Financial Statements are written in the language of Accounting and an advanced interpretation of what this accounting language is saying is the “ART of FINANCIAL STATEMENTS ANALYSIS”. Different users extract meanings of their concern (as discussed in previous chapter: Users’ of Financial Statements) from financial statements; how they will do that? For this purpose the art of extracting information from financial statements comes into play which is called financial statements analysis.
Financial Statement Analysis is pure JUDGEMENTAL. In other words this is not the science where 2 + 2 is always 4 rather the decision is based on judgment which requires knowledge as well as experience.
Well, for experience, I cannot do anything as the experience comes with EXPERIENCE; for knowledge, I have summarized the Financial Statement Analysis into two:
- Financial Statements Analysis Techniques
- Explanatory Information
Financial Statements Analysis Techniques
This part of financial statements analysis is purely concerned with mathematical formulae and interpretation of results obtained as a result of applying these formulae. Simple arithmetic math is sufficed for the purpose of learning these techniques.
In these techniques, primarily only Statement of Financial Position and Statement of Comprehensive Income are used as sources of information.
Broadly these techniques are divided (by me) into:
- Common Size Statements – Vertical Analysis
- Common Size Statements – Horizontal Analysis
- Ratio Analysis
The coming pages give detailed explanations of what the above mentioned mean.
This part of financial statement analysis requires study, research and reading the soft information about company i.e. information that is not presented in the form of figures by the company but provided in other forms e.g. director’s and auditor’s report that form part of the Financial Statements of the company.
Such information manifold increases the meaning and significance of the information obtained by applying analysis techniques (horizontal, vertical or ration analysis). Thus obtaining and using such information is essential for a complete and accurate analysis of financial statements.
Sources of such information could include but are not limited to following:
- Director’s Report: This report normally addressed to shareholder gives some insight into various decisions taken by management e.g. why company is going to liquidate some part of its business or going to invest in new markets. Similarly what, in the opinion of the directors, is the future of the company and so on.
- Auditor’s Report: Auditor’s report normally provides the information of going concern (i.e. whether the company will continue to business in next 12 months or not) and any major qualifications if highlighted by auditors.
- Other Publications: For example company executive personnel’s interviews in magazines, newspapers or reports by different agencies (human rights agencies, corruption monitoring agencies) about the companies. Such information provides additional information that might be helpful while making decisions.
- Comparisons: Results obtained from “Analysis Techniques” have more meaning when compared with some benchmarks. There are some professional companies in the market that provide such information e.g. industry ratios, benchmarks etc.
“ANALYSIS TECHNIQUES” & “EXPLANATORY INFORMATION” Relationship
You might have already grasped some idea of relationship between “Analysis Techniques” and “Explanatory Information” this will, however, be more evident from the following example.
Example Suppose you have surplus funds and wish to invest these funds for earning a reasonable return. Further suppose that you have decided to invest in the shares of companies. Now the question arises, out of so many companies which one is better for you to invest? Thus the need of “Financial Statements Analysis” comes into play, you will pick the financial statements published by the company and using “Analysis Techniques” e.g. ratio analysis arrive at the decision that company is in loss and is a bad choice for investment. At this moment you decision is solely based on results obtaind by “Analysis Techniques”.
However, now you study “Explanatory Information” and in director’s report you read that company’s CEO is saying, “We have entered into negotiations with a major investor who will invest a lot and as a result the company will be profitable in coming years”. This information, perhaps, change you r first decision and you decide to invest in the same company you have reject based on “Analysis Techniques”.
Therefore Analysis Techniques always go with Explanatory Information. Remember Financial Statements Analysis is the art of Judgment thus requiring the consideration of many variables.
Coming pages explain in great detail the Analysis Techniques and how to interpret them.