Question

Let’s discuss the interim or final results of the financial statement analysis paper that you're working on for this week.

• Be sure to indicate the company you selected and discuss at least one of the ratios you analyzed.
• What was the result, and what does it tell us about the financial health of the organization?

Answer 1

Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization as well as to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

Financial Statement Analysis:

Analyzing Financial Statements

The financial statements of a company record important financial data on every aspect of a business’s activities. As such they can be evaluated on the basis of past, current, and projected performance.

In general, financial statements are centered around generally accepted accounting principles (GAAP) in the U.S. These principles require a company to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting. Public companies must follow GAAP standards which requires accrual accounting. Private companies have greater flexibility in their financial statement preparation and also have the option to use either accrual or cash accounting.

Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques include horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical affects line items have on other parts of the business and also the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships.

Financial Statements As mentioned, there are three main financial statements that every company creates and monitors: the balance sheet, income statement, and cash flow statement. Companies use these financial statements to manage the operations of their business and also to provide reporting transparency to their stakeholders. All three statements are interconnected and create different views of a company’s activities and performance.

Balance Sheet The balance sheet is a report of a company's financial worth in terms of book value. It is broken into three parts to include a company’s assets, liabilities, and shareholders' equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency. Liabilities include its expense arrangements and the debt capital it is paying off. Shareholder’s equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance with assets minus liabilities equaling shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value. This value is an important performance metric that increases or decreases with the financial activities of a company.

Income Statement The income statement breaks down the revenue a company earns against the expenses involved in its business to provide a bottom line, net income profit or loss. The income statement is broken into three parts which help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit which subtracts indirect expenses such as marketing costs, general costs, and depreciation. Finally it ends with net profit which deducts interest and taxes.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations.

Cash Flow Statement The cash flow statement provides an overview of the company's cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firm wide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much cash a company has available.

Free Cash Flow and Other Valuation Statements Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company. Free cash flow statements arrive at a net present value by discounting the free cash flow a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public.

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by comparing information contained in its financial statements. Ratio analysis is a cornerstone of fundamental analysis.

When investors and analysts talk about fundamental or quantitative analysis, they are usually referring to ratio analysis. Ratio analysis involves evaluating the performance and financial health of a company by using data from the current and historical financial statements.

The data retrieved from the statements is used to compare a company's performance over time to assess whether the company is improving or deteriorating, to compare a company's financial standing with the industry average, or to compare a company to one or more other companies operating in its sector to see how the company stacks up.

Ratio analysis can be used to establish a trend line for one company's results over a large number of financial reporting periods. This can highlight company changes that would not be evident if looking at a given ratio that represents just one point in time.

Comparing a company to its peers or its industry averages is another useful application for ratio analysis. Calculating one ratio for competitors in a given industry and comparing across the set of companies can reveal both positive and negative information.

Since companies in the same industry typically have similar capital structures and investment in fixed assets, their ratios should be substantially the same. Different ratio results could mean that one firm has a potential issue and is underperforming the competition, but they could also mean that a certain company is much better at generating profits than its peers. Many analysts use ratios to review sectors, looking for the most and least valuable companies in the group.

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio. Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.

• Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital.
• Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
• Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.