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 in order to increase the value of the firm and viability in case of sale.
Financial statements are reports that show the financial position of a company. Recordkeeping is important in order 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.
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 overvalued 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, cash flow statement and notes to account. There are different types of reports because different types of information are needed to effectively manage a company and plan for the future. Sometimes companies use financial reporting information internally, and in some cases they are 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. But, Tracy warned 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 types of 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.
The general categories on balance sheets are assets and liabilities. A publicly traded firm also includes shareholder equity. A typical balance sheet shows assets a company owns. Assets include cash, accounts receivable, inventory and any prepaid expenses. Balance sheets also record property the company owns and any depreciation on 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 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 not only important 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 their accountant. Accountants and other financial advisors can use software to quickly perform somewhat complex analysis and generate reports for their clients.
Arar (2012 ) wrote that small businesses operating in the 2010s have "more accounting software options than ever, including Web-based subscriptions." For those businesses with large inventories or client databases, however, or those that choose not to entrust data to the cloud, such desktop tools as Acclivity AccountEdge Pro 2012, Intuit QuickBooks 2013, and Sage 50 Complete Accounting 2013 are good options (Arar 2012 ).
Analyzing Balance Sheet & Income Statements
Analyzing balance sheets and income statements requires more than simply reading the categories of figures. The numbers have to be read with an eye towards what they mean and 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.
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 quick 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 last are able to remain profitable even under unfavorable conditions.
Help in Financial Analysis
Many business owners and managers, especially in small businesses, may need help in using financial information to analyze company 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 the financial information means and make a connection between the financial information reported and the day-to-day operations they know and understand.
Hol (2007 ) discussed the analysis of financial statements as a predictor of business bankruptcy for firms in Norway; over 19,000 firms were studied. Most studies have shown that healthy companies are compared to financially distressed ones based on how they differ financially. However, a stronger predictor of bankruptcy is to consider industry factors and business cycle movements and not just financial statement information to determine how likely a company is to fail. The 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 that are used by banks but they tend to only consider the internal financial information and usually do not rely much on external factors over which a company may not have any control. Hol recognized that many of bankruptcy prediction models were developed in the 1960's and 1970's 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 factors. A comprehensive strategy adds to internal factors an allowance for external ones.
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 a number of 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 take into account the unique factors that affect the business. This means 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 ready 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 can include investors, creditors, customers, suppliers, auditors, and industry analysts and fund managers.
- Investors that currently invest in a company or have an interest in investing in a company want to know if the company is a good investment. If a company's financials and performance indicate that the company is a good investment, the investor 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 a losing investment and investors could be limiting themselves by tying up capital that could be invested in a better prospect.
- Creditors want to know if a company is a good risk to loan money to and if the company will be able or likely to pay a loan back. If a company defaults on a loan, that is a bad risk for the creditor; if the company pays back the loan plus the fees associated with the loan, the creditor receives a profit.
- Customers are concerned about a company's financial health because they want to be sure the company will be around if they plan to continue to purchase products. In addition, those who have already purchased products want to do business with a company that will be around to service the products purchased. 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 of not such a relationship is advisable.
- Suppliers want a relationship with their customers and want to align themselves with financially sound companies that they can grow with and that can afford and value the products they sell. Inconsistency in a company's financial health means it won't be a consistent buyer of the supplier's products which jeopardizes the financial health of the supplier. Suppliers can often attract investors or impress creditors by their customer list.
- Auditors have to provide an objective viewpoint on the financial health of the audited company. Auditors are expected to be accurate and impartial and 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 the auditor's 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).
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 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.
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.
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(8), 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(3), 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(2), 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 .
Hol, S. (2007). The inf luence of the business cycle on bankruptcy probability. International Transactions in Operational Research,14(1), 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
Lanza, R.B. & Brooks, D. (2006). Are you looking outside enough? Internal Auditor, 63(4), 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
Morgenson, G. & Harvey, C. R. (2002). The New York Times dictionary of money investing. New York: Times Books .
Need help understanding financial statements? (2005). Managing Credit, Receivables & Collections, 5(9) 8. 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(7), 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
Prepare financial statements. (2007). 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(6), 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(2), 153-164. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebsco-host.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 .
Biddle, I. (2007). Watching for warning signs (analysing financial records). Businessdate, 15(5), 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
Financial fraud study shows patterns. (2007). Financial Executive, 23(7), 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(10), 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
NACM offers attendees a boost with financial statement analysis. (2007). Business Credit, 109(10), 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
Essay by Marlanda English, Ph.D.
Dr. Marlanda English is president of ECS Consulting Associates which provides executive coaching and management consulting services. ECS also provides online professional development content. Dr. English was previously employed in various engineering, marketing and management positions with IBM, American Airlines, Borg-Warner Automotive and Johnson & Johnson. Dr. English holds a doctorate in business with a major in organization and management and a specialization in e-business.