Financial Statements: Conclusion

Financial analysis determines a company’s health and stability, providing an understanding

of how the company conducts its business. But it is important to know that financial
statement analysis has its limitations as well. Different accounting methods adopted by
different firms’ changes the visible health and profit levels for either better or worse.
Different analysts may get different results from the same information. Hence, we must
conclude that financial statement analysis is only one of the tools (although a major one)
while taking an investment decision.

All three accounting statements are important for understanding and analyzing a
company’s performance from multiple angles. The income statement provides deep insight
into the core operating activities that generate earnings for the firm. The balance sheet and
cash flow statement, however, focus more on the capital management of the firm in terms
of both assets and structure.

Overall, top performing companies will achieve high marks in operating efficiency, asset
management, and capital structuring. Management is responsible for overseeing these
three levers in a way that serves the best interest of the shareholders, and the
interconnected reporting of these levers is what makes financial statement reporting so
important.

The main purpose of this study is to determine, forecast and evaluate the best of economic
conditions and company’s performance in the future. The other purpose of this study is to
analyze the financial statement and than give information for financial managers to make
through decisions about their business. The financial statement applies tools, analytical
techniques and required methods for business analysis. It is a diagnostic tool for evaluating
financing activities, investment activities and operational activities as well as an
assessment tool for management decisions and other business decisions. The analysis of
financial statements, respectively the analysis of the financial reports are used by
managers, shareholders, investors and all other interested parties regarding the company's
state. Managers use financial reports to see the situation in which the company stands and
then provide information to shareholders, to see how reasonable are the investments made
in the company. To potential investors, the analysis of the financial statements of the
company is very important, because, first they want to know the actual state of the
company and then decide whether to invest or not.

Judging The Earning Capacity

On the basis of the nancial analysis, the earning capacity of the business concern may be
computed. In addition to this, the future earning capacity of the concern may also be
forecasted. All the external users of accounts, specially the investors and potential
investors are interested in this.
Judging The Managerial Eciency
The nancial statement analysis helps to pinpoint the areas where in the managers have
shown better eciency and the areas of ineciency. For example, using nancial ratios, it is
possible to analyze relative proportion of production, administrative and marketing
expenses.
Any favorable or unfavorable variations can be identied and reasons thereof can be
ascertained to pinpoint managerial eciency and deciency Judging The Short-term & Long-
term Eciency Of The Enterprise On the basis of nancial analysis, long-term as well as short-
term solvency of the concern may be judged.
Creditors or suppliers are interested to know the short-term solvency/liquidity of the
concern i.e. ability to meet short-term liabilities. Debenture holders and lenders judge the
ability of the company to pay the principal amount and interest on the basis of nancial
analysis

Inter-Firm Comparison
Inter-rm comparison becomes easy with the help of nancial analysis. It helps in assessing
own performance as well as that of others, if merges and acquisitions are to be considered.
Making Forecasts & Preparing Budgets. Past nancial statement analysis helps a great deal
in assessing developments in the future, especially the next year. For example, given a
certain investment, it may be possible to forecast the next year’s prot on the basis of
earning capacity shown in the past. Analysis thus helps in preparing the budgets.

Understandable
Financial analysis helps the users of the nancial statements to understand the complicated
matter in simplied manner. Dierent date can be made more attractive by charts and
diagrams which can be easily understood Uses of Financial Statement

Security Analysis
It is a process by which the investor comes to know whether the rm is fullling hi
expectation with regard to payment of dividend, capital appreciation and security of
money. Such analysis is done by a security analyst who is interested in cashgenerating
ability, dividend payout policy and the behavior of share prices

Credit Analysis
Such analysis is useful when a rm oers credit to a new customer or a dealer. The manager
of the rm would like to know whether to extend credit to them or not. Such analysis is also
useful for a bank before granting loan to the public.

Debt Analysis
Such analysis is done by the rm to know the borrowing capacity of a prospective borrower.

Dividend Decision
Financial analysis helps the rm in deciding about the rate of dividend. Management would
have to decide about how much portion of earnings to distribute and how much to retain.
Such decisions indicate the protability of the rm and hence to some extent aect the
behavior of share prices

General Business Analysis

Financial analysis can be used to identify the prot drivers and business risks in order to
assess the prot potential of the rm. It helps in the future growth scenarios of the rm
Limitations Of Financial Statement

Historical Analysis
Financial statement analysis is a historical analysis. It analysis what has happened till date.
It does not reect the future. Person like shareholders, investors, etc are more interested in
knowing the likely position in the future.

