Analyzing Financial Statements

ambcreations By ambcreations, 20th Aug 2013 | Follow this author | RSS Feed
Posted in Wikinut>Business>Analysis

In the world of business management and financial analysis, the use of financial statements can not be over emphasized. Many analysts use these statements to make informed decisions as well as advising their clients on necessary course of actions.

Analyzing Financial Statements

Accounting is said not to be an end in itself but a means to an end. As a result, accounting information is not prepared for fun but for making meaningful decisions. The financial statements are the most commonly prepared accounting information. The three key financial statements are Statement of financial positions, Statement of income and other comprehensive income and Statement of cash flows.

There are various uses of these statements but I will limit myself to these;

To determine the liquidity capacity of a company
To determine the profitability of a company
To determine the long term stability of a company


I. Determining the liquidity capacity of a company. To determine the liquidity capacity of a company, the two most important ratios that are used are the current ratio and the acid test ratio; the current ratio is used to determine if the company can meet its short term obligations. It measures by comparing the current asset with the current liabilities. On the other hand, the acid test ratio compares current assets minus inventories to current liabilities. This ratio determines the assets which can be quickly converted to cash. Inventories are excluded because they are most nundibetaly liquid

Determining the profitability of a company. There many ratios to measure a company’s profitability but return on capital employed (ROCE) and Earnings Per Share (EPS).The ROCE measures the overall profitability of the business while EPS tries to measure the amount of par tax profit attributable to ordinary shareholders.
The third use of a company’s financial statement is to measure its long term stability. You can determine if a company is healthy in the long run by looking at its Gearing ratio and Total debt to Shareholders’ funds ratio. These two ratios measure the long term stability of the company. Where the gearing ratio is high it means the company is being finance mostly by debt, as a result one can conclude that the company is unhealthy.

Your use of a financial statement will depend on your needs. The information a creditor will look for in a financial statement is quite different from what the management, staff or shareholders will look for.

Statement of cash flows only measures how funds are generated and used within a specified period of time.

Other accounting ratios that can also be used to analyze a financial statement are: Gross profit margin, Net profit margin, debt to equity ratios, interest cover, Dividend Per Share, Inventory Turnover Ratio, Assets Turnover Ratio, Accounts Receivable Turnover Ratio, Dividend Yield, Dividend Payout Ratio etc.

NB: This article serves as an overview of analyzing financial statements. It does not explain how each of these ratios is calculated. In my subsequent write ups, I will explain how most these ratios are calculated and there uses.

Tags

Accounting, Analysis, Business, Finance, Investment

Meet the author

author avatar ambcreations
I am a chartered accountant with experience in all accounting and finance functions. I am interested in writing articles on accounting, finance, business, leadership and motivation.

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