This article encompasses the reasons why financial statement analysis is required by different stakeholders of various companies, what is financial analysis, what are the methods to perform such an analysis, what are vertical and horizontal analyses, how to use and interpret various analyses and what are the limitations of such analyses.
What is Financial Statement Analysis?
Just like a medical doctor examines a patient to find out various symptoms (both good and bad) in order to help identify good and bad trends in his health structure. In a similar way, an accountant, a financial analyst or another stakeholder of a company also need to examine the financial health of a Company before they could make any decisions relating to such a company.
A doctor needs a blood sample from the patient to identify certain trends in his health. Similarly, a financial analyst needs financial statements as a starting point to carry out his examination.
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Such an examination of the financial statements of a company aiming at identifying various trends to depict how the company is performing, what is its debt-equity structure, will it be able to carry out its operations in the long term etc. is known as financial analysis and if this is done by means of using financial statements, it is called Financial Statement Analysis.
Apart from financial statements, there are many other data and factors that can be used in such analysis. For example, market analysis, statistical data, customer surveys etc.
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Who is in need of Financial Statement Analysis?
There are different stakeholders in a Company or organization. Each of them has different needs in relation to such a Company or organization. Some examples of various stakeholders of the Company and their possible information needs are listed below:
|Shareholders||Existing shareholders need to analyze the financial health of their company, what is its liquidity position, will it be able to survive in the long term (i.e. going concern), how is its debt and equity ratios as compared to other companies, what is its market share and trends etc.
Potential shareholders looking for investments in various companies will also need to assess the strength of the company, its dividend payout ratios, historical profits and similar trends etc.
They will need profitability analysis, liquidity analysis, efficiency analysis etc. to find out the information they need.
|Creditors (and Lenders)||Creditors and lenders’ major concern is whether they will be able to get back their money along with interest on a timely basis. This information can be obtained by analyzing the profitability position of a Company, financial strength (i.e. in terms of the value of assets compared to liabilities), liquidity positions of the company etc.
They need to do a balance sheet analysis, cash flow statement analysis, working capital analysis etc. to reach out the information required by them.
|Customers||Customers are normally looking for high-quality products and services at suitable prices. Some such information may be available in financial statements which will be compared with other competitors to assess prices and quality. A good financial position and health of a Company with consistent performance over the years may also serve as an indicator that Company has good quality products and services based on which it has sustained over the years.
For this information, an analysis of financial statements especially balance sheet statement analysis, sensitivity analysis for various price changes etc. might serve as useful tools.
For example, an analysis of profit by a sensitivity of its costs may provide information on whether the company can provide discounts or not. If the profits margins are higher, the Company has the ability to allow large discounts and vice versa.
|Employees||Employees normally look for good companies that could pay higher benefits and commissions/ bonuses. This information can be obtained by an analysis of the financial strength of the company, its liquidity ratios and profitability analysis.|
|Government and general public||Government need various information, but their focus is on the Companies ability to pay taxes. The general public also has a wide range of information needs that are mostly covered above.|
There are many other users of financial statements with needs varying from very specific to general ones. These information needs may be found out through various analyses such as:
- General Financial Statements Analysis
- Vertical Analysis
- Horizontal Analysis
- Leverage Analysis
- Dupont Analysis
- Profitability Analysis
- Liquidity Analysis
- Efficiency Analysis
- Sensitivity Analysis
- Income Statement Analysis
- Balance Sheet Statement Analysis
- Cash Flow Statement Analysis
- Working Capital ratios and Analysis
We will discuss two such Analysis i.e. Vertical Analysis and Horizontal Analysis in this article.
How do these Analyses meet Future Information Needs?
Since most of the information available regarding companies relates to the past, there arises a question of how decisions can be made based on this information for future actions?
The information and analysis made are projected for the future and obviously, the results may differ in future, but they are expected to follow an average or similar trend as in the past. Various statistical techniques such as regression and correlation and probability analysis can be used to make suitable future estimates of the figures and trends.
Having little and small information about the future is always better than having no information at all to make informed and useful decisions.
