The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. The role of financial statement analysis is to use the company’s financial statements & other relevant information to make economic decisions. Two major areas where financial statement analysis is used to help make decisions are :
Evaluate company’s past performance and current financial position
Project company’s ability to earn profits and future cash flows
The major economic decisions that can be taken through financial statement analysis are:
Whether to invest in the company’s securities
Whether to extend bank credit to the company
While doing financial statement analysis the analyst must classify the business activities into three groups. Understanding the nature of activities of a firm helps the analyst to ascertain where the company is doing good and where it is lacking.
Operating Activities : – Activities that are part of a day-to-day business functionality of an entity . Eg. sales of goods and services to customers, costs of providing the goods and services, taking deposits and making loans by bank.
Investing Activities : – Activities associated with the acquisitions and disposals of a long term assets. Eg. purchase and sale of a office building, plant and machinery, purchase or sale of other entities equities or debt securities.
Financing Activities : – Activities related to obtaining and repaying capital. Eg. issuing common shares , bonds etc . Issuance or repayments of debt , payments of distribution ( dividend ).
Different financial statements used for analytical purposes are:
Income Statements is a financial statement that reports a company’s financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities.
Balance Sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
Cash Flow provides information about sources and uses of cash of the firm. It provides information to assess firm’s liquidity, solvency and financial flexibility.
Statement of change in owner’s equity details the change in owners’ equity over an accounting period by presenting the movement in reserves comprising the shareholders’ equity.