Ignore Price Level Changes

Price level changes and purchasing power of money are inversely related. A change in the
price level makes analysis of nancial statements of dierent accounting years invalid
because accounting records ignore change in the value of money

Qualitative Aspects Ignored

Since the nancial statements are conned to the monetary matters alone, the qualitative
aspects like the quality of management, quality of labor force, public relations are ignored
while carrying out the analysis of nancial statement

Not Free From Bias

In many situations, the accountant has to make a choice out of alternative available, e.g.
choice in the method of inventory valuation or choice in the method of depreciation. Since
the subjectively is inherent in personal judgment, the nancial statements are, therefore, not
free from bias

Variation In Account Practices

For inter-rm comparison, it is necessary that accounting practices followed by the rms
don’t vary signicantly. As there may be variations in accounting practices followed by
dierent rms, a meaningful comparison of their nancial statements is not possible

Let the Business Model Shape Your Focus Areas

The average 10-K annual report is stuffed with dozens of dense footnotes and adjusted
numbers offered as alternatives to the recognized numbers contained in the body of the
income statement and balance sheet. For example, companies often disclose six or eight
versions of earnings per share, such as the "as reported," "adjusted," and "pro forma"
versions for both basic and diluted EPS. But the average individual investor probably does
not have the time to fully assimilate these documents.

Therefore, it may be wise to first look at industry dynamics and the corresponding
company business model and let these guide your investigation. While all investors care
about generic figures, such as revenue and EPS, each industry tends to emphasize certain
metrics. And these metrics often lead or foreshadow the generic performance results.

The table below illustrates this idea by showing some of the focus areas of a few specific
industries. For each industry, please keep in mind that the list of focus areas is only a
"starter set"--it is hardly exhaustive. Also, in a few cases, the table gives key factors not
found in the financial statements in order to highlight their shortcomings:

You can analyze balance sheet numbers through a series of ratio tests to draw conclusions,
check your cash status, and track your debt. Because these are the types of tests financial
institutions and potential investors use to determine whether or not to loan money to or
invest in your company, it’s a good idea to run these tests yourself before seeking loans or
investors.

Testing your cash

When you approach a bank or other financial institution for a loan, you can expect the
lender to use one of two ratios to test your cash flow: the current ratio and the acid test
ratio (also known as the quick ratio).

Current ratio

This ratio compares your current assets to your current liabilities. It provides a quick
glimpse of your company’s ability to pay its bills.

The formula for calculating the current ratio is:

Current assets ÷ Current liabilities = Current ratio

The following is an example of a current ratio calculation:

$5,200 ÷ $2,200 = 2.36 (current ratio)

Lenders usually look for current ratios of 1.2 to 2, so any financial institution would
consider a current ratio of 2.36 a good sign. A current ratio under 1 is considered a danger
sign because it indicates the company doesn’t have enough cash to pay its current bills.

Acid test (quick) ratio

The acid test ratio only uses the financial figures in your company’s Cash account, Accounts
Receivable, and Marketable Securities. Although it’s similar to the current ratio in that it
 examines current assets and liabilities, the acid test ratio is a stricter test of a company’s
ability to pay bills.

The assets part of this calculation doesn’t take inventory into account because it can’t
always be converted to cash as quickly as other current assets and because, in a slow
market, selling your inventory may take a while.

Calculating the acid test ratio is a two-step process:

1. Determine your quick assets.

Cash + Accounts Receivable + Marketable Securities = Quick assets
2. Calculate your quick ratio.
Quick assets ÷ Current liabilities = Quick ratio

The following is an example of an acid test ratio calculation:

$2,000 + $1,000 + $1,000 = $4,000 (quick assets)

$4,000 ÷ $2,200 = 1.8 (acid test ratio)
Lenders consider a company with an acid test ratio around 1 to be in good condition. An
acid test ratio less than 1 indicates that the company may have to sell some of its
marketable securities or take on additional debt until it’s able to sell more of its inventory.

Assessing your debt

Before you even consider whether or not to take on additional debt, you should always
check out your debt condition. One common ratio that you can use to assess your
company’s debt position is the debt to equity ratio. This ratio compares what your business
owes to what your business owns.

Calculating your debt to equity ratio is a two-step process:

1. Calculate your total debt.

Current liabilities + Long-term liabilities = Total debt
2. Calculate your debt to equity ratio.
Total debt ÷ Equity = Debt to equity ratio

The following is an example of a debt to equity ratio calculation:

$2,200 + $29,150 = $31,350 (total debt)
$31,350 ÷ $9,500 = 3.3 (debt to equity ratio)
Lenders like to see a debt to equity ratio close to 1 because it indicates that the amount of
debt is equal to the amount of equity. With a debt to equity ratio of 3.3, most banks
probably would not loan the company in this example any more money until either its debt
levels were lowered or the owners put more money into the company.

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