Financial statement analysis is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis.
What are financial statements?
Financial statements are a formal record of the financial activities of an entity. They reveal critical information about the business activities and the state of affairs of a Company. Since, these statements are audited and filed by the Company with the Registrar of Companies, they are quite a reliable source of information. The statements reveal three basic details about the company:
- Financing Activities: From where is the Company getting funds to run its business and acquire assets.
- Investing Activities: Where and how is the Company utilizing the funds and in which assets and business lines they are invested in.
- Operating Activities: How efficiently and effectively is the Company using its resources. These activities also tell us about the performance of the Company. For example, sales turnover, profits, various running expenses etc.
The important financial statements used for analysis are:
- Balance Sheet: It gives a bird’s eye view of the state of affairs of the Company. It is a statement of sources of funds and the utilization of funds of the Company. It gives details of the assets, liabilities and shareholders’ equity of a company at a given point in time.
- Income Statement: It gives information on the operations of the Company like sales made during a year, expense incurred on various heads, interest cost, profits, taxes, etc. In brief, it summarizes the revenue, expenses and the profit or loss over a particular period of time, generally one financial year.
- Cash Flow Statement: It gives a detailed picture of inflow and outflow of funds in a Company. It provides clearly the sources from which the funds flowed into the Company and the activities that led to their outflow from the Company. It further categorizes funds outflow and inflow in financing, investing and operating activities.
- Statement of Shareholders’ Equity: It mentions the shareholders of a Company, shares and stake held by them and any changes occurring in the shareholding pattern during a period.
- Management Discussion and Analysis: It provides Management’s view on the business activities, past performance and future perspective of the Company. Depending on the quality of disclosure provided by the Management in this section, the information may vary from opportunities and threats faced by the Company to its future strategies, business lines, ongoing and upcoming projects etc.
In addition to the above, footnotes, supplementary schedules, auditor’s report and proxy statements also reveal critical information required for analysis.
Purpose of Financial Statement Analysis
As is clear from the above discussion, the purpose of financial statement analysis is to enable informed business decisions. However, as there are different parties involved in any business, the purpose to which they will put this analysis to use varies. This difference arises from the fact that their requirements are not the same. For example, a lender is concerned with the solvency of the company, i.e., its ability to pay back the obligations that are due; whereas, a shareholder would be concerned with the profitability of the company, i.e., the ability of the company to make sustained profits to result in appreciation of his investments.
The following segment would explain the purpose of the analysis for different parties involved in any business.
Who might be interested in Financial Statement Analysis?
- Management: Managers use financial statement analysis to take informed and improved financing, investing and operating decisions. Further, similar analysis can be done for competitors for various purposes such as bench markingthis analysis can be used to assess competitors and, thus, forms an integral part of the strategy formulation.
- Investors: Investors look for appreciation of their investments through the allocation of their funds among various available investment tools including company stocks. For this purpose they have to assess a company’s future earning potential to arrive at a Buy, Sell or Hold decision. This requires a thorough analysis of the financial statements.
- Lenders and Creditors: Lenders and creditors provide short term and long-term financing and bear the risk of default by the company. Hence, they require analysis of the creditworthiness of the companies which is done through financial statement analysis.
- Board of Directors: The Board of Directors is accountable to the shareholders for the performance of the company. The Board uses financial statement analysis to monitor, control and evaluate management decisions.
- Suppliers: The suppliers provide goods and services to the company, which may be provided on cash or credit basis. They use financial statement analysis of the Company to set the payment terms for them.
- Investment Advisers/ Fund Managers/ Portfolio Managers: Investment advisers manage portfolio for their clients and make Buy, Sell or Hold decisions based on the analysis of the financial statements.
- Investment Bankers: Investment bankers are responsible for Merger and Acquisition deals, carrying out Initial Public Offers, buying and selling financial products on behalf of their clients, etc. and use financial statements to gather, analyze and interpret the risk and returns associated, to determine company value, fund allocation, etc.
- Regulatory Bodies: The government generates its revenues from the taxes it collects. The audit and verification of the taxes received is done through the financial statements as well.
Having learnt about the purpose and users of financial statement analysis, the next question arises how to actually do it. In the articles to come, we will further elaborate on the areas of financial analysis and take a detailed look at the tools and techniques available for the same. These articles will include suitable and elaborate examples to enable the readers to get a practical experience of the financial analysis.
Author – Vishal, a recent addition to Team Tofler, combines his passion of writing with searching for a worthy story in a Company, to make an interesting read.
Editor – Anchal, founder at Tofler, is a CA, CS and has more than 5 years experience in company analysis. She likes to explore and track companies, their performance and senior management.