All financial statements are essentially historical historical documents. They tell what has happened during a certain period of time. However, most users of financial statements are concerned about what will happen in the future. Shareholders are concerned about future earnings and dividends. Creditors are concerned about the company’s future ability to pay its debts. Managers are concerned about the company’s ability to finance future expansion. Despite the fact that financial statements are historical documents, they can still provide valuable information related to all of these concerns.
Financial statement analysis involves careful selection of financial statement data with the primary goal of forecasting the financial health of the company. This is accomplished by examining trends in key financial data, comparing financial data between companies, and analyzing key financial ratios.
Managers are also very concerned about financial reasons. First, the ratios provide indicators of how well the company and its business units are performing. Some of these ratios would normally be used in a balanced scorecard approach. The specific ratios selected depend on the company’s strategy. For example, a business that wants to emphasize responsiveness to customers might closely monitor inventory turnover. Since managers must report to shareholders and may wish to raise funds from outside sources, managers should pay attention to the financial ratios used by outside inventories to assess the investment potential and creditworthiness of the company.
Although financial statement analysis is a very useful tool, it has two limitations. These two limitations imply the comparability of financial data between companies and the need to look beyond the ratios. Comparing one company to another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare companies’ financial data. For example, if one company values its inventories by the LIFO method and another company by the average cost method, then direct comparisons of financial data such as inventory valuations and cost of goods sold between the two companies can be misleading. Sufficient data is sometimes presented in footnotes to the financial statements to restate the data on a comparable basis. Otherwise, the analyst must take into account the lack of comparability of the data before drawing a definitive conclusion. However, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.
An inexperienced analyst may assume that the reasons are sufficient in themselves as a basis for a judgment about the future. Could not be farther from the truth. Conclusions based on ratio analysis should be considered as an attempt. The proportions should not be seen as an end, but as a starting point, as indicators of what should be pursued in greater depth. They ask a lot of questions, but they rarely answer any questions for themselves. In addition to ratios, other data sources must be analyzed to make judgments about the future of an organization. The analyst must look at, for example, industry trends, technological changes, changes in consumer tastes, changes in general economic factors, and changes within the company itself. A recent change in a key management position, for example, could provide a basis for optimism about the future, even if the company’s past performance has been lackluster.
Few numbers that appear in financial statements have much meaning on their own. It is the relationship of one figure to another and the amount and direction of change over time that is important in financial statement analysis. How does the analyst identify the significant relationship? How does the analyst discover important trends and changes in a company? Three analytical techniques are widely used; Dollar and percentage changes in statements, common size statements, and financial ratio formulas.