Question

Please go in depth over trends and relationships that can be gleaned from financial statements.

Answer 1

Before understanding the fact that what trends and relationships can be obtained from the Financial Statements,

Firstly the thing that needs to be made very clear is what Financial Statements are :

Financial Statements are the records that are meant to present the financial information of the entity in question.

Financial Statements for businesses usually include Income Statements, Balance Sheets, Statement of Changes in Equity and Cash Flow Statements.

Financial Statements are often audited by Government agencies, accountants, Firms etc. to ensure accuracy and for tax, financing or investing purposes.

So, this was a brief introduction of what financial statements are.

Now getting to the main question that what trends and relationships can be obtained from the financial statements, Firstly we would discuss the very basic purpose of the Financial Statements,

As mentioned earlier, Financial statements usually comprise of four elements which are : Balance Sheet, Income Statement, Statement of Changes in Equity and Cash Flow Statement.

Now, very basic purpose of all these four elements are as mentioned below:

1. A Balance Sheet reports on Company's Assets, Liabilities and Owners's Equity at a given point of time.

2. An Income Statement/Profit & Loss Account/Statement of Revenue & Expenses reports on Company's Income, expenses and Profit over a period of time, It basically provides the information about the Operations of the Enterprise such as Sales and the various expenses incurred during the stated period.

3. A Statment of Changes in Equity reports on the changes in equity of the company during the stated period.

4. A Cash Flow Statement of the company reports on the Company's Cash Flow activities particularly its Operating, Investing and Financing activities.

Now, moving to finanancial Statement analysis, most common types of financial statement analysis are:

a) Horizontal and Vertical Analysis:

# A horizontal analysis consists of a two-year comparison of financial data with other years. This type of financial analysis is also known as trend analysis. The horizontal analysis is often expressed in monetary terms (currency) and percentages.

A horizontal analysis expressed as a percentage, provides more insight and feeling about the significance of an increase or decrease.

Dollar and percentage changes are computed by using the following formula:

Dollar Change = Amount of the item in comparison year-Amount of the item in base year

Percentage change = Dollar Change/Amount of the item in base year *100

# A vertical analysis reports each amount on a financial statement as a percentage of another item. For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets. If inventory is $100,000 and total assets are $400,000 then inventory is presented as 25 ($100,000 divided by $400,000). If cash is $8,000 then it will be presented as 2 ($8,000 divided by $400,000). The total of the assets will now add up to 100. If the accounts payable are $88,000 they will be presented as 22 ($88,000 divided by $400,000). If owner's equity is $240,000 it will be presented as 60 ($240,000 divided by $400,000).

b) Ratio Analysis

A ratio between two quantities, are used to represent relationships between various figures on a balance sheet, profit and loss account or other accounting records. Ratios always represent a ratio of one figure related to another.

Four most common ratios are:

1. Profitability ratio and profitability: This shows how well a company can generate profits from its operations. Profit Margin, return on assets, return on equity, return on capital employed and gross margin ratios are the examples of the profitability ratios.

2. Liquidity ratio: These measure a company's ability to pay off its short term debts, liquidity ratios include current ratio, quick ratio and working capital ratio.

3. Efficiency ratio: Also known as activity ratios, these evaluate how well a company uses its assets and liabilities to generate sales and maximise profits. Examples are Asset Turnover ratio, inventory turnover and days sales in inventory.

4. Solvency ratio: also called Financial leverage ratios, these compare a company's debt level with its assets, equity and earnings to evaluate that whether a company can stay afloat in the long term by paying its long term debt and interest on the debt. Examples are det equity ratio, debts assets ratio and interest coverage ratio.