What is Financial Statements?
Financial Statements are a type of curated financial record that depicts the snapshot of a company’s business performance over a fiscal year and uncover the health, liquidity, and sustainability information to its investors, creditors, and regulatory bodies. These statements include the Balance Sheet, the Income Statement (Profit & Loss Statement), and the cash flow statement.
Financial Statements show various information about the company such as its liquidity level, where its money comes from, where was it spent, how much money the company owes to its creditors, which assets the company possesses, and so on. While financial statements are typically prepared yearly, some companies might publish interim financial statements on a quarterly and semi-annual basis. The exact nature and structure of the financial statements may differ from company to company and country to country.
Different Types of Financial Statements
Financial statement analysis involves dealing with different sets of financial statements.
1. Balance Sheet
The balance sheet is a crucial statement that lists the company’s assets, liabilities, and equity. It reveals crucial information about the company’s financial position so that stakeholders can assess the solvency and overall health.
- Monetary Assets
Assets on the balance sheet represent a company’s resources and holdings. They include tangible items like cash, inventory, and property, as well as intangible assets like patents.
- Monetary Liabilities
Liabilities on the balance sheet encompass a company’s obligations and debts. These can be current, like short-term loans, or long-term, such as bonds.
- Equity Capital
Equity, also known as shareholders’ equity or net assets, reflects the residual interest in a company’s assets after deducting liabilities during Financial statement analysis.
2. Income Statement
The income statement is an important statement that provides information about the company’s revenues, expenses, and net income. It offers a crucial insight into profitability and operational efficiency, aiding strategic decision-making.
- Revenue Stream
Revenue on the income statement represents the amount of money (income) generated from a company’s primary operations.
- Expenses
In an Income Statement, expenses encompass the costs incurred by a company to generate revenue. They include operating costs, interest, and taxes.
- Profit & Loss
The Profit & Loss statement is also called the income statement. It provides a host of details such as income and expenditures, etc.
3. Cash Flow Statement
A Cash Flow Statement (also called a Statement of Cash Flow) tracks the inflow and outflow of cash within a specific period of time. The Cash Flow Statement helps understand the liquidity position of the company and gain insights into the company’s operational efficiency.
- Operating Activities
The Cash flow statement has a section called Operating Activities. It provides information about various cash transactions relating to the core business of the company.
- Investing Activities
Investing activities appear in the Statement of Cash Flow. They provide crucial details about the cash transactions such as acquiring and disposing of long-term assets.
- Financing Activities
Financing activities on the cash flow statement involve cash transactions with a company’s owners and creditors.
Importance of Financial Statements
Financial statement analysis is crucial for businesses as it provides a comprehensive snapshot of the company’s financial health, aiding in informed decision-making by management, investors, and stakeholders.
1. Investor Confidence
Transparent financials inspire investor trust by showcasing a company’s financial health, stability, and growth potential. Investors rely on these statements to make informed decisions, fostering confidence in the business.
2. Improving Creditworthiness
Lenders use financial statements to evaluate a company’s creditworthiness, determining the risk associated with providing loans or credit. Accurate financial reporting is essential for establishing trust and securing favorable credit terms.
3. Regulatory Compliance
Financial statements ensure compliance with regulatory standards, promoting transparency and accountability. Accurate reporting is essential to meet legal requirements, build trust with stakeholders, and avoid legal repercussions.
4. Tax Planning
Accurate financial statements are essential for effective tax planning. Businesses can optimize tax liabilities, take advantage of available incentives, and ensure compliance with tax regulations, minimizing the risk of financial penalties.
5. Risk Management
Financial statements aid in identifying and managing financial risks. By assessing financial health, businesses can implement strategies to mitigate risks, enhance resilience, and ensure long-term sustainability in a dynamic business environment.
Commonly Used Financial Ratios
Audited financial statements contain various financial ratios that help businesses identify the areas where they are outperforming and underperforming, and gain insights into financial trends.
1. Liquidity Ratio
- Quick Ratio
Quick Ratio is also known as Acid-test Ratio which is an important ratio used in the financial statement analysis. It reveals the company’s ability to cover its short-term obligations with its most liquid assets. It excludes inventory from current assets, focusing on cash, receivables, and marketable securities.
- Current Ratio
The current ratio includes all current assets (cash, receivables, inventory) and divides them by current liabilities. The formula is Current Assets / Current Liabilities. A ratio above 1 indicates a company can meet its short-term obligations, but excessively high ratios may suggest inefficient use of resources.
2. Profitability Ratios
- Gross Margin
Gross margin assesses a company’s profitability by measuring the percentage of revenue retained after deducting the cost of goods sold (COGS). The formula is (Revenue – COGS) / Revenue. A higher gross margin indicates efficient production and pricing strategies.
