Financial Statement Analysis

Financial statements are records that can provide indications of the financial health of a company. Accurate financial records are necessary to keep track of financial warning signals such as inordinately high expenses, high levels of debt, or a poor record of collecting bills. Public companies often have specific procedures for gathering, verifying, and reporting financial information. Recent corporate scandals have placed greater scrutiny on the managers and corporate officers of publicly held firms. Privately held firms are not held to the same standard but often adhere to strict guidelines to increase the value of the firm and viability in case of sale.

Keywords Accounting; Accounting Methods; Accounts Payable; Accounts Receivable; Assets; Balance Sheet; Cash Flow; Cash Flow Statement; Current Assets; Current Liabilities; Fixed Costs; Liabilities

Finance > Financial Statement Analysis

Overview

Financial statements are reports that show the financial position of a company. Recordkeeping is important to understand a company's value and to comply with various regulations and tax requirements. Accurate records allow companies to account for how money was spent and handled, what assets are owned and what debts are owed.

In addition to the various business needs that are served by the publication of financial statements, there are many legal requirements for these as well. For example, the United States Security and Exchange Commission (SEC) requires businesses to make available financial statements on both a quarterly and annual basis. The SEC then performs a monitoring function to ensure these statements accurately reflect the financial health of the business. In the absence of such regulatory efforts, people would be far less confident in investing in businesses. Businesses, in turn, would lose access to financial resources that allow them to pursue their objectives. The economy as a whole benefits from this type of transparency.

Businesses differ in how they are valued depending on whether they are public or private firms. Information about public companies is available, especially to shareholders, while it is difficult to get audited and financially sound information about the financial workings of a private company (Antia, 2006). Antia (para. 2) calls the value of a business the "free cash flow" that has various adjusted risk elements deducted from it. Private companies don't provide information on their cash flow and have greater opportunities to engage in financial benefits not available to public companies, such as:

• Above-market salaries for family members.
• Mixing of personal and business funds.
• Exaggeration of business expenses to reduce taxes.

Other concerns regarding a business' value can depend on what a buyer sees in the business. If the business represents a strategic purchase, a higher price might be garnered even for an over-valued private business. If a buyer is a minority buyer, they may want to pay less due to the minimal amount of control they can exert on the business (Antia, para. 3).

Types of Financial Statements

Basic financial statements include the balance sheet, the income statement, the cash flow statement, and notes to account. There are different types of reports because different types of information are needed to manage a company and plan for the future effectively. Sometimes companies use financial reporting information internally and may be required to release this information externally. Tracy (1999) called cash the "lubricant" of business. Without cash, it is difficult for a business to function, and it increases the likelihood that a business may fail. Nonetheless, Tracy warns that cash flows only show part of the picture and give no information about the business' profit or financial condition. Since cash flows only show part of the picture, other financial reports are needed.

The most common financial reports are the balance sheet and the income statement.

• The balance sheet (also called the statement of financial position) provides information about the financial condition of a company.
• The income statement (also called the earnings or profit and loss statement) shows the profitability of the business.

Balance Sheets

The general categories on balance sheets are assets and liabilities. A publicly traded firm also includes shareholder equity. A typical balance sheet shows the assets a company owns. Assets include cash, accounts receivable, inventory, and any prepaid expenses. Balance sheets also record the property the company owns and any depreciation on its assets. The balance sheet is a two-sided report because it records assets on one side and liabilities on the other. Liabilities include accounts payable and accrued expenses, income tax owed, loans, and stockholders' equity. Stockholders' or shareholders' equity is any claim that owners of company stock have against the assets that a company has. Stockholders' or shareholders' equity is also called net worth. Stockholders' equity is found by deducting liabilities and debt from assets (Morgenson & Harvey, 2002).

Income Statements

Income statements show the profitability of a business. The income statement is for a period of one year and shows the total sales revenue for the year. Subtracted from sales revenue is the cost of goods sold or the expenses a company incurs in producing finished goods to sell. Also deducted from the revenue are expenses for operating costs and depreciation. If a company is publicly owned, its income statement must also report earnings per share (Tracy, 1999). Earnings per share is a measure of company profitability (Godin, 2001). It is calculated by dividing net income by the total shares of stock. When looking at the income statement of a company, the profitability isn't just the gross profit, it is also important to look at the ratio of expenses as a percentage of profit. If a company has high profits but also has high expenses, the company could be mismanaged.

