Wednesday, April 13, 2016




Financial statement analysis provides information to those interested in the financial condition and operating results of a company. When financial statement items are considered individually, they usually will have a limited significance. A better perspective is gained when comparisons are made with previous statements, other businesses and industry averages. The main purpose of conducting financial analysis is to measure profitability and solvency. A business which is not able to make interest payments will experience difficulty in obtaining credit. This could lead either to reduced profitability or bankruptcy. A company with lower than average earnings may also find credit harder and more expensive to obtain.

Most analytical measures are expressed as percentages or ratios. This allows easy comparison with other businesses regardless of size. Horizontal and vertical analyses express entire financial statements in percentages. The horizontal analysis is an analysis of the rate of change in items of financial statements form year to year. The vertical (or common size) analysis presents each item as a percentage of total assets for the balance sheet and sales for income statement. When using these analytical measures, one should take the following factors into consideration: 1) industry trends, 2) changes in price levels, and 3) future economic conditions.

A current position analysis is used to measure the ability of a firm to meet its current (and non-current) obligations. Three popular methods of analysis are: 1) determining working capital, 2) current ratio, and 3) quick ratio. The primary users of current position analysis are creditors. Working capital information is less meaningful than current or quick ratios. These ratios must be compared with other firms in the same industry to see if they are in line.

An accounts receivable analysis is used to measure a firm's solvency. The size and composition of accounts receivable is under continuous change, and therefore must be watched closely. Since funds tied up in accounts receivable yield no benefits or interest, it is best to keep this balance to a minimum. The quicker a firm is able to turn-over its accounts receivable, the lesser the risk of loss from uncollectible accounts. In addition, the firm has the option to put these funds into more productive uses.

Two commonly used methods to analyze accounts receivable are
1) accounts receivable turnover, and
2) number of days' sales in receivables (or days sales outstanding).
Both methods measure a firm's ability to generate sales and quickly collect its accounts receivable. A lower number of days' sales in receivables indicates a firm is collecting receivables quicker. Both of these measures must be compared with other firms in the same industry.

A business should maintain an adequate inventory balance to meet demands of its operations, but at the same time keep this balance to a minimum. When a firm has excess inventory, it will have higher operating expenses, reduced solvency, increased risks of losses due to price declines and obsolescence, and, in addition, it limits its chances to take advantage of more favorable investment opportunities. Two measures commonly used to assess inventory management efficiency are
1- inventory turnover ratios and
2- the number of days' sales in inventory.
These figures must be compared with industry averages to properly evaluate inventory management.

The following methods are commonly used to evaluate the safety of long-term creditors:
1) ratio of shareholders' equity to liabilities (debt-to-equity),
2) ratio of plant assets to long-term liabilities,
3) operating income divided by interest expense, as well as other payments (known as times-interest-earned or coverage ratios).
For all these methods of analysis, the higher the number, the greater the amount of safety. This information is used by investors, creditors, shareholders and management. It indicates the ability of a firm to meet its financial obligations.

Profitability analysis measures the ability to generate income. Common measures used are
1) profit margin: sales divided by net income,
2) total assets turnover: ratio of net sales to total assets,
3) return on assets: net income divided by total assets,
4) return on equity: net income divided by either shareholders' total equity or common stock only,
5) earnings per share of common stock,
6) dividends per share of common stock.
In addition, investors also use price-earnings ratio, and dividend yield. All these ratios are most useful to those interest in the future ability to prosper, that is the shareholders and other investors, as well as management.

Analytical measures are used to assess solvency and profitability. The type of analytical measure chosen usually is dependent on the following factors: 1) the size of the company, 2) its capital structure, and 3) the type of business activity. Analytical measures are useful for evaluating the financial results of a business and the performance of management. They are also used to predict future performance.

Corporate annual reports contain information that summarizes the activities of the past year, and the future plans of the company. No standard or required format exists. However, annual reports must by law provide accurate financial statements. Most annual reports contain the following sections:
1) financial highlights,
2) management report,
3) president's letter,
4) an independent auditors' opinion, and
5) historical data.

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