READING AND VOCABULARY. What is financial statement analysis?

What is financial statement analysis?

The financial/economic analysis sponsored and used by the economic manager can be viewed within a broad hierarchy of decision-making needs. One of the most important areas of applying basic financial analysis is the support of day-to-day decisions made by managers and employees. Despite its importance, analytical practice in this area often tends to be the least developed, because the pressure of daily activities foreshortens the time for reflective thinking about operational issues and trade-offs.

The practice of financial analysis is generally more developed in the area of supporting strategy development, as it is subject to more senior management scrutiny and authority because of the size and implications of the decisions made. The analysis of strategic alternatives and the commitment of resources to investments involves a set of economic trade-offs, viewed within competitive framework.

Thus, financial analysis involves the identification of the following items for a company's financial statements over a series of reporting periods:

§ Trends. Create trend lines for key items in the financial statements over multiple time periods, to see how the company is performing. Typical trend lines are for revenues, the gross margin, net profits, cash, accounts receivable, and debt.

§ Proportion analysis. An array of ratios are available for discerning the relationship between the size of various accounts in the financial statements. For example, you can calculate a company's quick ratio to estimate its ability to pay its immediate liabilities, or its debt to equity ratio to see if it has taken on too much debt. These analyses are frequently between the revenues and expenses listed on the income statement and the assets, liabilities, and equity accounts listed on the balance sheet.

Financial statement analysis is an exceptionally powerful tool for a variety of users of financial statements, each having different objectives in learning about the financial circumstances of the entity.

There are a number of users of financial statement analysis. They are creditors, investors, management, regulatory authorities.

In order to held an analysis there are two key methods. The first method is the use of horizontal and vertical analysis. Horizontal analysis is the comparison of financial information over a series of reporting periods, while vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. Thus, horizontal analysis is the review of the results of multiple time periods, while vertical analysis is the review of the proportion of accounts to each other within a single period.

The second method for analyzing financial statements is the use of many kinds of ratios. You use ratios to calculate the relative size of one number in relation to another. After you calculate a ratio, you can then compare it to the same ratio calculated for a prior period, or that is based on an industry average, to see if the company is performing in accordance with expectations. In a typical financial statement analysis, most ratios will be within expectations, while a small number will flag potential problems that will attract the attention of the reviewer.

There are several general categories of ratios, each designed to examine a different aspect of a company's performance.

While financial statement analysis is an excellent tool, there are several issues to be aware of that can interfere with your interpretation of the analysis results. These issues are:

§ Comparability between periods. The company preparing the financial statements may have changed the accounts in which it stores financial information, so that results may differ from period to period. For example, an expense may appear in the cost of goods sold in one period, and in administrative expenses in another period.

§ Comparability between companies. An analyst frequently compares the financial ratios of different companies in order to see how they match up against each other. However, each company may aggregate financial information differently, so that the results of their ratios are not really comparable. This can lead an analyst to draw incorrect conclusions about the results of a company in comparison to its competitors.

§ Operational information. Financial analysis only reviews a company's financial information, not its operational information, so you cannot see a variety of key indicators of future performance, such as the size of the order backlog, or changes in warranty claims. Thus, financial analysis only presents part of the total picture.

1. Choose the best answer:

1. Financial analysis is used by ...

a) a manager and staff

b) an economist

c) an accountant

2. Financial analysis in the area of supporting strategy development is ...

a) more detailed

b) less important

c) more important and accurate

3. Trend analysis demonstrates ...

a) the company performance in general ...

b) the development of the company ...