Balance sheets are important not only to companies but also to investors (Godin, p. 52). Balance sheets can tell investors whether or not a company is a good investment based on its financial condition. Financial statements are often prepared by accountants and reviewed by auditors to ensure that the records are accurate and to avoid the temptation not to report factual information or to hide financial flaws. A reason business owners may use financial professionals is to reduce the chance of error and to stay out of an area where they may not have expertise. O'Bannon (2005) cautioned business owners against being lulled to sleep by the power of current accounting software products, which cannot replace the knowledge gained by using professional financial advice. O'Bannon felt that one of the primary benefits of the newer software is that it allows owners and financial advisors to speak the same language and lets business owners provide easy-to-use documentation to accountants. Accountants and other financial advisors can use software to quickly perform somewhat complex analyses and generate reports for their clients. Arar (2012) wrote that small businesses have "more accounting software options than ever, including Web-based subscriptions."

In 2023, Forbes Magazine listed its best choices for accounting software. These include Zoho Books as the best free software. FreshBooks was deemed the easiest to use. Xero was noted for its advanced features, and Intuit QuickBooks was recommended for small business entrepreneurs.

Analyzing Balance Sheet & Income Statements

Analyzing balance sheets and income statements requires more than simply reading the categories of figures. The numbers must be read with an eye toward what they might mean in combination. Scott (2005, p. 108) stated that financial statement analysis means interpreting the data "in a meaningful way" instead of looking at "past results." This can mean looking at the company's management strategy, the way the business is operated, and the plans the business has for the future. Scott suggested asking the following questions to get close to figuring out how internal factors, especially management, influence financial statement content:

• How is the company distinguishing itself from the competition?
• How does it compete? E.g., on price, quality, responsiveness, availability?
• Is the company's strategy viable given the marketplace economy?
• Is management adapting its strategy to a changing environment?

These questions and others can provide qualitative information in addition to the quantitative numbers provided in financial statements. Using the information in aggregate can give a broader picture of the company's financial health.

Ratio Analysis

Ratios are one method of analyzing what financial statements may mean. There are several types of ratios including liquidity and profitability ratios. Ratio analysis shows the relationship between financial information, the way it behaves over time and what risks are implied by the behavior (Morgenson & Harvey, 2002).

Liquidity ratios are a measure of how 'liquid' a company is or how well it can come up with cash or quickly converted assets that can help the company meet its financial obligations. If the ratio is high, that is a good number. An example of a liquidity ratio is to divide current assets by current liabilities. The result shows how much cash is available for the company to manage current financial requirements. A helpful ratio is a liquidity ratio that eliminates slow moving inventory from current assets to give a more accurate picture of a company's liquidity. Companies can compare their liquidity to others in their industry to see how they fare among similar companies. A debt-to-equity ratio is a measure of the ability of a company to use debt to finance its operations. Profitability ratios measure the company's profit performance by comparing profits to sales. Companies that endure are those able to remain profitable even under unfavorable conditions.

Support with Financial Analysis

Many owners and managers, especially in small businesses, may need support in using financial information to analyze a company’s position. Managing Credit (2005) directed readers to a website where they could download a free financial statement analysis worksheet that not only helps the user prepare financial statements but has preconfigured formulas for calculating ratios and ratio analysis. Technology has made it easier to find tools that will help demystify managing and using financial data. Some of these tools can help non-financial managers understand what particular financial information means and make a connection between the financial information reported and the day-to-day operations they know and understand.

Bankruptcy Prediction

In a study of over 19,000 Norwegian firms, Hol (2007) discussed the analysis of financial statements as a predictor of business bankruptcy. Most studies focus on financial differences in comparing distressed businesses to healthy ones. Nonetheless, a stronger predictor of bankruptcy is industry factors and business cycle movements and not just financial statement information. to Industry and external factors include the "gross domestic product gap, industrial production index and the money supply" (Hol, p. 88). There are complex bankruptcy prediction models used by banks but they tend only to consider the internal financial information. They usually do not rely on external factors where company may not have control. Hol recognized that many bankruptcy prediction models were developed in the 1960s and 1970s and did not take into account market factors. When looking at internal financial statement information, Hol noted that four financial ratios need to be high to indicate a lower likelihood of bankruptcy:

• Cash flow to debt.
• Financial coverage to financial costs.
• Liquidity to current debt.
• Solidity to total capital.

