Analyzing financial statements
After following the entire accounting cycle from the beginning of preparing journal transactions, posting it into ledger, and preparing the financial statements, the last section of preparing these financial statements is to analyze them.
The main purpose of analyzing the financial statements is to know the financial position of the business. It also evaluates company’s financial health, risks, performance, and future of a business. Even though you have a start-up, these statements will prove to be a guide for the business owner.
It definitely depends upon the business owner to choose methods of financial statement analysis from the most general to the most specific. It majorly depends upon the business size, if a business is publicly held, external parties such as investors will analyze the company’s financial statements to know about future investments.
Before understanding various methods of financial analysis, let’s understand the summary of what is a financial statement?
What is a financial statement?
A financial statement is a summary of all the financial information that gives us the performance of a business and financial position at the end of the specific year. There are three most important financial statements that are:
#1 Income or profit and loss statement:
It shows the business financial position in terms of revenues and expenses.
#2 Balance sheet:
It shows the business financial position in terms of assets and liabilities as well as owner’s equity.
#3 Cash flow statement:
Cash flow statement summarizes the cash inflows and outflows at a particular period of time.
So, these were the basic financial statements. Let’s explore the various types of financial statement analysis in detail:
Types of financial statement analysis
There are different varieties of analysis carried out according to the company’s preference. Some of them are explained below:
Basic financial ratio analysis
Financial ratios help the managers and investors compare the relationship between the firm’s financial accounts and financial figures. Given below are the most common and useful financial ratios:
#1 Liquidity ratio
It shows how the company’s current assets are converted into cash. It is used to pay the short-term liabilities.
The different liquidity ratios are:
Current ratio: It helps us to find the ability to pay off current liabilities
Formula: Current assets/ current liabilities
Quick ratio: It deducts the inventory from current assets to give more precise information of the ability to pay off current liabilities.
Formula: (Current assets – inventory)/ current liabilities
Cash ratio: It indicates the percentage of cash having for short-term debts.
Formula: (cash + marketable securities)/ current liabilities
#2 Efficiency ratios
These ratios will help you to understand how well your business uses its assets. The various efficiency ratios are:
Inventory turnover: indicates how frequently your stock is sold and restocked in a particular year.
Formula: Net sales/ average inventory at selling price
Accounts receivable turnover: indicates how often your accounts receivable are paid and collected.
Formula: Net credit sales/ average accounts receivable
Accounts payable turnover: indicates how quickly you pay off the money to your creditors.
Formula: Net purchases/ average accounts payable
Total asset turnover: indicates how smartly you use your company’s assets to generate revenue.
Formula: sales/ average total assets
#3 Solvency ratios
These ratios indicate the businesses’ ability to pay long-term debt obligations.
The various solvency ratios are:
Debt to equity: indicates the equity amount that can cover debts
Formula: total liabilities/ shareholder’s equity
Debt to asset: indicates the percentage of assets funded by debts
Formula: total debts/ total assets
#4 Coverage ratios
These ratios indicate the ability of businesses to service its debt.
The various coverage ratios are:
Interest coverage ratios: indicates the ability of a company to meet its interest charges on a debt
Formula: Earnings before interest and taxes (EBIT)/ Interest expenses
#5 Profitability ratios
These ratios measure whether a company is maximizing the shareholder’s wealth and generating profit.
The most common profitability ratios are:
Return on assets: indicates the return that assets are creating for a business.
Formula: Net income/ total assets
Return on equity: states whether the owner’s equity is being used to generate shareholder’s wealth.
Formula: Net income/ shareholder’s equity
These were some of the most commonly used financial ratios. However, there is plethora of various other financial ratios to compare and analyze the financial performance.
Trend analysis
Trend or time series analysis helps to analyze the financial performance by comparing multiple time periods and using the financial information available.
Trend analysis is performed using the business income statement and balance sheet. It helps to compare the company’s previous performance throughout various years with the current financial information.
It helps the financial manager to determine the positive and negative changes in the liquidity, solvency, efficiency, and profitability.
Industry analysis
Industry analysis, also known as cross-sectional or benchmarking analysis, compares the financial ratios with the sample of chosen companies who are in the same line of industry or business.
Here the time periods are matched and industry average ratios are compared which are publicly available. It helps the financial manager to understand whether the company is moving in the right direction or not.
Horizontal analysis
Horizontal analysis compares the financial position with multiple time periods. It allows you to spot trends and indicates where your business or company is performing well and where any red flags might create problems. Horizontal analysis is done in three different methods:
- Direct comparison
- Percentage method
- Variance method
Vertical analysis
It is comparatively easier to analyze through vertical analysis than horizontal analysis. It deals with a basic one-year period and compares the company’s balance sheet and basic sized income statements. For income statement, it provides to compare from the cost of goods sold scenario. Here the assets and sales are considered to be 100%.
Wrapping up
It is important to analyze the financial statements because it provides you the visibility of your company’s financial position and go according with the trends. In case if you find any flaws regarding the financial performance you can make changes in order to steer your business towards profitability and efficiency.
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