Using Financial Statements to Understand a Business
Internal and external users rely on a company’s financial statements to get an in-depth understanding of the company’s financial position.
Explain how a company would use the financial statements to perform risk analysis and profitability analysis
- By using a variety of methods to analyze the financial information included on the statements users can determine the risk and profitability of a company.
- Financial statement analysis consists of reformulating reported financial statement information and analyzing and adjusting for measurement errors.
- Two types of ratio analysis are performed, analysis of risk and analysis of profitability.
- Analysis of risk typically aims at detecting the underlying credit risk of the firm.
- Analysis of profitability refers to the analysis of return on capital.
- reformulation: A new formulation
- profitability ratio: measurements of the firm’s use of its assets and control of its expenses to generate an acceptable rate of return
- ratio: A number representing a comparison between two things.
- profitability: The capacity to make a profit.
The Role of Financial Statements
Internal and external users rely on a company’s financial statements to get an in-depth understanding of the company’s financial position. For internal users such as managers, the financial statements offer all the information necessary to plan, evaluate, and control operations. External users, such as investors and creditors, use the financial statements to gauge the future profitability and liquidity of a company.
Financial Statement Analysis
By using a variety of methods to analyze the financial information included on the statements, users can determine the risk and profitability of a company. Ideally, the analysis consists of reformulating the reported financial statement information, analyzing the information, and adjusting it for measurement errors. Then the various calculations are performed on the reformulated and adjusted financial statements. Unfortunately, the two first steps are often dropped in practice. In these instances financial ratios are calculated on the reported numbers without thorough examination and questioning, though some adjustments might be made.
An example of a reformulation used on the income statement occurs when dividing the reported items into recurring or normal items and non-recurring or special items. This division separates the earning into normal earnings, also known as core earnings, and transitory earnings. The idea is that normal earnings are more permanent and therefore more relevant for prediction and valuation.
Normal earnings are also separated into net operational profit after taxes (NOPAT) and net financial costs. In this example the balance sheet is grouped in net operating assets (NOA), net financial debt, and equity.
Types of Analysis
Two types of ratio analysis are analysis of risk and analysis of profitability:
Risk Analysis: Analysis of risk detects any underlying credit risks to the firm. Risk analysis consists of liquidity and solvency analysis. Liquidity analysis aims at analyzing whether the firm has enough liquidity to meet its obligations. One technique used to analyze illiquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also useful in evaluating risk. Solvency analysis aims at determining whether the firm is financed in such a way that it will be able to recover from a loss or a period of losses.
Profitability analysis: Analyses of profitability refer to the analysis of return on capital. For example, return on equity (ROE), is defined as earnings divided by average equity. Return on equity could be furthered refined as:
ROE = ( RNOA )+ (RNOA – NFIR ) * NFD /E
RNOA is return on net operating assets, NFIR is the net financial interest rate, NFD is net financial debt and E is equity. This formula clarifies the sources of return on equity.