Notes on Chapter 4: Analysis of Financial Statements

Definition of Financial Statement Analysis

• Involves making assessments of a company's financial status and outcomes.
• Aims to estimate and forecast future financial conditions.
• Identifies connections and highlights strengths and weaknesses of a business.

Importance of Financial Statement Analysis

• Assesses managerial performance, corporate efficiency, and financial strengths and weaknesses.
• Assists in resource allocation and evaluates operational success.
• Determines a company's ability to meet financial obligations, influencing suppliers and lenders.
• Assists investors and labor unions in decision-making.
• Provides insights for economists and researchers about economic trends.

Goals of Analyzing Financial Statements

• Evaluate profitability and efficiency of the company and its departments.
• Determine significance of financial aspects.
• Identify reasons for changes in profitability and financial status.
• Assess debt repayment capability and financial liquidity.
• Based on factual data, accounting conventions, and postulates.
• Personal judgment may influence the preparation of statements.

Tools for Analyzing Financial Statements

1. Comparative Statements
   • Shows profitability and stability over different periods.
   • Compares key financial statements like balance sheets and profit-loss statements.
2. Common Size Statements
   • Shows relationship of items to a common item as percentages.
3. Trend Analysis
   • Studies changes in operations and health over multiple years.
4. Ratio Analysis
   • Evaluates profitability, stability, and efficiency.
5. Cash Flow Analysis
   • Examines cash movement, detailing inflows and outflows.

Comparative Statement

• Includes profit and loss statements and balance sheets with figures from current and previous years.
• Shows absolute and relative changes, aiding in understanding account balances and operational activities.

Preparing Comparative Statements

• List figures for two periods.
• Determine absolute changes and percentage changes.

Common Size Statement

• Analyzes changes in financial position and operational results as a percentage of total revenue or aggregate figure.

Preparing a Common Size Statement

• List figures for two periods and choose a common base (often set as 100).
• Calculate percentage of each item based on the common base.

Limitations of Financial Statement Analysis

• Does not account for price level changes.
• Can be misleading with changes in accounting procedures.
• Focuses only on monetary information, ignoring non-monetary aspects.
• Prepared according to accounting concepts, which might not reflect current position accurately.