Question

What is Financial Statement analysis? Why is it so important What are six steps of Financial statement analysis? Please describe each step with some examples

Answer 1

Analyzing a company's financial statement for decision making process is called financial statement analysis.It can be referred to as the process of understanding the risk and profitability of a company by analyzing reported financial information ,especially annual and quarterly reports.The financial statement of a company record financial data centered around generally accepted accounting principles (GAAP) in U.S.These principles requires a company to create and maintain three main financial statements,the balance sheet, the income statement, and the cash flow statement.Financial statement analysis is the study about the accounting ratios among various items included in the balance sheet.The ratios such as assest utilization ratios,profitability ratios,leverage ratios,liquidity ratios and valuation ratios helps in analyzing the financial statements and is method for determining the past,current, and prospective performance of the companies.There are three important techniques of financial statement analysis which are horizontal analysis, vertical analysis and ratio analysis.

Financial Statement analysis is important because it provides an idea to the investors about deciding on investing their funds in a particular company.It also lets the regulatory bodies ensure the company is following the required accounting standards.It is helpful tok the government agencies in analyzing the taxation owed by the company.Also it helps the company to ananlyze their own performance.

The steps to financial statement analysis is as follows:

1.Identify the industry economic characteristics - This lets us know about the performance of the company. It helps to know about the company in the form of solvency, profit/loss of of the enterprise. e.g. Detemining a value chain analysis for the industry ie the chain of activities involved in creation, maufacture and distribution of the firm's product and/or services.Example: Porter's five forces analysis is used.

2.Identify the company's strategies - This step involves looking at the nature of product/service being offered by the firm including the level of profit margin,control of costs to ensure their profit. Investors will only invest in profit making organization.Examples: The firm with good profitabilty ratio will atract more investors.More EPS will attract equity investors and other stakeholders.Identify the companies strategies are thus very important.

3.Assess the quality of the firm's financial statements - The company's/firm's accounts and financial statements must follow all the relevant accounting standards.The main important aspect is the know whether the balance sheet is the complete representation of the firm's economic position and satement of income is properly reflecting company's performance.Cash flows helps in understanding the liquidity position from its operating, investments and financial activities.Example:analyzing the balance sheet where one should identify that a a company raises money through debt / or owners(equity) and uses it to buy assets.So debt(liabilities) +Owner(equity) = Assets.

4.Analyze current profitability and risk- This is basically the step where financial statement is crtically evaluated in a comparative manner,looking at current ratios in relation to those from earlier periods or relative to other firms or industry averages.Examples: fiancial statements is evaluated on the basis of ratio anaylsis tools such as liquidity ratios, asset mangement ratios, debt management ratios/ coverage ratios risk/ market valuation.

5.Prepare the forecasted financial statements- This fiancial professionals must make reassonable assumptions about the future of the firm and (its industry) and determine how these assumptions will impact both the cash flows and the funding in future.Example: Preaparation of pro - forma financial statements.These statements are prepared by professionals on the basis of diferent approaches such as percent of sales approach is used to determine cash flows,etc.

6.Valuation of the firm - This step involves deriving the value of the firm using different approaches.The most ideal is the discounted cash flows methodology.Economic value added is another favourable approach.Other examples is to determine the proected cash flows which could be in the form of projected dividends, or more detailed techniques such as free cash flows.rmation