If company managers are aware of what factors are important, they can put management strategies in place to maximize the positive factors and reduce the negative ones. A comprehensive strategy adds to internal factors and provides an allowance for external ones.

Viewpoint

Who Analyzes Financial Statements & Why

Microsoft (2007) notes that many different types of people may want to read and analyze financial statements for different reasons. One group that is interested in and that uses financial statements includes credit lenders to small business. Scott (2005) noted that, at the time of his writing, there were over 24 million small businesses, which accounted for over 50% of U.S. private gross domestic product. A market this large seems as if it would be very attractive to lenders and could offer many opportunities. However, Scott (p. 105) warns that the market is large but hardly uniform and can be plagued with problems. These companies may have undependable financials with "volatile earnings swing[s]" and are more likely to present a risk of fraud. The small business market is also difficult to categorize by industry because descriptive factors and trends may not be consistent across industry lines. Scott recommends using stringent, consistent, and traditional underwriting practices that treat each case as a unique one and consider the unique factors that affect the business. This means a careful examination of financial documents within the context of the business.

Scott (2006) describes a context model for analyzing small business financials that uses a cause-and-effect relationship to determine what information should be available and what that information should look like when examined. The primary measures Scott recommends using are "profitability, cash flow, liquidity, and solvency."

• Profit is a company's revenue less its costs.
• Cash flow is a measure of how much cash is coming into a company and flowing out of a company. The company may also be interested in tracking the rate of cash inflow and outflow.
• Tracy (p 75) calls liquidity "having too little ready cash" and described solvency as "not being able to pay liabilities on time."

Company managers should have a good knowledge of these factors in order to plan and manage the business. If any of these factors reaches a dangerous point, the health of the company could be in serious jeopardy.

There are various parties beyond the business owner with an interest in reading financial statements. These entities include investors, creditors, customers, suppliers, auditors, industry analysts, and fund managers.

• People want to know if a company is a good investment. If a company's financials and performance indicate this is true, investors can expect a good rate of return by sharing in the profits of the company. Investors want to monitor financial performance because it is important to know when to pull out of an unprofitable situation. Bad investments can have additional negative effects by tying up capital that could be placed toward better uses.
• Creditors want to know if a company is a good risk and if the company will likely repay a loan. If a company defaults on a loan, the creditor loses. If the company repays the loan plus the fees associated, the creditor receives a profit.
• Customers are concerned about a company's financial health because they want to be sure the company will exist in the future if they need additional products or services. In addition, customers want to do business with a company that will continue to provide future services. If a company cannot stand behind its products, the customer may decide to go elsewhere. Some customers considering engaging in a long-term relationship with a company and planning to purchase high volumes may ask for financials to determine whether such a relationship is advisable.
• Suppliers want a relationship with their customers and want to align themselves with financially solid companies. This helps with planned, affordable growth. Unpredictability in terms of a company's financial health means it cannot be a consistent buyer of a supplier's products. This situation bleeds over to the supplier, whose own revenue streams become unpredictable as well. Suppliers can often attract investors or impress creditors with their customer list.
• Auditors must provide an objective viewpoint on the financial health of the audited company. Auditors are expected to be accurate and impartial. Additional business is based on the credibility of the auditor. Recent corporate scandals have also charged auditors with irresponsibly overlooking financial warning signals. Aligning an auditor with such activity could ruin its reputation. Auditors might look at the financial information of a company to find errors and inaccuracies such as "duplicate or missing items and unauthorized transactions" (Lanza & Brooks, 2006, p.29). Auditors can be more accurate in analyzing the financial picture of a company if they go beyond the financial statements, competitive factors and risk analysis. The Securities and Exchange Commission (SEC) has online information that helps auditors to identify disclosure requirements and issues to look for in an audit.
• Industry analysts and fund managers advise others as to whether or not to invest in a company. The information that they provide, if accurate, can give them satisfied customers and greater credibility as industry analysts. These examples show that many people may be interested in the financial health and financial reporting of a company. The examples also indicate the importance of carefully and accurately prepared financial statements as they affect the ability of a company to do business, receive credit and attract investors and customers.

