Financial Statement Analysis: Understanding Financial Ratios and Making Decisions
Financial Statement Analysis is both an art and a science, an essential skill that enables investors, creditors, management, and other stakeholders to understand a company’s performance, financial position, and future trends. Financial Statement Analysis goes beyond simply reading numbers; it involves delving deep into financial data to extract valuable insights that aid in making informed economic decisions. In this article, we will explore the world of Financial Statement Analysis, discuss its objectives and tools, focusing on how to use financial ratios and indicators to understand a company’s performance, and highlight the importance of Financial Statement Analysis in making investment, financing, and management decisions.
What is Financial Statement Analysis?
Financial Statement Analysis is the process of reviewing and evaluating a company’s financial statements to understand its financial performance and position. It involves using various tools and techniques, such as horizontal analysis, vertical analysis, and ratio analysis, to extract meaningful information from financial data.
Objectives of Financial Statement Analysis:
- Evaluate Financial Performance: To assess the company’s profitability, operational efficiency, liquidity, and solvency.
- Identify Strengths and Weaknesses: To help identify strengths and weaknesses in the company’s performance and financial position.
- Predict Future Performance: To use the results of Financial Statement Analysis to predict the company’s future performance and develop financial plans.
- Make Informed Decisions: To provide essential information for making investment, financing, and management decisions by various stakeholders.
- Compare Company Performance with Competitors: To use Financial Statement Analysis to compare the company’s performance with other companies in the same industry.
- Assess Earnings Quality: To evaluate the quality of the company’s earnings, i.e., how sustainable and repeatable these earnings are in the future.
- Assess Investment Risks: To help assess the risks associated with investing in the company, such as bankruptcy risk or the risk of inability to repay debts.
Tools of Financial Statement Analysis:
Financial Statement Analysis tools vary and can be classified into three main categories:
1. Horizontal Analysis:
- Definition: Comparing financial statement items for the same company across different time periods (two or more years) to identify trends in the company’s performance and financial position.
- Objective: To identify strengths and weaknesses in the company’s performance and predict future performance based on past trends.
- How to Perform:
- Choose a base year: Represents the starting point for comparison.
- Calculate changes: Subtract the item’s value in the base year from its value in the following year.
- Calculate the percentage change: Divide the change in the item by the item’s value in the base year, then multiply the result by 100.
- Analyze results: Interpret the percentage changes to identify positive and negative trends.
2. Vertical Analysis:
- Definition: Expressing each item in the financial statement as a percentage of another key item in the same statement.
- Objective: To understand the structure of financial statements and the relative relationships between their various items.
- How to Perform:
- Income statement: Express each item as a percentage of sales revenue.
- Statement of financial position: Express each item as a percentage of total assets or total liabilities and equity.
3. Ratio Analysis:
- Definition: Calculating and using financial ratios extracted from financial statements to assess various aspects of the company’s performance and financial position.
- Objective: To provide quantitative indicators that help assess the company’s performance, profitability, liquidity, solvency, and operational efficiency.
- Types of Financial Ratios:
- Profitability Ratios: Measure the company’s ability to generate profits, such as gross profit margin, net profit margin, return on assets, and return on equity.
- Liquidity Ratios: Measure the company’s ability to meet its short-term obligations, such as the current ratio and quick ratio.
- Solvency Ratios: Measure the company’s ability to meet its long-term obligations, such as the debt-to-equity ratio and debt-to-total assets ratio.
- Efficiency Ratios: Measure the company’s efficiency in managing its operations and using its resources, such as inventory turnover and accounts receivable turnover.
- Market Ratios: Measure the company’s performance in the stock market, such as earnings per share and price-earnings ratio.
The Relationship between Financial Statement Analysis and Decision Making:
Financial Statement Analysis is an essential tool for decision-making by various stakeholders, such as:
- Investors: Use Financial Statement Analysis to assess the company’s performance, profitability, and investment risks, and make decisions about buying, selling, or holding the company’s shares.
- Creditors: Use Financial Statement Analysis to assess the company’s ability to repay its debts and make decisions about granting credit and determining interest rates.
- Management: Use Financial Statement Analysis to assess the company’s performance and make operational and strategic decisions, such as pricing, production, and investment decisions.
