Financial Statement Analysis
All financial statements are essentially historically historical
documents. They tell what has happened during a particular period of
time. However most users of financial statements are concerned about
what will happen in the future. Stockholders are concerned with future
earnings and dividends. Creditors are concerned with the company's
future ability to repay its debts. Managers are concerned with the
company's ability to finance future expansion. Despite the fact that
financial statements are historical documents, they can still provide
valuable information bearing on all of these concerns.
Financial statement analysis involves careful selection of data from
financial statements for the primary purpose of forecasting the
financial health of the company. This is accomplished by examining
trends in key financial data, comparing financial data across
companies, and analyzing key financial ratios.
Managers are also widely concerned with the financial ratios. First
the ratios provide indicators of how well the company and its business
units are performing. Some of these ratios would ordinarily be used in
a balanced scorecard approach. The specific ratios selected depend on
the company's strategy. For example a company that wants to emphasize
responsiveness to customers may closely monitor the inventory turnover
ratio. Since managers must report to shareholders and may wish to raise
funds from external sources, managers must pay attention to the
financial ratios used by external inventories to evaluate the company's
investment potential and creditworthiness.
Although financial statement analysis is a highly useful tool, it
has two limitations. These two limitations involve the comparability of
financial data between companies and the need to look beyond ratios.
Comparison of one company with another can provide valuable clues about
the financial health of an organization. Unfortunately, differences in
accounting methods between companies sometime makes it difficult to
compare the companies' financial data. For example if one company
values its inventories by the LIFO method and another firm by average
cost method, then direct comparisons of financial data such as
inventory valuations are and cost of goods sold between the two firms
may be misleading. Some times enough data are presented in foot notes
to the financial statements to restate data to a comparable basis.
Otherwise, the analyst should keep in mind the lack of comparability of
the data before drawing any definite conclusion. Nevertheless, even
with this limitation in mind, comparisons of key ratios with other
companies and with industry averages often suggest avenues for further
investigation.
An inexperienced analyst may assume that ratios are sufficient in
themselves as a basis for judgment about the future. Nothing could be
further from the truth. Conclusions based on ratio analysis must be
regarded as tentative. Ratios should not be viewed as an end, but
rather they should be viewed as a starting point, as indicators of what
to pursue in greater depth. They raise may questions, but they rarely
answer any question by themselves. In addition to ratios, other sources
of data should be analyzed in order to make judgments about the future
of an organization. They analyst should look, for example, at industry
trends, technological changes, changes in consumer tastes, changes in
broad economic factors, and changes within the firm itself. A recent
change in a key management position, for example, might provide a basis
for optimism about the future, even though the past performance of the
firm may have been mediocre.
Few figures appearing on financial statements have much significance
standing by themselves. It is the relationship of one figure to another
and the amount and direction of change over time that are important in
financial statement analysis. How does the analyst key in on
significant relationship? How does the analyst dig out the important
trends and changes in a company? Three analytical techniques are widely
used; dollar and percentage changes on statements, common-size
statements, and financial ratios.
