Why is analyzing financial statements important

As such, they can be evaluated on the basis of past, current, and projected performance. In general, financial statements are centered around generally accepted accounting principles GAAP in the U.

These principles require a company to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting.

Public companies must follow GAAP which requires accrual accounting. Private companies have greater flexibility in their financial statement preparation and also have the option to use either accrual or cash accounting.

Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques include horizontal analysis , vertical analysis , and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Ratio analysis uses important ratio metrics to calculate statistical relationships. Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and also to provide transparency to their stakeholders.

The balance sheet is a report of a company's financial worth in terms of book value. The income statement breaks down the revenue a company earns against the expenses involved in its business to provide a bottom line, meaning the net profit or loss.

The income statement is broken into three parts which help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit.

It then moves to operating profit , which subtracts indirect expenses such as marketing costs, general costs, and depreciation. Finally, after deducting interest and taxes, the net income is reached.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations.

The cash flow statement provides an overview of the company's cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firmwide investments. The financing activities section includes cash flow from both debt and equity financing.

The bottom line shows how much cash a company has available. Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company.

Extension Of Credit The creditors are the providers of loan capital to the company. Therefore they may have to take decisions as to whether they have to extend their loans to the company and demand for higher interest rates.

The financial statement analysis provides important information to them for their purpose. Investment Decision The prospective investors are those who have surplus capital to invest in some profitable opportunities.

Therefore, they often have to decide whether to invest their capital in the company's share. In spite of financial statement analysis being a highly useful tool, it also features some limitations, including comparability of financial data and the need to look beyond ratios. Besides, many a times, sufficient data are on hand in the form of foot notes to the financial statements so as to restate data to a comparable basis.

Or else, the analyst should remember the lack of data comparability before reaching any clear-cut conclusion. However, even with this limitation, comparisons between the key ratios of two companies along with industry averages often propose avenues for further investigation.

To summarize, financial statement analysis is concerned with analyzing the balance sheet and the income statement of a business to interpret the business and financial ratios of a business for financial representations, business evaluation, in addition to financial forecasting.

No registration required! But if you signed up extra ReadyRatios features will be available. Have you forgotten your password? Are you a new user? ReadyRatios - financial reporting and statements analysis on-line IFRS financial reporting and analysis software. FAQ Manuals Contacts. Follow these tips for conducting accurate financial statement analysis: Maintain objectivity by knowing that decisions should be based on more than numbers listed on financial statements.

Accountants should consider intangible variables as well. For example, employee satisfaction should be considered when planning for future financial expenditures. Avoid developing a false sense of security. While financial statements can be used to show whether a business is stable and profitable, accountants should also use real-time observations of business activities.

For example, a dwindling inventory that cannot be replaced easily could cause big issues eventually. Stay focused on relevance. Recent trends should be taken into consideration when analyzing financial information. Trust intuition, as the decision to invest in a product should be based on more than numbers alone. For example, past success anticipating trends should be taken into consideration when making future investments.

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