- Government: Uses Financial Statement Analysis for tax and regulatory purposes and to assess the economic performance of various sectors.
- Employees: May be interested in Financial Statement Analysis to assess the company’s stability and their career opportunities.
The Impact of Financial Statement Quality on Analysis:
The quality of Financial Statement Analysis depends heavily on the quality and reliability of the financial information provided in the financial statements. Errors or misstatements in the financial statements negatively affect the accuracy of the analysis and the validity of the decisions made based on it. Therefore, it is essential to ensure that the financial statements have been prepared in accordance with International Financial Reporting Standards and are free from material errors
The Role of Technology in Financial Statement Analysis:
Accounting software and Enterprise Resource Planning (ERP) systems provide advanced analytical tools that help analyze financial statements more efficiently and effectively, through:
- Automating the calculation of financial ratios.
- Creating charts and graphs that show trends in financial ratios over time.
- Conducting comparative analyses with other companies in the same industry.
- Identifying strengths and weaknesses in the company’s financial performance.
- Predicting future financial performance based on historical data.
- Performing sensitivity analysis to assess the impact of changes in key variables (such as sales prices and cost of goods sold) on the company’s profitability.
Examples of Financial Statement Analysis:
- Example 1: Analyzing the Income Statement of Company “A” using Horizontal Analysis:
| Statement | 2022 | 2023 | Percentage Change (%) |
|---|---|---|---|
| Sales Revenue | 500,000 | 600,000 | 20% |
| Cost of Goods Sold | 300,000 | 330,000 | 10% |
| Gross Profit | 200,000 | 270,000 | 35% |
Analysis:
The Income Statement data for Company “A” indicates positive growth in sales revenue and gross profit in 2023 compared to 2022. Horizontal analysis shows that sales revenue grew by 20%, while the cost of goods sold grew by only 10%, leading to a 35% increase in gross profit. These results indicate an improvement in cost management efficiency at the company.
Example 2: Analyzing the Statement of Financial Position of Company “B” using Vertical Analysis:
| Item | Amount (SAR) | Percentage (%) |
|---|---|---|
| Assets | ||
| Cash | 50,000 | 12.5% |
| Receivables | 75,000 | 18.75% |
| Inventory | 100,000 | 25% |
| Fixed Assets | 175,000 | 43.75% |
| Total Assets | 400,000 | 100% |
| Liabilities | ||
| Payables | 80,000 | 20% |
| Long-term Loans | 120,000 | 30% |
| Total Liabilities | 200,000 | 50% |
| Equity | ||
| Capital | 100,000 | 25% |
| Retained Earnings | 100,000 | 25% |
| Total Equity | 200,000 | 50% |
- Analysis:
- Fixed assets represent the largest percentage of the company’s total assets (43.75%), indicating that the company relies heavily on fixed assets in its operations. The company finances 50% of its assets through liabilities (debt) and 50% through equity.
- Example 3: Analyzing the Income Statement of Company “C” using Financial Ratios:
| inancial Ratio | Value |
|---|---|
| Gross Profit Margin | 40% |
| Net Profit Margin | 15% |
| Return on Assets (ROA) | 12% |
| Return on Equity (ROE) | 20% |
Analysis:
Gross Profit Margin (40%): Indicates that the company earns a gross profit of 40 halalas from every riyal of sales. Net Profit Margin (15%): Indicates that the company earns a net profit of 15 halalas from every riyal of sales. Return on Assets (12%): Indicates that the company generates a return on its assets of 12%. Return on Equity (20%): Indicates that the company generates a return on its equity of
Conclusion:
Financial Statement Analysis is an essential tool for understanding a company’s performance and financial position. Horizontal and vertical analysis provide insight into changes and trends in financial statement items, while financial ratios help assess the company’s profitability, operational efficiency, liquidity, and solvency. Mastering Financial Statement Analysis skills is essential for investors, creditors, and other stakeholders to make informed economic decisions. Furthermore, understanding how to analyze financial statements enhances your financial accounting skills and helps you succeed in the world of finance and business. Finally, technological developments facilitate Financial Statement Analysis and improve the quality and accuracy of financial information provided, thereby enhancing the effectiveness of these statements as a tool for evaluating performance.