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Analyzing and Interpreting Financial Statements

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This research paper is aimed to analyze the importance of financial statements in business. Their role can never be underestimated by investors, newly opening businesses, auditors, competitors, shareholders and business owners. The paper will be focused on the essential impact they make on a company’s further strategy. It will cover the standard set of financial statements, in detail with their analysis and interpretation, also paying separate attention to notes and GAAP importance. The connections between financial statements will be explored and explained. Also, the paper will look into detail at ratios used in financial analysis. Thus, the main point of this research will be as follows:

  1. GAAP necessity and importance.
  2. Standard financial statements overview, their role in assessing the company’s health.
  3. How three financial statements are connected.
  4. Notes to financial statements.
  5. Ratios and ratio analysis. 

One will thoroughly research the topic matter according to the outline above. 

GAAP Necessity and Importance

GAAP (Generally Accepted Accounting Principles), being a designating element to financial statements, are simply a set of accounting standards, principles, practices and procedures used when compiling financial statements. GAAP are a “combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information” (Vishwanath & Krishnamurti, 2009, p.112). GAAP were created and are now imposed on companies, so that investors, shareholders and creditors could have a uniform way to obtain an accurate and consistent picture of a company’s financial state with a minimal risk of fraud and error. GAAP are not required by law. Nevertheless, most companies prefer using their regulations when compiling their financial statements.

Standard Financial Statements Overview

The most generalized definition of financial statements would call them a collection of reports, which reveal a company’s financial state and results (Ross, Westerfield, & Jaffe, 2010). In a deeper economic understanding, financial statements appear to be the tool that helps to quantitatively analyze a company’s activity and assess its’ effective strength.  If looking in more detail, financial statements give an opportunity to:

-  Establish a company’s ability to bring profit;

-  List and analyze sources of a company’s income;

-  Check ways by which the money is spent;

-  Prove whether a company is capable of paying back its’ liabilities

- Identify and forecast the trend a company is following (Ross, Westerfield, & Jaffe, 2010).

Mentioned above arguments supporting the undoubted role of financial statements prove that the financial statement “is imperative for the management because it can provide a rough guide to the future performance of the firm” (Vishwanath & Krishnamurti, 2009, p.117) and reveal shortcomings in a company’s financial strategy. Moreover, many companies find it vital to develop “a financial model that allows management to control value creation” (Vishwanath & Krishnamurti, 2009, p.117) by constructing cash flows from the financial statements and having a permanent assessment of the firm value.

The standard financial statements’ set contains balance sheet, income statement, statement of cash flows and supplementary notes or footnotes. All of them “provide with fundamental and informative inputs for analyzing and diagnosing the corporation’s health” (Ross, Westerfield, & Jaffe, 2010, p.35). Each of them will be reviewed in more detail below.

The balance sheet (also known as a statement of financial position) measures the book-value wealth of a firm (Velez-Pareja & Tham, 2008, p.4). The balance sheet gives a snapshot of the company’s financial state at a taken period of time. It shows company’s assets, liabilities and presents information about the shareholders’ equity. Balance sheets tell people what a company owns (company’s assets) and what it owes (its’ liabilities) at a fixed point of time. Every balance sheet is divided into three main parts - assets, liabilities and shareholder equity. The complied result of a balance sheet could be demonstrated by this formula: Total assets = Total liabilities + Equity (Velez-Pareja & Tham, 2008, p.4).

A company’s balance sheet is commonly set up like the basic accounting equation shown above. Companies list their assets on the left side of the balance sheet. They list their liabilities and shareholders’ equity on the right side. In some periods, balance sheet shows assets at the top, with the shareholders’ equity at the bottom, followed by liabilities. The aim of a balance sheet is to evaluate a company’s liquidity and ability to pay debts.  (Ross, Westerfield & Jaffe, 2010)

Income statements demonstrate company’s expenditures and revenues over a period of time. As the Income Statement is a dynamical financial statement, it measures the economic activity of the firm during a given period (Velez-Pareja & Tham, 2008). Therefore, the primary purpose of the income statement is to report company's earnings to investors over a specific period of time showing revenues and expenses, and the resulting profit or loss.

