Economic decisions through Financial Statement Analysis

The financial statement analysis is the process of assessing and analyzing the business’ financial statements to make an economic decision to gain income and profit in the future. It involves all of the subsequent aside from the guarantee that the business entity is in profit within the upcoming future.

It will be discussed in detail why the financial statement analysis cannot assure that the company will be more profitable in the future and also what are the building blocks of the financial statements.

What is a Financial Statement?

They are the financial records of a business entity or a company that shows the financial position of a business and its performance in an accounting year.

Elements of the financial statement:

  1. Assets of the company
  2. Liabilities of the company
  3. Equity
  4. Revenues
  5. Expenses

Purposes of preparing financial statements

  • To provide a company’s financial information. The main objective of the financial statements is to know the company’s financial position.
  • Serve the existing and potential investors. The financial statements act as a primary source of information for the investors to the company’s financial information. It helps the investors to decide whether they should invest more or withdraw the existing amount.
  • To oversee the company’s expected future net cash inflows. The financial statement does not provide the investors or the users to know the company’s exact profit or loss in the future instead it provides the users and investors the prediction of the company’s future cash flow.

What is Financial Statement Analysis?

The financial statement analysis is the process of analyzing the company’s financial statements to know the net cash flow of the company during an accounting period and making various financial decisions.

Users of financial statement analysis:

  • Creditors: The one who is lending the fund to the company will be interested to know the cash flow of the company so that the creditor could know the company would be able to pay the debt amount or not.
  • Investors: The existing and potential investors are interested to know the financial conditions of the company for making decisions about issuing dividends and generate cash flow.
  • Management: The managers and company’s controllers prepare the financial statement to make necessary decisions related to finance and the company in the future.
  • Government Authorities: If the company is based in the public sector, then the financial statements of the company are inspected by the Securities and Exchange Commission to check whether the company is following the rules of the SEC.

Methods of Analyzing the Financial Statements

a. Use of horizontal and vertical analysis

  • Horizontal Analysis: Comparison of financial statement of one year with the previous year and one line item is compared with the same item in another period.
  • Vertical Analysis: The proportional analysis of the financial statement, where every line item is expressed as a percentage of the other item.

b. Use of ratio analysis

  • Liquidity Ratio: It is used to find out the company’s ability to pay the short-term debt and also the ability of a company to stay in the business.
  • Activity Ratio: These are used to know the efficiency of the business and also the efficiency of the company’s assets that is used by the management.
  • Leverage ratios: This ratio is used to identify the company’s total funds raised due to debt and its ability to pay back the debt.
  • Profitability ratios: These ratios are used to know the company’s performance and how well is the company generating income and profits.

What does the Financial Statement Analysis not involve?

The financial statement analysis involves all of the subsequent aside from the guarantee that the business entity is in profit within the upcoming future.

This is because one cannot assure the future profit or loss of a business in advance. It can only be predicted whether a company is going to face the loss or the profit based upon the various financial statements.

The financial statement analysis provides the current year information related to the financial position of the business and gives an idea to estimate the future losses and profits but never assures it.

Building blocks of the financial statement analysis do not include external analyst services. The External analyst is responsible for the company’s business risk. It examines the company’s threats that exist in the environment.

The building blocks of financial statement analysis do not give information regarding the company’s future risk it only gives a prediction.