As the name suggests, “horizontal” analysis means comparing data with various periods over time. For example, comparing sales for the year 2020, with the year 2019 and 2018 to find out whether sales or increasing or decreasing over the years and what is the increase or decrease rate or percentage.
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This analysis can be made through simple analysis of figures, accounting ratios, cash flow trends etc.
The resulting percentages and trends can be compared with other companies and industries to assess the relative strength of a company in its industry.
Calculation of horizontal analysis is easier. For example, variance analysis of historical data for a particular year in comparison with its prior-year can be calculated as:
[(Current year figure-Last year Figure)/Last year figure] *100
This result will show a percentage increase or decline in the stated line item.
Example of a Horizontal Analysis of a Profit and Loss Account:
Revenue is increasing and so is the gross profit over the years suggesting a good gross profitability trend. However, other information will also be needed to analyze further. For example, the industry in which such a company operates might have higher profit percentages which might lead us to decide that the profitability of the Company is not good.
Expenses are increasing on average over the year and Company has incurred a loss. However, there is a need to get additional information on the nature of expenses, there might be items that represent a one-time expense that is not a usual nature e.g. an unusual impairment loss of assets due to an accidental fire. So additional care is needed to make such analyses. Industry information is also relevant to assess the general industry trends against which useful comparisons can be made.
In the vertical analysis, items are compared with other items in a vertical sequence in the same year. For example, general and admin expenses are compared and calculated as a percentage of total net profit.
Similarly, loans appearing in the balance sheet are compared with total noncurrent liabilities.
This method helps to find out or highlight unusual or significant items for example, if general and admin expenses are very high as compared to total expenses, this may suggest a tagging point for further investigation of general and admin expenses.
Similarly, a comparison with prior years and industry / other companies can be made which may provide useful insights. For example, if in the above case, general and admin expenses are consistent over the years and in line with industry trends, this may not suggest a deficiency point.
Example of a Horizontal Analysis of a Balance Sheet Account:
Few points that can be assessed from the above analysis may include:
- There has been a significant decrease in intangible assets as compared to the prior year with reference to total assets while the PPE is increasing. This may be due to a reclassification between the two categories and may be due to a number of other reasons which needs to be inquired to make any further decision.
- Inventories and cash and bank balances are consistent over the two years representing a consistent performance i.e. there has been no significant increase or decrease in these balances in comparison with total current assets over the year. If there has been a significant increase or decrease, this may point to the issue that these assets are not operated efficiently. For example, if cash balances are increasing, they need to be invested somewhere to earn additional income.
- Trade receivables have increased significantly as compared to total current assets which reflect a lower collection rate. This may suggest that most trade receivables are not recoverable, and a bad debt expense is inevitable. This points out issues in the debtors handling department which may need timely actions to resolve.
- Receivables from related parties are decreasing as compared to the total over the two years, however, this is an unusual account and more information may be needed to assess this. There may be an unusual transaction in the prior period.
- Equity portion represents a normal trend with share capital not changing and retained earnings are slightly increasing mainly due to profit impact for the year.
- Non-current liabilities also don’t represent a significant change suggesting a consistent performance of these liabilities.
- In the current liabilities section, trade and other payables are increasing over the years in comparison with total current liabilities. This may suggest management is not paying the creditors on a timely basis which may be due to liquidity issues. Such issues will require management quick attention to fix.
All the above issues are discussed mainly from the management’s point of view. However, different users may have different uses and analyses for the same information. For example, an auditor conducting an audit of this entity may find some audit risks in these areas. An increase in trade receivables may represent fraudulent sales as an audit risk.
Limitation of these Analyses:
- These analyses represent past information; however, decisions are needed to be made for future results and actions. Accordingly, this information is not fully relevant in decision making and needs consideration of other factors.
- Sometimes data is not available to make more detailed analyses. For example, an unusual trend in expenses have been noted in comparison with competitors’ expenses, however, no disaggregated data is available for competitors to identify the nature of unusual expenses in detail.
- Expert staff is not available to most of the persons needing such analysis who is well versed with financial, accounting, economic and other aspects of the business. A single analysis may need various skills to analyze a situation to make informed decisions.
- These analyses provide a range or estimate and do not come out with more specific information needed for informed decision making.
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