The cash flow statement demonstrates company’s liquidity. In other words, it illustrates “the amount of cash available or in hand at each instant of time” (Velez-Pareja & Tham, 2008, p.5). It summarizes company’s cash inflows and outflows with regards to financing, operating and investing activities. While an income statement indicates whether a company managed to get any profit, a cash flow statement reveals whether the company generated cash.  Moreover, this report shows the change trend over a period of time, but not actual money amounts at a certain period.

Connectedness of the Financial Statements

The balance sheet, the income statement and the cash flow statement are not stand-alone reports. They all come in line together, each disclosing a particular side of business’s financial state and its association. For example, the line Sales Revenue (Income statement) influences Cash and Accounts receivable (Balance sheet); Cost of Goods Sold (Income statement) is directly linked to Accounts payable and Inventory (Balance Sheet); Fixed Assets (Balance sheet) affects Depreciation Expense (Income statement), while Depreciation in its turn has an impact on Accumulated depreciation (Balance sheet). The cash flow statement combines the data from both balance sheet and income statement – it begins with Net income (Income statement) and its Ending cash will be Cash and Cash Equivalents in the balance sheet.

Notes to Financial Statements

Supplementary notes may contain interpretation of various business activities and extra information on certain accounts. They report additional details, which cannot be derived from main financial statements. Among others, notes may include such highlights: significant accounting policies and practices (as companies may be choosing among two or three GAAP for many expenses, there should be a footnote per each significant accounting choice), income tax (detailed overview of company’s deferred and current income tax), stock options, interest rates, maturity rates, etc.

Notwithstanding notes are an obligatory element of any financial statement, there are no standards for clarity or conciseness. Notes to financial statements are a GAAP-mandated inherent part of financial statements.

Ratios and Ratio Analysis

Financial analysis widely uses accounting ratios when evaluating company’s activities on the market. Ratios demonstrate relations between figures appearing on a balance sheet, income statement and cash flow statement and are commonly expressed as percentage, proportion, co-efficient or a rate.   Here are just a few examples of ratios split by groups depending on what they are aimed to analyze:

Liquidity ratios measure a company’s ability to meet its short-term liabilities (Velez-Pareja, 2012). Current Ratio demonstrates a company’s ability to pay its liabilities using company’s assets. Quick Ratio forecasts whether a company would be capable of immediate settlement of debts and liabilities.

Turnover ratios measure effectiveness and efficiency of using resources. For example, Inventory Turnover Ratio assesses inventory policy that the company has implemented in its operation (Velez-Pareja, 2012). Cash Conversion Cycle estimates the time when the company needs to finance raw materials’ purchase (Velez-Pareja, 2012).

Financial leverage and debts ratios are used to evaluate financial risks of a company (Drake, 2007). Coverage of Fixed Costs is one of the main indicators of company’s survivability, as it shows whether the company is able to cover and pay fixed costs (Velez-Pareja, I., 2012), Debt to Equity Ratio and Debt to Assets both describe the extent to which a company is reliable on external sources or debts for financing, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is used to detect whether a company is capable of paying its liabilities. Moreover, it evaluates the business in general (Drake, 2007);

Return on investment and margin ratios measure the ability to generate profit, e.g. Gross profit margin “indicates how much of every dollar of sales is left after costs of goods is sold” (Drake, 2007, p.7), Return on investments (ROI) compares earnings with the cause (investment) of those earnings (Velez-Pareja, 2012).

Value Ratios are used by investors as the main indicator of a worthwhile investment, as they show the integrated value in stocks - Price to Earnings (P/E), Dividend, etc. (Drake, 2007).

Ratio analysis allows evaluating the company’s performance at a certain period of time and in the trend. Ratios create benchmarks for high and stable efficiency (Russel, 2004). They help to indicate weak sides that need improvement and strong competitive advantages. Although, they may not be a single reliable forecasting tool. They provide an accurate and quick cross-section for a particular sphere of interest. The main aim of ratio analysis is to obtain a quick and highly-informative estimation of company’s performance.

Neither ratios nor financial statements may give one a complete picture of how the business is doing. Only combining the data from all of them, attentive research and comparison will provide one with a significant scope of information, which might become one’s real asset in the wise investment process. Thus, potential investors, creditors and other users are provided with an opportunity to make a thoughtful decision.

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