- Operating Margin
Operating margin in financial statement analysis evaluates a company’s operational efficiency by determining the percentage of operating income (revenue minus operating expenses) relative to revenue. The formula is (Operating Income / Revenue) * 100. A higher operating margin reflects effective cost management and profitability from core business activities.
- Net Profit Margin
Net profit margin in financial statement analysis gauges overall profitability by expressing net income as a percentage of revenue. The formula is (Net Income / Revenue) * 100. This ratio considers all costs, including taxes and interest. A higher net profit margin indicates effective overall cost management and profitability after all expenses.
3. Financial Leverage Ratios
- Debt-to-Equity Ratio
The debt-to-equity ratio is another important ratio in audited financial statements that measures a company’s financial leverage by comparing its total debt to shareholders’ equity. The formula is Total Debt / Shareholders’ Equity. A higher ratio suggests a higher degree of financial leverage, indicating more reliance on debt for financing, which can amplify returns but also increase risk.
- Interest Coverage Ratio
The interest coverage ratio helps external stakeholders understand the company’s ability to pay the interest payments on time. It is calculated as (Operating Income / Interest Expense). A higher ratio indicates a company has more earnings to cover interest costs, reflecting better financial health and a lower risk of default.
4. Market Ratios
- Price-to-Earnings Ratio (P/E Ratio)
The P/E ratio evaluates a stock’s valuation by comparing its market price to earnings per share (EPS). It reflects investor expectations and risk perception, with a higher P/E indicating higher expectations for future earnings growth.
- Earnings Per Share (EPS)
EPS represents a company’s profit allocated to each outstanding share. It’s a key metric for investors, indicating a company’s profitability on a per-share basis. Higher EPS signifies greater profitability and potential shareholder value.
5. Efficiency Ratios
- Inventory Turnover Ratio
Inventory turnover measures how efficiently a company manages its inventory. The ratio is calculated during financial statement analysis by dividing the cost of goods sold by the average inventory, revealing how quickly inventory is sold and replaced.
- Receivables Turnover Ratio
Receivables turnover assesses how efficiently a company collects cash from credit sales. It’s calculated by dividing net credit sales by the average accounts receivable, providing insights into the effectiveness of credit management.
- Asset Turnover Ratio
Asset turnover gauges a company’s ability to generate revenue from its assets. It’s calculated by dividing total revenue by average total assets, showing how efficiently a company utilizes its assets to generate sales.
- Return on Assets (ROA)
Much like an asset management solution, ROA evaluates a company’s profitability relative to its total assets. The ratio is calculated by dividing net income by average total assets, indicating how efficiently a company generates profit from its asset base.
Limitations of Financial Statement Analysis
Now that we’ve discussed everything including financial statements meaning, let us discuss its limitations.
1. Historical Information
Financial statements offer historical data, hindering real-time insights. Future events and current market dynamics may not be accurately captured, limiting their relevance for decision-making in dynamic business environments.
2. Qualitative Factors Ignored
Financial statements often overlook crucial qualitative factors such as employee morale or brand reputation, providing an incomplete picture of a company’s overall health and performance.
3. No Future Predictions
Financial statements are retrospective, offering no predictive capabilities. They cannot forecast future financial trends, hindering strategic planning and decision-making in an ever-evolving business landscape.
4. Dependence on Historical Cost
Financial statements frequently rely on historical cost, potentially distorting a company’s actual economic standing by not reflecting current market values, leading to inaccuracies in asset valuation.
5. Potential Manipulation
Financial statements are susceptible to manipulation and fraud, jeopardizing their reliability. Unethical practices, such as window dressing or accounting irregularities, can mislead stakeholders, impacting trust and accurate decision-making.
FAQs
1. What is Financial Statements Meaning?
Financial statements are formal records that present the financial activities and position of a business. They include the Balance Sheet, Income Statement, and Cash Flow Statement. Each of these statements reveals crucial details about the financial elements of your business.
2. How is the Balance Sheet Different than the Income Statement?
As illustrated in the financial statements meaning, the Balance Sheet provides a snapshot of the company’s financial position over a period of time, with complete information about its assets, liabilities, and equity. In contrast, the Income Statement summarizes revenues and expenses over a period, revealing the profitability of operations.
3. What is Vertical Analysis of Financial Statements?
Vertical analysis of financial statements is a method of financial statement analysis that expresses each line item on a financial statement as a percentage of a base item. Typically, in vertical analysis, each line item in the financial statement is expressed as a percentage of total revenue or total assets.
4. What are Common size Financial statements?
Common size Financial Statements presents each line item in the form of a percentage of the base item, usually total revenue or total assets. This approach makes it easier to identify trends, assess relative proportions, and compare financial statements across industries or competitors.
5. Why are Liquidity Ratios Important?
During financial statement analysis, liquidity ratios like the current ratio and quick ratio help external stakeholders such as shareholders and banking institutions, evaluate the company’s ability to meet its short-term obligations.