Financial statements are records that can provide indications of the financial health of a company. Accurate financial records are necessary to keep track of financial warning signals such as inordinately high expenses, high levels of debt or a poor record of collecting bills. Public companies often have specific procedures for gathering, verifying and reporting financial information. Recent corporate scandals have placed greater scrutiny on the managers and corporate officers of publicly held firms. Privately held firms are not held to the same standard but often adhere to strict guidelines in order to increase the value of the firm and viability in case of sale.
Keywords Accounting; Accounting Methods; Accounts Payable; Accounts Receivable; Assets; Balance Sheet; Cash Flow; Cash Flow Statement; Current Assets; Current Liabilities; Fixed Costs; Liabilities
Finance: Financial Statement Analysis
Financial statements are reports that show the financial position of a company. Recordkeeping is important in order to understand a company's value and to comply with various regulations and tax requirements. Accurate records allow companies to account for how money was spent and handled, what assets are owned and what debts are owed.
Businesses differ in how they are valued depending on whether they are public or private firms. Information about public companies is available, especially to shareholders, while it is difficult to get audited and financially sound information about the financial workings of a private company (Antia, 2006). Antia (para. 2) calls the value of a business the "free cash flow" that has various adjusted risk elements deducted from it. Private companies don't provide information on their cash flow and have greater opportunities to engage in financial benefits not available to public companies, such as:
- Above-market salaries for family members.
- Mixing of personal and business funds.
- Exaggeration of business expenses to reduce taxes.
Other concerns regarding a business' value can depend on what a buyer sees in the business. If the business represents a strategic purchase, a higher price might be garnered even for an over-valued private business. If a buyer is a minority buyer, they may want to pay less due to the minimal amount of control they can exert on the business (Antia, para. 3).
Types of Financial Statements
Basic financial statements include the balance sheet, the income statement, cash flow statement and notes to account. There are different types of reports because different types of information are needed to effectively manage a company and plan for the future. Sometimes companies use financial reporting information internally, and in some cases they are required to release this information externally. Tracy (1999) called cash the "lubricant" of business. Without cash it is difficult for a business to function and it increases the likelihood that a business may fail. But, Tracy warned that cash flows only show part of the picture and give no information about the business' profit or financial condition. Since cash flows only show part of the picture, other types of financial reports are needed.
The most common financial reports are the balance sheet and the income statement.
- The balance sheet (also called the statement of financial position) provides information about the financial condition of a company.
- The income statement (also called the earnings or profit and loss statement) shows the profitability of the business.
The general categories on balance sheets are assets and liabilities. A publicly traded firm also includes shareholder equity. A typical balance sheet shows assets a company owns. Assets include cash, accounts receivable, inventory and any prepaid expenses. Balance sheets also record property the company owns and any depreciation on assets. The balance sheet is a two-sided report because it records assets on one side and liabilities on the other. Liabilities include accounts payable and accrued expenses, income tax owed, loans and stockholders' equity. Stockholders' or shareholders' equity is any claim that owners of company stock have against the assets that a company has. Stockholders' or shareholders' equity is also called net worth. Stockholders' equity is found by deducting liabilities and debt from assets (Morgenson & Harvey, 2002).
Income statements show the profitability of a business. The income statement is for a period of one year and shows the total sales revenue for the year. Subtracted from sales revenue is the cost of goods sold or the expenses a company incurs in producing finished goods to sell. Also deducted from the revenue are expenses for operating costs and depreciation. If a company is publicly owned, its income statement must also report earnings per share (Tracy, 1999). Earnings per share is a measure of company profitability (Godin, 2001). It is calculated by dividing net income by the total shares of stock. When looking at the income statement of a company, the profitability isn't just the gross profit, it is also important to look at the ratio of expenses as a percentage of profit. If a company has high profits but also has high expenses, the company could be mismanaged.
Balance sheets are not only important to companies but also to investors (Godin, p. 52). Balance sheets can tell investors whether or not a company is a good investment based on its financial condition. Financial statements are often prepared by accountants and reviewed by auditors to ensure that the records are accurate and to avoid the temptation not to report factual information or to hide financial flaws. A reason business owners may use financial professionals is to reduce the chance of error and to stay out of an area where they may not have expertise. O'Bannon (2005) cautioned business owners against being lulled to sleep by the power of current accounting software products, which cannot replace the knowledge gained by using professional financial advice. O'Bannon felt that one of the primary benefits of the newer software is that it allows owners and financial advisors to speak the same language and lets business owners provide easy to use documentation to their accountant. Accountants and other financial advisors can use software to quickly perform somewhat complex analysis and generate reports for their clients.
Arar (2012) wrote that small businesses operating in the 2010s have "more accounting software options than ever, including Web-based subscriptions." For those businesses with large inventories or client databases, however, or those that choose not to entrust data to the cloud, such desktop tools as Acclivity AccountEdge Pro 2012, Intuit QuickBooks 2013, and Sage 50 Complete Accounting 2013 are good options (Arar 2012).
Analyzing Balance Sheet
Analyzing balance sheets and income statements requires more than simply reading the categories of figures. The numbers have to be read with an eye towards what they mean and what they might mean in combination. Scott (2005, p. 108) stated that financial statement analysis means interpreting the data "in a meaningful way" instead of looking at "past results." This can mean looking at the company's management strategy, the way the business is operated and the plans the business has for the future. Scott suggested asking the following questions to get close to figuring out how internal factors, especially management, influence financial statement content:
- How is the company distinguishing itself from the competition?
- How does it compete? E.g., on price, quality, responsiveness, availability?
- Is the company's strategy viable given the marketplace economy?
- Is management adapting its strategy to a changing environment?
These questions and others can provide qualitative information in addition to the quantitative numbers provided in financial statements. Using the information in aggregate can give a broader picture of the company's financial health.
Ratios are one method of analyzing what financial statements may mean. There are several types of ratios including liquidity and profitability ratios. Ratio analysis shows the relationship between financial information, the way it behaves over time and what risks are implied by the behavior (Morgenson & Harvey, 2002).
Liquidity ratios are a measure of how 'liquid' a company is or how well it can come up with cash or quickly converted assets that can help the company meet its financial obligations. If the ratio is high, that is a good number. An example of a liquidity ratio is to divide current assets by current liabilities. The result shows how much cash is available for the company to manage current financial requirements. A quick ratio is a liquidity ratio that eliminates slow moving inventory from current assets to give a more accurate picture of a company's liquidity. Companies can compare their liquidity to others in their industry to see how they fare among similar companies. A debt to equity ratio is a measure of the ability of a company to use debt to finance its operations. Profitability ratios measure the company's profit performance by comparing profits to sales. Companies that last are able to remain profitable even under unfavorable...