Financial statement analysis involves the analysis of a company’s past, present as well as its future prospects. Companies report their performance to interested parties such as investors, creditors and analysts through financial statements. The interested parties use the information provided in the financial statements along with other relevant information to analyze and make decisions about the concerned company such as whether to invest in the stock of the company or to sell out, whether to suggest investing in the stock to others, etc.
Types of financial statements
Analysis of the balance sheet forms an integral part of financial statement analysis. The balance sheet of a company also known as the statement of financial position represents a company’s financial position as of a given date. It is made up of three components;
Assets – which are the resources controlled by the company
Liabilities – which are the debts owed by the company to its creditors. Liabilities are undertaken for creation of assets. The assets created are expected to earn more than the liabilities so as to generate profits for the owners or shareholders.
Owner’s equity – which is the excess of assets over liabilities. Assets are created from borrowed money (liabilities) and from the money invested by the owners or shareholders which is the owner’s equity. Owner’s equity is also called residual interest in the assets after deducting liabilities.
In a balance sheet the assets are recorded on one side and the liabilities and owner’s equity are recorded together on the other side. A balance sheet should always balance at the end of the accounting period, i.e. Assets should equal the liabilities plus owner’s equity.
Income statement or profit/loss statement or statement of operations
The next important aspect of financial statement analysis is the analysis of the income statement. The income statement along with the balance sheet forms the crux of a company’s financial statements.
The income statement reports the results of the business operations and non-business operations undertaken by the company over the accounting period. It records the revenues, expenses, gains or losses. Unlike a balance sheet which represents a company’s financial position as at a given point in time, the income statement reports the company’s performance during the accounting period.
The income statement begins by recording sales/revenue and works downwards towards net income and earnings per share after deducting all expenses incurred.
Statement of cash flows
Statement of cash flows discloses the sources and uses of cash in the company. It is divided into three parts;
Cash flows from operating activities – which are cash flows from the business transactions undertaken by the company
Cash flows from investing activities – which are cash flows from activities where cash was either invested in an asset or cash was generated from sale of an asset.
Cash flows from financing activities – which are cash flows resulting from either issuance of fresh debt to finance the activities of the company or retirement of existing debt of a company.
Statement of changes in owner’s equity
This statement records the changes in the owners’ investment in the business over the accounting period i.e. if investment in the business was increased and by how much or stake was diluted by sale – to whom and for how much. Read more about owner’s equity
Financial statement notes / footnotes
Analysis of financial statements also involves the analysis of the footnotes. Footnotes provide details of the information summarized in the financial statements. Footnotes provide details such as
- Accounting methods, assumptions and estimates used by the management of the company
- Additional information about business acquisitions and disposals, legal actions, employee benefit plans, contingencies and commitments, etc
Management’s Discussion and Analysis
Management discussion and analysis is one of the most important and useful sections of a company’s financial reports and forms an integral part of analysis of financial statements. In this section a company is required to discuss future outlook, favorable and unfavorable trends, significant events and uncertainties facing the company, effects of inflation and changing prices, critical accounting policies adopted by the management that require the management to make subjective judgments and that have significant impact on the company’s reported results and other material events and uncertainties that can cause a company’s future earnings and financial condition to be significantly different from the current reported performance.
An audit is an independent review by an accounting firm of a company’s financial statements to gauge the correctness, fairness and reliability of the financial statements. An auditor examines a company’s accounting system and tries to verify if there are no errors in the financial statements.
An auditor gives an unqualified opinion if he believes the financial statements to be free of material omissions and errors. If he doesn’t believe so he can give an adverse opinion and explain the errors in the audit report. If he believes there are exceptions to the accounting principles in the financial statements he may give a qualified opinion and explain the exceptions in the audit report.
Other sources of information for financial statement analysis
Besides the annual financial statements of a company additional sources of information can be interim financial statements which provide the updated position of the company since the last annual financial reports. They may however not be audited.
Another source of information can be the proxy statements released by companies to its shareholders whenever a matter needs to be put to vote. Proxy statements are good source of information for management’s compensation, election of board of directors, conflicts of interest between the board, management and shareholders.
Information can also be gleaned from a company’s website and its press releases. Besides gathering information about a company, information should also be collected about the industry in which the company operates and the peers of the company in order to put the company’s performance in perspective.
Hence financial statement analysis is a mosaic that is made up of not just the analysis of financial statements but also the analysis of supporting information gathered from other reliable sources.
That brings us to the end of the first post on financial reporting and analysis……hope you liked reading it and will remember to share it…embedded below is a ppt summarising the post….you can use it for your reference and you can share it too if you like…
…in the next two posts we will discuss the mechanics of financial reporting and double entry accounting system….we will learn about how various elements are classified into various accounts and the basics of double entry accounting…..watch out for it…seeya until then…
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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