What Is Financial Statement Analysis?

Dear Stewart

Your question has two parts - financial statement(s) and analysis.

Every organisation prepares, usually once in a year, financial statements, there are three key statements, namely the ‘Statement of Affairs’ or ‘Balance Sheet’, ‘Statement of Profit and Loss’ or ‘Income and Expenditure’ and ‘Cash Flows Statement’. These three, along with the schedules and notes annexed, provide the information required to enable the public to analyse them and draw meaningful conclusions.

Now we come to the key part of your question; what does analysis mean? It means studying, dissecting, drawing up certain important ratios or proportions generally employed by the financial world. These ratios fall under four broad heads, as follows:

1. Profitability Ratios: These include margins or profits under the various ‘Gross Profit’, ‘Earnings Before Depreciation, Interest, Tax and Appropriations (EBDITA)’, ‘Earnings Before Tax (EBT)’, ‘Profit Before Tax (PBT)’ and ‘Profit After Tax (PAT)’. All these various ratios evaluate the profitability of the operations of the company or organisation.
2. Liquidity Ratios: Liquidity ratios assess the ability of the organisation to meet its short term liabilities, maturing within one year, like trades payable or sundry creditors, outstanding expenses, etc. out of current assets like inventory, customer receivables, cash and bank balances. Even though the operations may be profitable, unless the organisation ploughs back adequate amount of profits into current assets, the organisation will become sick. ‘Current’ and ‘Quick’ ratios are usually used.
3. Solvency Ratios: Solvency ratios measure the ability of the corporation to meet the long term commitments. This is measured by comparing the long term debts with the the net worth (equity capital and reserves). One to one is considered adequate, more net worth the better and lower than one shows weakness.
4. Efficiency Ratios: These evaluate how efficiently various assets are turned around in the business. Inventory and receivables ratios measure how many these are rotated during the year and obtained by dividing annual sales turnover by amount of inventory and receivables. Similarly, ‘Fixed Assets Turnover Ratio’ is obtained by dividing sales by value of fixed assets. More the turnover number, better is the efficiency.

The cash flow statement describes how cash is generated and how it is used, judging the judiciousness of cash, the most valuable resource.

Kindly note analysis of financial statements is not just a mechanical process. Drawing meaningful conclusion about the business, the managers, their attitudes and so on, with the aim of making critical investment decisions is the real purpose of the exercise, which requires besides knowledge, a lot of experience.

So in conclusion, analysis of financial statements employs widely accepted techniques to draw valuable conclusions about the business with an objective of making investment decisions.

To learn about finance and investing, please visit my blog ‘Wealth Vidya’ regularly, and learn for FREE!

Thank you,

With Best Regards

Anand

Written 26m ago · Answer requested by Stewart Desjardins

Note: This is a reproduction of the question I had answered on the website ‘Quora’.