Ethics in Financial Reporting

The recent corporate financial scandals and crises have caused government intervention in the regulation of corporate financial reporting. These changes have increased the penalties corporate officers face if found to engage in fraud or providing misleading financial information. Without government regulation, many believe that it is impossible to ensure adequate protection for the investors and employees of companies when companies are driven by profit.

The United States Sarbanes-Oxley act of 2002 is federal legislation that was enacted in response to many of the corporate scandals such as Enron. The act governs accounting and financial reporting and provides for holding corporate officers and even accounting and auditing personnel responsible for giving accurate information about the financial health of corporations.

Another piece of legislation, the Dodd-Frank Wall Street Reform and Protection Act, was enacted in 2010. One of its main goals was to consolidate and strengthen consumer financial protection by granting the newly created Consumer Financial Protection Bureau (CFPB or Bureau) the power to enforce existing financial protection laws and to promulgate additional rules (Administrative law - agency design - Dodd-Frank Act creates the consumer financial protection bureau - Dodd-Frank Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010), 2011).

Ethics Training

The increased temptation to fudge the numbers to present a more appealing picture has not just affected government regulation of corporations. An emphasis on ethics in business and accounting classes is being made to have a positive affect on the future business leaders and managers (Smith, Smith, & Mulig, 2005). Smith et al (2005) found that exposure to ethics training "influenced student ethical development" as well as how students perceive ethics in terms of importance and how they view unethical behavior as acceptable or not.

Trust

Trust is noted as the underpinning of ethical business transactions. Without trust, there can be a breakdown in communication and lack of trust can ultimately affect buyer and seller willingness to engage in open market transactions. When trust is missing, energy is taken out of the economic systems and unfavorable ethical conditions could cause the collapse of the entire economic system. Smith et al (2005) list ten universal ethical values including "honesty, integrity, promise-keeping, fidelity, fairness, caring, respect for others, responsible citizenship, pursuit of excellence and accountability." Some of these values may come from a person's background, upbringing, religious beliefs, or from things a person has learned from reading or observation.

Ethics Guidelines

Smith et al suggested that management use ethical guidelines for decision-making and noted that most corporations have ethics guidelines for employee behavior. The employee business conduct guidelines often include topics like ethics, safety, harassment, operations, alcohol and drug use as well as conflicts of interest. Company guidelines cannot stop unethical behavior by employees nor can it stop fraud and abuse by employees who handle and manage financial information. However, the company can identify behaviors and suggest consequences for those who violate the rules.

Dubbink and Smith (2011) in fact argued that in liberal, democratic societies, there is an "underlying political need" to attribute greater levels of moral responsibility to corporations. "Corporate moral responsibility is essential to the maintenance of social coordination that both advances social welfare and protects citizens' moral entitlements," they wrote. When making decisions, there are certain questions to ask when considering whether or not a decision is ethical. These questions include (Smith et al, 2005):

• Are there legal concerns?
• Is it right?
• Does it comply with company values?
• Does it comply with principles of your profession (accountants, etc.)?
• Would you be embarrassed by your decision if others knew about it?
• Who else is affected by this (co-workers, customers, etc.)?
• Are you willing to take sole responsibility for this decision?
• Is there another course of action that does not create an ethical dilemma?
• How will it look in the newspaper?
• Do you think a reasonable person would agree with your decision? (Ask an appropriate person).

These questions are good guidelines for individuals facing an ethical dilemma. It is likely that someone might realize there is an ethical dilemma just by the fact that they have questions about it. While educating students and employees on ethical behavior is no guarantee to stopping financial fraud, it is a way to ensure that people who might be tempted are at least presented with information to avoid problems.

Terms & Concepts

Accounting Methods: The rules for reporting income and expenses.

Accounts Payable: A financial account for paying debts owed to suppliers and others.

Accounts Receivable: The accounts for which payment is owed.

Assets: An item of value owned by an individual or company and that can be used in future transactions for financial benefit.

Balance Sheet: A financial statement listing the value of the assets and liabilities.

Cash Flow Statement: A financial statement that shows incoming and outgoing cash where income is listed as revenue and outgoing cash is expense.

