Question

Why does the management of any companies analyze financial statements? Explain by using the different tools in analyzing financial statement with proper numerical example. (This Q. is already listed but I need new answer)

Answer 1

Financial istatement ianalysis iis ithe iprocess iof ianalyzing ia icompany's ifinancial istatements ifor idecision-making ipurposes. iExternal istakeholders iuse iit ito iunderstand ithe ioverall ihealth iof ian iorganization ias iwell ias ito ievaluate ifinancial iperformance iand ibusiness ivalue. iInternal iconstituents iuse iit ias ia imonitoring itool ifor imanaging ithe ifinances.

The ifinancial istatements iof ia icompany irecord iimportant ifinancial idata ion ievery iaspect iof ia ibusiness’s iactivities. iAs isuch ithey ican ibe ievaluated ion ithe ibasis iof ipast, icurrent, iand iprojected iperformance.

In igeneral, ifinancial istatements iare icentered ion igenerally iaccepted iaccounting iprinciples i(GAAP) iin ithe iU.S. iThese iprinciples irequire ia icompany ito icreate iand imaintain ithree imain ifinancial istatements: ithe ibalance isheet, ithe iincome istatement, iand ithe icash iflow istatement. iPublic icompanies ihave istricter istandards ifor ifinancial istatement ireporting. iPublic icompanies imust ifollow iGAAP istandards iwhich irequire iaccrual iaccounting. iPrivate icompanies ihave igreater iflexibility iin itheir ifinancial istatement ipreparation iand ialso ihave ithe ioption ito iuse ieither iaccrual ior icash iaccounting.

All ipublicly itraded icompanies iand ilarge iprivate ientities iprepare ifinancial istatements iperiodically. iThe ipurpose iof icreating ifinancial istatements iis ito icapture ia icompany’s ifinancial iposition ifor ia igiven iperiod. iThis iallows iusers iof ifinancial iinformation ito ianalyze iand icompare ithe ihealth iof ione icompany ito ianother. iFinancial istatements iprovide iassessment iof ia icompany’s iprofitability, iliquidity iand ioperational iefficiency. iAs ia iresult, ithere iare ia inumber iof ireasons iwhy imanagers ianalyze ifinancial istatements.

1. Company iPerformance

The igreater ithe inumber iof itransactions ia icompany imakes, ithe iharder iit iis ifor ithe icompany ito igauge iits iperformance iat iany igiven imoment. iFinancial istatement ipreparation iforces ia icompany ito iclose ithe ibooks iand irecord ithe icompany’s iactual ifinancial iposition ion ia iregular ibasis. iThus ifinancial istatements ican ibe ias ivaluable iinternally ias ithey iare iexternally. iManagers iuse ithese ibooked ifigures ito imonitor imeasurements ilike idebt ileverage, icosts, isales, iassets iand iliabilities. iFinancial istatements ihelp imanagers iassess iachievement iof ifinancial igoals.

2. Strategy iand iBenchmarking

Managers ianalyze icompetitors' ifinancial istatements iand icompare ithem ito iinternal ifinances. iThis iis iuseful iin ideveloping itactical ioptions iand istrategies. iBenchmarking ifinancial iperformance irelative ito ithe imarket icompetition iallows ileaders ito iidentify iareas iof icompetence ior iweakness. iIt ialso iaids iin iinvestment, ifinancing iand ioperational idecision-making.

3. Investment iOpportunities

Companies iengaged iin imergers iand iacquisitions ianalyze ifinancial istatements ito ihelp idetermine ia iprospective iinvestment’s ivalue. iFor iexample, ibook ivalue iis icalculated iusing iinformation iin ifinancial istatements. iAlso iuseful iin ivaluation iare ihistorical icash iflows iand iprofit, iwhich ican ithen ibe iused ito iestimate ifor ifuture iyears. iCompanies ialso iinvest iin istock ito iearn iinterest ion iunused icash. iFinancial istatements ican ibe iused ito ihelp iidentify iundervalued icompanies.

