One of the major aspects while taking a right investment decision is to analyze the financial statements of any company. Financial Statement analysis is a process to select, evaluate and interpret financial data in order to assess a company’s past, present and future financial performance. Various questions about the company like whether it has debt repaying capacity, is it financially sound or stressed, does it have an apt financial mix, is it rightly placed to provide returns to shareholders, revenue generating efficiency, working capital management being among the major ones which can be analyzed to a larger extent through financial reports. Although the information used is historical, the purpose is to arrive to future forecasts and an estimated performance of the company.
Methods of Financial Statement Analysis:
Academically, we are all aware of common size analysis which is restating the financial information in a standardized format. This could be done by horizontal analysis which compares two or more years of financial data in both Rupee and percentage form and vertical where each category of accounts on the balance sheet is shown as a percentage of the total accounts. This can be complimented with the DuPont model and also ratio analysis. Furthermore, we then use relationships among financial statement accounts, forecasting the company’s future income statements and balance sheets, to see how the company’s performance is likely to evolve. This step is normally based on the guidance given by the company management.
Users of Analysis:
Financial analysis is carried out by investors, regulators, lenders and suppliers to decide whether to invest in a particular company, whether to extend credit to it or no. The management of the company also carries out financial analysis to evaluate the current performance and implement strategies for the future. A thorough financial analysis of a company is examining its efficiency in putting its assets to work, its liquidity position, its solvency and its profitability.
To start off, the annual report of the past 3-5 years of the company is to be acquired. The various components of the annual report add to the conclusion drawn on the company. The different parts of the financial statements need to be scanned for abnormalities, and if any found, reasons for the same are to be chalked.
The revenue model is an outcome of the reported income statement. The past data has to be seen to model growth of the company. Consistency is preferred to swings in the statement. Erratic movements build suspicion. The expense part of the model should have percent to sales calculated, like percent of cost of goods sold over sales, general and administrative expenses over sales to mention a few. This also helps in determining a spending trend, reflecting the strategy of the company. Further, non-recurring and non operative expenses also need to be analysed for concluding the earnings quality. One of the major expense that needs to be calculated is the cost of raw material and that too after taking the adjustments (increase/decrease) of inventory. The operating ratio which in common parlance is known as EBIDTA is also the key as it truly reflects the management efficiency in controlling costs. It also depicts the effective utilization of the installed capacity.
Â It is a reflection of what the company owns and owes. The balance sheet stands on the three important pillars that indicate the quality of investments, namely working capital adequacy, asset performance and capitalization structure. The major components of the balance sheet; under the scanner are the assets, liabilities and equity.
Assets, or the means used to operate the company, are balanced by a company’s financial obligations along with the equity investment brought into the company and its retained earnings. Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. The various components of each like Assets: Current Assets (Cash and Cash equivalents, accounts receivables and inventory) and noncurrent (tangible and intangible assets), Liabilities: current (will come due for payment in a years’ time) and long-term (more than a year of repayment), also need to be analysed for any abnormalities which could be an indicator for the future projections. Reasons for the growth or slowdown seen in these individual numbers are also to be registered.
Equity represents what shareholders own, so it is often called shareholder’s equity. One needs to analyze whether the company has issued new shares or done a buyback. We need to closely see how a company puts the retained capital to use and how a company generates a return on it. These figures depict the long term strategy of the company. Also the higher the part of owners’ equity in comparison with debts, the more the company is financially autonomous, therefore solvent.
Cash flow analysis:
Cash flow statement actually depicts how the cash is generated and used in the business of the company. This is what actually interests the investors to take a call on the company. The (total) net cash flow of a company over a period is equal to the change in cash balance over this period: positive if the cash balance increases (more cash becomes available), negative if the cash balance decreases. The total net cash flow is the sum of cash flows that are classified in three areas which also need to be individually researched namely Operational Cash Flow, Investment Cash Flow and Financing Cash Flow.
All the above discussed financial statements finally help build the ratios of the company for final analysis. Different ratios across various categories like liquidity ratios, leverage ratios, profitability ratios, efficiency ratios help in analysing the overall health of the company. The trend across each shall help indicate any favorable or unfavorable numbers reported by the company. These ratios can also be compared with the data across other companies in the same industry as well.
Besides these majors points to be studied, there are other factors which also throw some light on the business, strategy and positioning of the company.
One needs to see if the dividend policy of the company supports its strategies. Like a growing company would retain the earnings to reinvest into the business rather than distributing to the investors. This is also an indicator of the future strategies of the company.
One of the key elements in fundamental analysis is management discussions and analysis section of the annual report which portrays the management style of doing business. It provides investors with insights into how the business has performed in the past, its current financial condition as well as projections of future performance. It gives a view of the management on growth and strategy, challenges and opportunities, historical performance and future outlook, financials and investments to mention a few. This definitely helps in building an opinion on the company. But one should keep a note that although it does give an insight of the management minds, it’s a thought, not audited.
Notes to accounts:
These are the footnotes to all financial statements of a company. One needs to read them very carefully as it gives lot of information as regards to the accounting methods that have been followed in preparing the accounts like inventory calculations (Lifo,Fifo,Weighted average), method of depreciation provided to mention a few. Reading of this part is also important at it gives detailed discussion on the contingent liabilities the company is facing and they are not provided in the accounts as they have yet to fructify in concrete terms.
Stock market data:
The company’s’ stock price also indicates to a great extent what the researchers feel about the company. Reactions of the market towards the moves of the company also help in drawing conclusions on a broader scale.
Financial analysis determines a company’s health and stability, providing an understanding of how the company conducts its business. But it is important to know that financial statement analysis has its limitations as well. Different accounting methods adopted by different firms’ changes the visible health and profit levels for either better or worse. Different analysts may get different results from the same information. Hence, we must conclude that financial statement analysis is only one of the tools (although a major one) while taking an investment decision.
Related links you will like:
Investing in the right company
Time Diversification and its impact on Capital Allocation Decision