Unit 2: Financial Statements and Financial Analysis


2a. Use income statements, balance sheets, and cash flow statements to inform decision-making

  • Where do firms record their financial transactions?
  • How do firms report and track their activities to others?
  • What is the purpose of financial statements?
  • How are financial statements used to analyze a firm's operations and performance?

Firms keep official records of their operating activities, cash flows, and assets for tax purposes, general bookkeeping, regulatory reporting requirements, historical records, and information transparency to investors and other interested parties. These official records, which come in multiple types, are collectively called financial statements. The reporting requirements can differ based on company size, firm organizational structure, and whether or not a firm is publicly or privately owned. The three most common financial statements are the balance sheet, the income statement, and the statement of cash flows. These statements are produced at least yearly and contain key firm accounts and activities. The statements stand individually but are also connected because they either share the same information or provide information that informs the creation of one of the other statements. The purpose of financial statements is to allow businesses to understand their financial standing.

The balance sheet is the first statement created. It gives a portrait of the company's financial position at one point in time, which is most commonly at the end of the firm's calendar year. It shows the relationship between a firm's assets (what it owns) and its liabilities (debts and obligations that the company owes to external parties) and owners' equity (who has a claim on what the firm owns). The accounts on the balance sheet are grouped by whether they are assets, liabilities, or owner's equity. Within those categories, accounts are further separated by whether they are current (due or used within a year or less) or long-term (due or used in a period of greater than 12 months). The balance sheet is governed by the equation: assets = liabilities + owner's equity. For the statement to be correct, the sum of all assets must always equal the sum of liabilities and owners' equity. This maintains the balance.

The income statement shows how the company has created and allocated its income over the year. The major source of a firm's income is called sales revenue. Therefore, the income statement's equation is Sales – Expenses = Net Income. The income statement is connected to the balance sheet because some balance sheet accounts, especially those considered "current", are reflected as expenses on the income statement. Net income (the total profit remaining after all expenses, taxes, and costs have been subtracted from total revenue) is found at the bottom of the income statement. With net income, a firm can reinvest it in the company by putting it into the retained earnings account, or it can pay dividends. The retained earnings account is listed on the balance sheet. A firm's tax liability and depreciation are also on the income statement.

The statement of cash flows depicts the annual inflow and outflow of cash within the firm. It separates the firm's cash-generating activities into three categories: operating activities, investing activities, and financing activities.

Review

To review, see:


2b. Calculate major financial ratios to evaluate a company's performance

  • How are financial statements used to analyze a firm's operations and performance?
  • How do firms compare their performance across time and with their peers?
  • What are the categories of financial ratios?

Financial statements provide a comparison of the firm's financial activities over time. Financial ratios are another tool that helps managers evaluate a firm's performance. Financial ratios are a unique evaluation tool because they allow for comparing a firm's performance against its peers and against industry averages, not only against its own performance.

Financial ratios are percentages created by using various accounts on the financial statements. Five categories of performance are measured by financial ratios: liquidity or solvency, asset efficiency or turnover, profitability, financial leverage or debt, and market value. Comparisons across companies and within an industry can be made based on a specific ratio, a category of ratios, or over time. Ratio analysis is a multidimensional analysis technique that facilitates benchmarking and trend analysis. Firms also compare their performance across time and with their peers using trend analysis and common-size analysis. These tools help managers, investors, and analysts assess a company's financial health, efficiency, and competitiveness.

Review

To review, see:


2c. Use pro forma financial statements to evaluate a company's future performance

  • What would a firm use to plan operations for the future?
  • How can firms use historical performance to predict future performance?
  • How do pro forma financial statements differ from standard financial statements?

While important for assessing performance, a firm's financial statements are backward-looking. There is a lag between when activities occur and when the reports are created. Financial statements provide information about transactions and activities that have already happened at the firm. While analysis can be conducted from existing financial statements, there are times when it's necessary to have a forward-looking perspective about the firm's activities. Therefore, financial statements are forecasted into the future, using assumptions to create pro forma financial statements. Business managers can create a pro forma balance sheet, a pro forma income statement, and a pro forma cash budget.

Pro forma financial statement analysis is useful when assessing the firm's future state under assumed circumstances or an anticipated change in market conditions. Pro forma financial statements are also used as a valuation method for a firm. Many firms undergoing potential sale, acquisition, merger, or buyout activities will use pro forma financial statements to estimate the firm's future worth. The assumptions used in building pro forma statements can come from market averages and benchmark metrics or the company's past performance as exhibited in its financial statements.

To create a pro forma statement, the firm or an analyst can use the most recent financial statement as a starting point, change assumptions for the percentage growth of each category on the financial statements, and then calculate that multiple against the current values on the financial statement used as a base. The resulting figure will be what is placed on the pro forma statement. Applying the multiple can be done for one period or many periods. The percentages applied can also be changed each iteration of creating a new statement. The result would be creating a pro forma statement that, using certain assumptions, gives an idea of the company's future financial condition.

Review

To review, see:


2d. Interpret a company's financial statements

  • How do you use ratio analysis, pro forma statements, and industry information to judge a company's financial health?
  • Why are trend analysis and competitor comparisons important when judging a firm's financial health?
  • How do financial statements help in assessing a company's risk and return potential?

When analyzing a firm's financial health, analysts utilize all the tools of ratio analysis, pro forma statement analysis, and industry comparisons to judge a firm's financial health. After calculating all the appropriate financial ratios, the analyst will utilize databases and competitor information to find industry averages to compare against.

An overall picture of a company's financial health can be reached by looking at the performance versus these benchmarks (standard reference points or comparison metrics, such as industry averages, competitor performance, or historical company data, used to evaluate and measure a company's financial performance) for each ratio category. The analyst must also analyze the trends for the company being reviewed over time and compare those to the benchmarks over time. A detailed assessment of financial health can be made by looking at a trend analysis and a comparison to competitors in the industry.

It is important to remember that analyzing a company's financial statements leads to questions the investor discovers about its operations. Economic or extenuating factors may sometimes explain poor financial comparisons, and investors might want to see strategic plans to make changes. Conducting modeling is important, as various scenarios must be examined to judge potential future results.

In summary, financial statements allow stakeholders to assess return through evaluating profitability and efficiency; assessing risk by measuring liquidity, solvency, and stability. This will enable them to make informed investment, lending, or strategic decisions.

Review

To review, see:


Unit 2 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • asset
  • balance sheet
  • benchmark
  • financial ratio
  • financial statement
  • income statement
  • liability
  • net income
  • owners' equity
  • pro forma financial statement
  • ratio analysis
  • statement of cash flows
Back to 'Study Guide\'