Current Assets: An asset on the balance sheet that is expected to be used or sold within a year.

Current Liabilities: Debts that are due within a year.

Fixed Costs: Costs that remain relatively constant over time such as rent, utilities, taxes and insurance.

Bibliography

Administrative law - agency design - Dodd-Frank Act creates the consumer financial protection bureau - Dodd-Frank Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (to be codified in scattered sections of the U.S. Code). (2011). Harvard Law Review, 124, 2123-2130. Retrieved November 20, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=61294566&site=ehost-live

Antia, M. (2006). Principles of private firm valuation. Financial Analysts Journal, 62, 77-78. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21054271&site=ehost-live.

Arar, Y. (2012). Reviews & rankings: accounting software saves time and money. PC World, 46-48. Retrieved November 20, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=82535589&site=ehost-live.

Dubbink, W., & Smith, J. (2011). A political account of corporate moral responsibility. Ethical Theory & Moral Practice, 14, 223-246. Retrieved November 20, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=59928596&site=ehost-live.

Godin, S. (2001). If you're clueless about the stock market and want to know more. Chicago: Dearborn Trade Books.

Haan, K. and Main, K. (2023, Apr. 24). Best Accounting Software for Small Business 2023. Forbes. Retrieved June 8, 2023, from https://docs.google.com/document/d/1zBpaFJAj7ZlAXopi9YE-IhRlvLapWyI0/edit.

Hol, S. (2007). The influence of the business cycle on bankruptcy probability. International Transactions in Operational Research, 14, 75-90. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23408631&site=ehost-live.

Konchitchki, Y. (2013). Accounting and the macroeconomy: the case of aggregate price-level effects on individual stocks. Financial Analysts Journal, 69, 40–54. Retrieved November 24, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=92504364&site=ehost-live.

Kumaraswamy, M. R. (2012). Ethic-based management vs. corporate misgovernance—new approach to financial statement analysis. Journal of Financial Management & Analysis, 25, 29–38. Retrieved November 24, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86710877&site=ehost-live.

Lanza, R.B. & Brooks, D. (2006). Are you looking outside enough? Internal Auditor, 63, 29-33. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21904239&site=ehost-live.

Maverick, J.B. (2022, May 24). Why do Shareholders need Financial Statements? Investopedia. Retrieved June 8, 2023, from https://www.investopedia.com/ask/answers/032615/why-do-shareholders-need-financial-statements.asp.

Morgenson, G. & Harvey, C. R. (2002). The New York Times dictionary of money investing. New York: Times Books.

(2005). Need help understanding financial statements? Managing Credit, Receivables & Collections, 5, Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18002299&site=ehost-live.

O'Bannon, I. M. (2005). Lost in translation. CPA Technology Advisor, 15, 44-50. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18883435&site=ehost-live.

(2007). Prepare financial statements. Microsoft Help and How-to. Retrieved October 1, 2007, from http://office.microsoft.com/en-us/help/HA011622271033.aspx.

Scott, S. (2005). A systematic approach to contextual financial analysis in small business asset-based lending. Secured Lender, 61, 104-113. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19176308&site=ehost-live.

Smith, L.M., Smith, K. & Mulig, E. V. (2005). Application and assessment of an ethics presentation for accounting and business classes. Journal of Business Ethics, 61, 153-164. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18506364&site=ehost-live.

Tracy, J.A. (1999). How to read a financial report: For managers, entrepreneurs, lenders, lawyers, and investors. New York: John Wiley & Sons.

Suggested Reading

Biddle, I. (2007). Watching for warning signs (analyzing financial records). Businessdate, 15, 4-7. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26597069&site=bsi-live.

(2007). Financial fraud study shows patterns. Financial Executive, 23, 15. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26472673&site=bsi-live.

Junker, L. (2007). Meet your new (audit) standards. Associations Now, 3, 55-57. Retrieved November 12, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26635012&site=bsi-live.

Konchitchki, Y., & Patatoukas, P. N. (2014).Aaking the pulse of the real economy using financial statement analysis: implications for macro forecasting and stock valuation. Accounting Review, , 89, 669–694. Retrieved November 24, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=95293399&site=bsi-live.

(2007). NACM offers attendees a boost with financial statement analysis. Business Credit, 109, 63. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27392577&site=bsi-live.