All financial statements are essentially historical documents. They tell what has happened during a particular 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 future ability of the company to pay its debts. Managers are concerned about the company’s ability to finance future expansion. Even though financial statements are historical documents, they can still provide valuable information on all of these concerns.
Financial statement analysis involves a careful selection of financial statement data for the primary purpose of forecasting the financial health of the business. This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios.
Managers are also very concerned about financial ratios. First, the indices 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 strategy of the company. For example, a company that wants to emphasize responsiveness to customers can closely monitor the inventory turnover rate. Since managers must inform shareholders and may wish to raise funds from external sources, managers must pay attention to the financial ratios used by external inventories to assess the investment potential and solvency 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 company 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. Sometimes enough data is presented in footnotes to 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 reaching a final 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 reasons are sufficient in themselves as a basis for judging the future. Could not be farther from the truth. Conclusions based on reason analysis should be considered an attempt. Ratios should not be seen as an end, but as a starting point, as indicators of what to pursue in greater depth. They ask a lot of questions, but they rarely answer a question on their own. In addition to proportions, other data sources must be analyzed in order to make judgments about the future of an organization. The analyst must observe, 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 figures that appear in financial statements are of much importance 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 the analysis of financial statements. How does the analyst identify a significant relationship? How does the analyst discover important trends and changes in a company? Three analytical techniques are widely used; changes in dollars and percentages in account statements, common-size statements, and financial ratio formulas.