The firm itself and outside providers of capital creditors and investors all undertake financial statement analysis. The type of analysis varies according to specific interests of the party involved.
Trade creditors (supplier owed money for goods and services) are primarily interested in the liquidity of a firm. Their claims are short term, and the ability of the firm to pay these claims quickly is best judged by an analysis of the firmâ€™s liquidity. The claims of bondholders, on the other hand are long term. Accordingly, bondholders are more interested in the cash-flow ability of the firm to service debt over a long period of time. They may evaluate this ability by analyzing the capital structure of the firm, the major sources and uses of funds, the firmâ€™s profitability over time and projections of future profitability.
Investors in a companyâ€™s common stock are principally concerned with present and expected future earnings as well as with the stability of these earnings about a trend line. As a result, investors usually focus on analyzing profitability. They would also be concerned with the firmâ€™s financial condition insofar as it affects the ability of the firm to pay dividends and avoid bankruptcy.
Internally, management also employs financial analysis for the purpose of internal control and to better provide what suppliers seek in financial condition and performance from the firm. From an internal control stand point management needs to undertake financial analysis in order to plan and control effectively. To plan for the future, the financial manager must assess the firmâ€™s present financial position and evaluate opportunities in relation to this current position.
With respect to internal power control, the financial manager is particularly concerned with the return on investment provided by the various assets of the company and in the efficiency of asset management. Finally, to bargain effectively for outside funds, the financial manager needs to be attuned to all aspects of financial analysis that outside suppliers of capital use in evaluating the firm. The type of financial analysis undertaken varies according to the particular interests of the analysts.
Financial analysis involves the use of various financial statements. These statements do several things. First, the balance sheet summarizes the assets, liabilities, and ownersâ€™ equity of a business at a moment in time, usually the end of a year or a quarter. Next, the income statement summarizes the revenues and expenses of the firm over a particular period of time, again usually a year or a quarter. Though the balance sheet represents a snapshot of the firmâ€™s financial position at a moment in time, the income statement depicts a summary of the firmâ€™s profitability over time. From these two statements (plus, in some cases, a little additional information), certain derivative statements can be produced, such as a statement of retained earnings , a sources and uses of funds statement, and a statement of cash flows.
In analyzing financial statements, you may want to use a computer spreadsheet program. For repetitive analyses, such a program permits changes in assumptions and simulations to be done with ease. Analyzing various scenarios allows richer insight than otherwise would be the case. In fact, financial statements are n ideal application for these powerful programs, and their use for financial statements analysis (both external and internal) is quite common.
Balance Sheet Information:
Considering a balance sheet the assets are listed in the upper panel according to their relative degree of liquidity (that is, their closeness to cash). Cash and cash equivalents are the most liquid of assets, and they appear first. Further an asset is removed from cash, the less liquid it is. Accounts receivable are one step from cash, and inventories are two steps.
Accounts receivable represent IOUs from customers, which should convert into cash with in given billing period, usually 30 to 60 days. Inventories are used in the production of a product. The product must first be sold and a receivable generated before it can go the next step and be converted into cash. Because fixed assets, long-term investment, and other long term assets are the least liquid, they appear last.
The bottom panel of the balance sheet shows the liabilities and shareholdersâ€™ equity of the company. These items are ordered according to the nearness with which they are likely to be paid. All current liabilities are payable within one year, whereas the long term debt is payable beyond one year. Shareholdersâ€™ equity will be â€œpaidâ€? only through regular cash dividends and, perhaps, a final liquidation dividend. Shareholdersâ€™ equity, or net worth at it is sometimes called, consists of several subcategories. Common stock (at par) and additional paid-in capital together represent the total amount of money paid into the company in exchange for shares of common stock.
The additional paid-in capital section represents money paid in excess of par value for shares sold. For example, if the face value of original issue of a companyâ€™s share is $1 and if the company were to sell an additional share of stock for $6, there would be a $1 increase in the common stock section and a $5 increase in the additional paid-in capital section.
Retained earnings represent a companyâ€™s cumulative profits after dividends since the firmâ€™s inception; thus, these are earnings that have been retained (or reinvested) in the firm.