Analysis and Interpretation of Financial Statements

Read this chapter, which discusses how to analyze financial statements and demonstrates the use of ratios and the horizontal and vertical analysis tools that everyone from creditors to investors, vendors, and top management use when they want to identify the strengths and weaknesses in an organization. Analysis tools can help you compare companies of different sizes, companies in different industries, and the same company over time.

Objectives of financial statement analysis

Management's analysis of financial statements primarily relates to parts of the company. Using this approach, management can plan, evaluate, and control operations within the company. Management obtains any information it wants about the company's operations by requesting special-purpose reports. It uses this information to make difficult decisions, such as which employees to lay off and when to expand operations. Our primary focus in this chapter, however, is not on the special reports accountants prepare for management. Rather, it is on the information needs of persons outside the firm.

Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general purpose financial statements that companies publish. These statements include a balance sheet, an income statement, a statement of stockholders' equity, a statement of cash flows, and the explanatory notes that accompany the financial statements.

Users of financial statements need to pay particular attention to the explanatory notes, or the financial review, provided by management in annual reports. This integral part of the annual report provides insight into the scope of the business, the results of operations, liquidity and capital resources, new accounting standards, and geographic area data. Moreover, this section provides an economic outlook that an analyst may find very helpful when considering the possible future profitability of the company.

Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company's past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users of financial statements.

Present and potential investors are interested in the future ability of a company to earn profits - its profitability. These investors wish to predict future dividends and changes in the market price of the company's common stock. Since both dividends and price changes are likely to be influenced by earnings, investors may predict earnings. The company's past earnings record is the logical starting point in predicting future earnings.

Some outside parties, such as creditors, are more interested in predicting a company's solvency than its profitability. The liquidity of the company affects its short-term solvency. The company's liquidity is its state of possessing liquid assets, such as cash and other assets easily converted to cash. Because companies must pay short-term debts soon, liquid assets must be available for their payment. For example, a bank asked to extend a 90-day loan to a company would want to know the company's projected short-term liquidity. Of course, the company's predicted ability to repay the 90-day loan is likely to be based at least partially on its past ability to pay off debts.

Long-term creditors are interested in a company's long-term solvency, which is usually determined by the relationship of a company's assets to its liabilities. Generally, we consider a company to be solvent when its assets exceed its liabilities so that the company has a positive stockholders' equity. The larger the assets are in relation to the liabilities, the greater the long-term solvency of the company. Thus, the company's assets could shrink significantly before its liabilities would exceed its assets and destroy the company's solvency.

Investors perform several types of analyses on a company's financial statements. All of these analyses rely on comparisons or relationships of data that enhance the utility or practical value of accounting information. For example, knowing that a company's net income last year was USD 100,000 may or may not, by itself, be useful information. Some usefulness is added when we know that the prior year's net income was USD 25,000. And even more useful information is gained if we know the amounts of sales and assets of the company. Such comparisons or relationships may be expressed as:

  • Absolute increases and decreases for an item from one period to the next.
  • Percentage increases and decreases for an item from one period to the next.
  • Percentages of single items to an aggregate total.
  • Trend percentages.
  • Ratios.

Earlier chapters have discussed and illustrated many of these analysis techniques. However, in this chapter, we apply all of these techniques in analyzing Synotech, Inc.'s performance. This was the company introduced in Chapter 16.

Items 1 and 2 make use of comparative financial statements. Comparative financial statements present the same company's financial statements for one or two successive periods in side-by-side columns. The calculation of dollar changes or percentage changes in the statement items or totals is horizontal analysis. This analysis detects changes in a company's performance and highlights trends.

Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical analysis (item 3) consists of the study of a single financial statement in which each item is expressed as a percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales.

Financial statements that show only percentages and no absolute dollar amounts are common-size statements. All percentage figures in a common-size balance sheet are percentages of total assets while all the items in a common-size income statement are percentages of net sales. The use of common-size statements facilitates vertical analysis of a company's financial statements.

Trend percentages (item 4) are similar to horizontal analysis except that comparisons are made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time.

Ratios (item 5) are expressions of logical relationships between items in the financial statements of a single period. Analysts can compute many ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g. balance sheet and income statement). The only limiting factor in choosing ratios is the requirement that the items used to construct a ratio have a logical relationship to one another.