Question

A year-to-year analysis of comparative balance sheets and income statements is a useful analysis tool. Still, without proper care, such analysis can be misleading. Discuss factors or conditions that contribute to such a possibility, How can additional information and supplementary data (beyond financial statements) help prevent this possibility?

Answer 1

Their is no doubt that Income Statement and Balance sheet is one of the best tool for Fundamental Analysis of the company.

The first thing is that The Financial Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of flexibility and interpretation in accounting provisions and methods which means that company may use assumption as the want as they have that flexibility and due to Relations with company Auditors too don't notice them.

For Example Company have increased sale because of excessive credit sales and will post a Rosy picture about a company but in reality their may be lot of bad debt due to it and company have not taken that into Provisions and this can be tracked in Cash Flow statement as how much cash is received by the company in a year, suppose if Cash receive by the company is only 40 million and Account Receivable is 90 Million this show that company bargaining power is low and hence company is giving long credit period. In this case Income statement will show a very strong net profit but real picture can be seen in Cash Flow Statement.

Company may use lot of assumption while preparing a income statement suppose for example company have done a high risk deal where chance of bad debt is more but company have not taken enough prevision for it as it will impact net profit or company have taken very high provision for bad debt to reduce tax burden of the company; this type of assumption can be solved by reading Foot notes, where they elaborate whatever assumption is taken and you have to adjust accordingly.

There may be a case that company have installed a new plant or purchased new business which will impact their net profit because of depreciation but this investment will have a breakeven after 3 year and Its IRR will be 20% this type of information you will not get in balance sheet and Income statement.

For proper analysis along with Income Statement and Balance Sheet it is also important for the analyst to track Cash Flow Statement, Foot Notes, Annual Report and Management commentary. This will give us an idea about the future outlook of the company.