Question

Provide a paragraph to explain how an evaluation of financial statements are completed, explain why evaluation of financial performance is important to a variety of business organization, and describe how information from financial statement analysis is connected to strategic management processes.

Answer 1

The main types of financial statements are the balance sheet, the income statement and the statement of cash flows. These accounting reports are analyzed in order to aid economic decision-making of a firm and also to predict profitability and cash flows. The balance sheet is analyzed to obtain some key ratios that help explain the health of the firm at a given point in time.

Debt-Equity Ratio = Total Debt / Total Equity

Market-to-Book Ratio = Market Value of Equity / Book Value of Equity

Enterprise Value = Market Value of Equity + Debt – Cash

Some useful metrics based on the information provided in the income statement and the balance sheet are as follows:

Net profit Margin =Net Income / Net Sales

Return on Equity = Net Income / Book Value of Equity

(P/E) Ratio = Market Capitalization / Net Income = Share Price / Earnings per Share

In order to measure how much cash is available to the company for investments without outside financing or money diverting from operations, it is useful to conduct a simple cash flow statement analysis. The free cash flow, as the name suggests, allows a company to be able to pay dividends, repay its debts, buy back its stock and also make new investments to facilitate future growth. The excess cash produced by the company, free cash flow, is calculated as follows:

Net Income

+ Amortization/Depreciation

– Changes in Working Capital

– Capital Expenditures

= Free Cash Flow

There are different users of financial statement analysis. These can be classified into internal and external users. Internal users refer to the management of the company who analyzes financial statements in order to make decisions related to the operations of the company. On the other hand, external users do not necessarily belong to the company but still hold some sort of financial interest. These include owners, investors, creditors, government, employees, customers, and the general public. These users are elaborated on below:

1. MANAGEMENT: The managers of the company use their financial statement analysis to make intelligent decisions about their performance. For instance, they may gauge cost per distribution channel, or how much cash they have left, from their accounting reports and make decisions from these analysis results.
2. OWNERS: Small business owners need financial information from their operations to determine whether the business is profitable. It helps in making decisions like whether to continue operating the business, whether to improve business strategies or whether to give up on the business altogether.
3. INVESTORS: People who have purchased stock or shares in a company need financial information to analyze the way the company is performing. They use financial statement analysis to determine what to do with their investments in the company. So depending on how the company is doing, they will either hold onto their stock, sell it or buy more.
4. CREDITORS: Creditors are interested in knowing if a company will be able to honor its payments as they become due. They use cash flow analysis of the company’s accounting records to measure the company’s liquidity, or its ability to make short-term payments.
5. GOVERNMENT: Governing and regulating bodies of the state look at financial statement analysis to determine how the economy is performing in general so they can plan their financial and industrial policies. Tax authorities also analyze a company’s statements to calculate the tax burden that the company has to pay.
6. EMPLOYEES: Employees need to know if their employment is secure and if there is a possibility of a pay raise. They want to be abreast of their company’s profitability and stability. Employees may also be interested in knowing the company’s financial position to see whether there may be plans for expansion and hence, career prospects for them.
7. CUSTOMERS: Customers need to know about the ability of the company to service its clients into the future. The need to know about the company’s stability of operations is heightened if the customer (i.e. a distributor or procurer of specialized products) is dependent wholly on the company for its supplies.
8. GENERAL PUBLIC: Anyone in the general public, like students, analysts and researchers, may be interested in using a company’s financial statement analysis. They may wish to evaluate the effects of the firm on the environment, or the economy or even the local community. For instance, if the company is running corporate social responsibility programs for improving the community, the public may want to be aware of the future operations of the company.