on coming pages).

Contents

The coming pages describe in detail about

• Particular Information each user (employees, shareholders, lenders etc) of financial statements is interested in and how to extract that information from financial statements.
• Financial Statement Analysis Techniques
• Horizontal Analysis
• Vertical Analysis
• Ratio Analysis (the most commonly used analysis technique)
• Limitations / Weaknesses of Financial Statement Analysis

Step by step approach has been used so that even a person having very limited knowledge of financial accounting can understand and use this guidance in his real life.

Financial Statement Users

Users require financial information for the purpose of DECISION MAKING. What decision is made and based

on what information such decision will be made, depends upon the type of users i.e. whether he is creditor, lender or shareholder and so on. Therefore let’s first define the list of users.

Users of financial statements may be identified in a variety of ways. However an easy to remember way of identifying such users of financial statement, in my opinion is, considering the “organization, a system”.

The concept of “organization, a system” comes from organizational studies according to which organization is considered as a system operating in environment. A system placed in an environment is taking input from the environment, processing it so that value is added in the form of output and then delivering this output in the environment.

Using this concept, users of financial statements and their particular needs can be identified at each level of system i.e. at input, process and output level. Such as:

Input (to the organization)

• Suppliers of raw materials
• Employees as suppliers of services
• Lenders as putting their money in organization

Process (by the organization for value addition on input)

• Management

Output (produced by the organization)

• Shareholders
• Lenders
• Government
• Society

Enlisted above are the most common users of financial statements. Besides these some other users might also be identified but they will fall under the broader category of input, output or process level. The coming pages define and explain in details the particular needs of financial statements users.

Users Needs for Information

Let’s see why these users (as enlisted on previous page) are eager to know about the organization they are

interacting with.

Input (to the organization)

Suppliers

If you are supplier, you might be supplying raw material or goods to an organization so that organization can process them and generate profits. You will normally supply on short term credit where company agrees to pay you after, perhaps, 10 day, 15 day, 1 month or 3 months. What will be your concern? Obviously you will be interested to know whether company will be able to pay the debt or not. 

Thus suppliers are particularly concerned about SHORT TERM LIQUIDATION of a company. They would like to know whether company will be able to meet its short term obligations or not. They will be interested in company’s current assets ability to meet current liabilities. If, from financial statements, the suppliers interpret that company will not be able to meet its short term obligations they will cease their business with the company on credit. 

Liquidity Ratios (explained on following pages) are, therefore, particular concern of suppliers.

Employees

If you are working for a company as an employee what will be your concerns? 
Logically the prime concern of yours might be JOB SECURITY. You would like to know the company’s financial health i.e. whether company will be going concern (prosperous) in future or not.

You might also be interested (and it is natural) about the PAY OR SALARY INCREEMENTS. If company is earning high profits you may expect bonuses and salary increments; if company is in losses you may have to stay on the same package of salary until the company starts earning profits or you decide to leave the company for better opportunity.  

Thus employees are interested to know the profitability and financial health of a company. Therefore, in financial statement analysis employees might be looking for profitability ratios (explained on following pages).

Lenders

Institutions (most commonly financial institutions) or persons lend the money to company so that company can use these funds to earn profits and in return, pay interest to those lenders as well as the principal amount being borrowed in accordance with the terms and conditions agreed between the company and lenders at the time of borrowing money. Normally such terms and conditions are long term i.e. for more than 1 year, perhaps, 2 years, 3 years, 5, 10 or may be longer than that.

Based on aforesaid think yourself as a lender to a company; what will be your prime concerns?

Obliviously you will be interested about the SAFETY OF MONEY you have given to the company i.e. does the company able to repay the principal amount borrowed by it, back or not? What is financial health of company?

Similarly you will also be interested to know the ability of the company to PAY INTEREST ON LOAN borrowed by it. Is the company generating enough “operating profits” to cover the interest to be paid on money borrowed? 

In short we may say that lenders are interested about the safety of money and payment of interest on such money forwarded as loan to the company. Therefore, among other things, they should particularly look forLong term solvency (liquidity) / financial leverage ratios (explained on following pages).

Process (of the organization)

Before reading this section I recommend to read 1.3- Output Users for understanding of thee external users’

needs of financial information. As already discussed users of financial information have been identified using the context of “Organization as a SYSTEM (for details refer 1- Financial Statement Users)”; therefore at process level the key user identified is Management.

Management

Management is responsible to receive input, process it and provide output. We know that both at input & output level, some users have expectations and for the same purpose input and output users are interpreting the financial statements. Thus it becomes extremely important for management to have knowledge of expectations of input & output level users and perform accordingly.

Output (from the organization) 

Shareholders

Shareholders can be categorized in:

1. Existing Shareholders who have already invested money in the shares of the company; and
2. Potential Shareholders who are deciding whether to invest or not in the shares of the company.
   

Existing shareholders have made investment in the company thus, logically; they will be interested in the profits earned by the company. The more the profits will be, the more these shareholders will have return on their investment in the form of dividends. 

Besides the profitability, shareholders are the authority who appoints management of the company. Thus they are interested to know the effectiveness and efficiency of management. 
PROFITIABLITY AND ASSETS UTILIZATION being the prime interest of existing shareholders might be based on Profitability and efficiency ratios (as explained on later pages).

On the other hand Potential Shareholders have to make crucial decision of whether to make investment in a particular company or not. They want to make invest in a company where they can earn maximum return for their investment as well as safeguard their investment. 

For potential shareholders, therefore, information about MARKET VALUE OF THE COMPANY becomes important as they have to know RETURN ON INVESTEMNT and FINANCIAL SOUNDNESS OF COMPANY. Market value ratios (as explained later) hence will be the topic attracting the attention of potential shareholders.

Lenders

As explained earlier, lenders are interested in securing the principal amount and interest on it; payable by the company on money borrowed from lenders. Thus lenders are interested in OPERATING PROFITS of the company. For details please refer the page: Input Users.

Government

TAX COLLECTION being the prime concern, profitability of companies might be checked by the government in order to determine the amount of tax payable by companies. Financial statements, as audited by the external auditors, are used by the tax authorities for this purpose.

Besides Profitability ratios, tax authorities might be interested in Horizontal Analysis to track the profits history of the company and assess tax accordingly.

Society

Society is normally interested in the ethical practices of the company. What is the form of business the company is taking? What are the human resource policies, the company is adopting? How the company is serving the community in which it is operating? And so on.

Primary source for obtaining all such information is Financial Statements published by the company. However, other information besides financial statements is also used.