4. Credit iRisk iManagement

Lenders iproviding iloan ior itrade icredit iwill iperform idue idiligence ion ithe icreditworthiness iof itheir icustomers. iThis iusually ientails ia ireview iand ianalysis iof ifinancial istatements. iBanks iand ifinancial iinstitutions ievaluate ifinancial istatements ito iapprove iloans. iThese iloans imay iinclude iratio icovenants ibased ion iannual istatements ias ia icondition ito ithe iloan iagreement. iLarge icompanies ihave icredit idepartments ithat iutilize ifinancial istatement ianalysis ito imanage ithe irisk iassociated iwith iunsecured ilending.

i i i i i i i i i i i i i i i i i i i i iIt ibehooves iinvestors ito itake iadvantage iof ithe iwealth iof iinformation iprovided iin ia icompany's ifinancial istatements ito ihelp ithem ievaluate ithe icompany ias ia ipotential iinvestment. iIn iterms iof ioverall iprofitability, ithe inet iincome iis ithe iobvious istarting ipoint iwhen ianalyzing ia ifinancial istatement. iThis ibottom-line idollar iamount ion ia icompany's iincome istatement iis ian iexcellent iindicator iof iprofitability ibecause iit iputs ia ivalue ion ithe iamount ia icompany itakes iin, ionce iall icosts iof iproduction, idepreciation, itax, iinterest iand iother iexpenses ihave ibeen ideducted. iHowever, inet iincome ishouldn’t ibe iused iexclusively iwhen ievaluating ia icompany.

Operating iProfit iMargin

The ioperating iprofit imargin iis ianother iimportant iindicator iof iprofitability iand iefficiency ithat icompares ithe iamount ia icompany iearns ibefore iinterest, iand itaxes ion isales iare icalculated. iThe imargin ihelps ianalysts iand ipotential iinvestors igauge ihow isuccessful icompany imanagers iare iat icontrolling iexpenses iand igenerating irevenue. iA ihigh ioperating iprofit imargin istrongly iindicates ithat ia icompany iis ishrewdly imanaging icosts iand igenerating isales.

Assessing iStock iPrice iand iProfitability ifor iShareholders

Financial istatements ican ibe iused ito iassess ithe icompany's istock iprice iand iprofitability ifor ishareholders. iA ivariety iof imetrics iare iuseful iin ithis iprocess. iEarnings iper ishare i(EPS) iare ian iindicator iof ireturn ion iinvestment, ishowing ia icompany's iper-share iprofitability. iThe iprice-earnings i(P/E) iratio iuses ia istock's iEPS, icompared ito iits ipresent ishare iprice, ifor ievaluation ipurposes. iThe iprice ito ibook i(P/B) iratio iis iconsidered ia ifoundational ivalue imetric ifor iinvestors, ias iit ireveals ithe imarket's ivaluation iof ithe icompany iin irelation ito iits iintrinsic ivalue.

Dividend iPayout iRatio

The idividend ipayout iratio iis ianother iuseful imetric ithat imeasures ia icompany's igrowth, ifinancial istability, iand ireturns ipaid ito istockholders. iThe idividend ipayout iratio icalculates ithe ipercentage iof icompany iearnings ipaid iout ito iequity iinvestors, iin ithe iform iof idividends. iThe ihigher ithe iratio ivalue, ithe imore ireliable ia icompany’s iearnings ican isustain idividend ipayouts, iand ithe imore istable ia icompany iis iconsidered ito ibe. iRetained iearnings, ithe inumber iof iprofits inot ipaid iout ito ishareholders ias idividends, ishows iwhat iportion iof iprofits ia icompany iis ireinvesting iin iexpanding iits ibusiness.

Assets iand iLiabilities

The ibreakdown iof iassets iand iliabilities icontained ion ia icompany's ibalance isheet iprovides iinvestors iwith ia ireliable isnapshot iof ithe icompany's ioverall ifinancial ihealth, ias iwell ias iits idebt isituation. iDebt iratios, isuch ias ithe icurrent iratio, iwhich ican ibe icalculated ifrom ithe iinformation iprovided iin ifinancial istatements, ilet ianalysts iassess ia icompany's iability ito ihandle ioutstanding idebt. iMajor icapital iexpenditures ican ibe iused iin ievaluating ia icompany's icurrent ifinancial icondition iand ican itelegraph ithe ipotential ifor igrowth.

Tools iof iFinancial iAnalysis

Financial istatements iare iprepared ito ihave icomplete iinformation iregarding iassets, iliabilities, iequity, ireserves, iexpenses iand iprofit iand iloss iof ian ienterprise. iTo ianalyze i& iinterpret ithe ifinancial istatements, icommonly iused itools iare icomparative istatements, icommon isize istatements ietc.

1. Comparative iStatements

Also iknown ias i‘horizontal ianalysis, iare ifinancial istatements ishowing ifinancial iposition i& iprofitability iat idifferent iperiods iof itime. iThese istatements igive ian iidea iof ithe ienterprise ifinancial iposition iof itwo ior imore iperiods. iComparison iof ifinancial istatements iis ipossible ionly iwhen isame iaccounting iprinciples iare iused iin ipreparing ithese istatements.

Comparative iBalance iSheet

The iprogress iof ithe icompany ican ibe iseen iby iobserving ithe idifferent iassets iand iliabilities iof ithe ifirm ion idifferent idates ito imake ithe icomparison iof ibalances ifrom ione idate ito ianother. iTo iunderstand ithe icomparative ibalance isheet, iit imust ihave itwo icolumns ifor ithe idata iof ioriginal ibalance isheets. iA ithird icolumn iis iused ito ishow iincreases/decrease iin ifigures. iThe ifourth icolumn igives ipercentages iof iincreases ior idecreases.

By icomparing ithe ibalance isheets iof idifferent idates, ione ican iobserve ithe ifollowing iaspects

a. Current ifinancial iposition iand iLiquidity iposition

b. Long-term ifinancial iposition

c. Profitability iof ithe iconcern

Comparative iIncome iStatement

Traditionally iknown ias itrading iand iprofit iand iloss iA/c. iNet isales, icost iof igoods isold, iselling iexpenses, ioffice iexpenses ietc. iare iimportant icomponents iof ian iincome istatement. iTo icompare ithe iprofitability, iparticulars iof iprofit i& iloss iare icompared iwith ithe icorresponding ifigures iof iprevious iyears iindividually. iTo ianalyze ithe iprofitability iof ithe ibusiness, ithe ichanges iin imoney ivalue iand ipercentage iis idetermined.

By icomparing ithe iprofits iof idifferent idates, ione ican iobserve ithe ifollowing iaspects:

a. The iincrease/decrease iin igross iprofit.

b. The istudy iof ioperational iprofits.

c. The iincrease ior idecrease iin inet iprofit

d. Study iof ithe ioverall iprofitability iof ithe ibusiness.

2. Common iSize iStatements

Common isize istatements iare ialso iknown ias i‘Vertical ianalysis’. iFinancial istatements, iwhen iread iwith iabsolute ifigures, ican ibe imisleading. iTherefore, ia ivertical ianalysis iof ifinancial iinformation iis idone iby iconsidering ithe ipercentage iform. iThe ibalance isheet iitems iare icompared:

a. To ithe itotal iassets iin iterms iof ipercentage iby itaking ithe itotal iassets ias i100.

b. To ithe itotal iliabilities iin iterms iof ipercentage iby itaking ithe itotal iliabilities ias i100.

Therefore ithe iwhole iBalance iSheet iis iconverted iinto ipercentage iform. iAnd isuch iconverted iBalance iSheet iis iknown ias iCommon-Size iBalance iSheet. iSimilarly iprofit i& iloss iitems iare icompared:

a. To ithe itotal iincomes iin iterms iof ipercentage iby itaking ithe itotal iincomes ias i100.

b. To ithe itotal iexpenses iin iterms iof ipercentage iby itaking ithe itotal iexpenses ias i100.

Therefore ithe iwhole iProfit i& iloss iaccount iis iconverted iinto ipercentage iform. iAnd isuch iconverted iprofit i& iloss iaccount iis iknown ias iCommon-Size iProfit i& iLoss iaccount. iAs ithe inumbers iare ibrought ito ia icommon ibase, ithe ipercentage ican ibe ieasily icompared iwith ithe iresults iof icorresponding ipercentages iof ithe iprevious iyear ior iof isome iother ifirms.

3. iTrend iAnalysis

Also iknown ias ithe iPyramid iMethod. iStudying ithe ioperational iresults iand ifinancial iposition iover ia iseries iof iyears iis itrend ianalysis. iCalculations iof iratios iof idifferent iitems ifor ivarious iperiods iis idone i& ithen icompared iunder ithis ianalysis. iWhether ithe ienterprise iis itrending iupward ior ibackward, ithe ianalysis iof ithe iratios iover ia iperiod iof iyears iis idone. iBy iobserving ithis ianalysis, ithe isign iof igood ior ipoor imanagement iis idetected.

4. Ratio iAnalysis

Quantitative ianalysis iof iinformation icontained iin ia icompany’s ifinancial istatements iis iratio ianalysis. iIt idescribes i