ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 1: Financial Reporting and Financial Analysis
Financial Reporting and Financial Statements
Financial reporting is the process of producing and presenting financial information to the financial statement users. The production and reporting of financial information require a certain order and a set of rules. The final products of the financial reporting are the financial statements. The financial statements that businesses prepare are as follows;
• Statement of financial position (Balance sheet), • Income Statement (statement of profit and loss and other comprehensive income for the period), • Statement of changes in equity, • Statement of cash flows, • And notes, comprising a summary of significant accounting policies and other explanatory information
Financial Reporting
Financial reporting is providing financial information to financial statement users. Financial reporting is a broader concept that includes the preparation of financial statements. Financial information is the main element used in investment and credit decisions. The quality of financial information is an important factor that increases the accuracy of the decisions to be taken. The quality of financial reporting largely depends on quality accounting standards and their effective implementation.
The objective of financial reporting is stated as providing information useful to financial statement users. That raises a question; What is useful information? In order to be useful, the information must be relevant and faithfully represent what it purports to present.
Relevancy represents the capacity of the information making a difference in decision making. Assume that a company has two different net income presentations.
Second characteristic of faithful representation demands financial information to be complete, neutral, and free of error. Relevance and faithful representation are the fundamental characteristics of useful information. Apart from these fundamental characteristics, useful information should have some enhancing characteristics. Those enhancing characteristics are comparability, verifiability, timeliness, and understandability.
Financial Statements
Financial statements are the final product of the financial accounting process. Financial statements contain the communicated information to the financial statement users. This information is related to the current financial position and historical financial performance of the business. Businesses present this information with 4 basic financial statements and their footnotes;
• Statement of financial position (Balancesheet) • Income Statement
• Statement of changes in equity • Statement of cash flows
Statement of Financial Position (Balance Sheet)
Statement of financial position (Balance sheet) shows assets, liabilities and equity of a company as of a specific date. Total assets of a business are equal to total liability and equity. Assets represent the current and non-current investment totals of the business. Businesses finance these investments with funds received from business owners (equity) or funds received from creditors (liabilities).
The equity of the business expresses the rights of the owners in the business. From the perspective of the business legal entity, equity represents the wealth of the business. The presentation of these elements in the statement of financial position may take different forms. Commonly used presentation formats are account and report forms.
Income Statement
The income statement provides information to the users regarding the profitability of the business in the previous period. Income statement presents the performance of a business by summarizing the income of a business in a certain period and the expenses it incurred to earn those income. In the relevant period, if total income is higher than total expenses, net profit occurs, if less, net loss occurs.
Operating profit is an indicator of how well the business operations are managed. It is the difference between the net sales and all operating costs and expenses. And the bottom line is called the net income. It represents the overall profitability and comprises all income and expense items.
Net profit is used in many analyses and the quality of this item is very important. Simply, the quality of net profit is proportional to its ability to be converted into cash. If an enterprise fails to make sufficient collection from its customers despite high profits, it may experience financial difficulties ending in bankruptcy.
Statement of Cash Flows
Although profitability is an important criterion for evaluating the performance of businesses, the ability of the company to continue its activities depends on its ability to generate cash. While profit is an accrual-based accounting measurement unit, cash is a physical unit. There are many cases where businesses manipulate the profit amount. Therefore, when making an assessment of profit, the quality of the profit should initially be examined. Cash flow statement information is important at this stage in evaluating the quality of the profit.
The cash flow statement classifies the cash transactions of the business in a certain period by classifying the basic business activities. Therefore, cash transactions in the cash flow statement are presented under the following classes:
• Cash flow from operating activities • Cash flow from investing activities • Cash flow from financing activities
The cash flow statement can be prepared using two different methods. These are called direct and indirect methods. The only difference between these methods is the different approach in preparing the cash flow from operating activities section. In the direct method, cash flow from operating activities is prepared to show the major collections and payments of the business. These major collections and payments are;
• Collection from customers • Payment to suppliers • Payment for expenses • Payment for taxes
On the other hand, in indirect method cash flow from operating activities are calculated through various adjustments based on the net profit or pretax profit figure in income statement. There is no difference in the calculation and presentation of the remaining sections for both methods.
Statement of Changes in Equity
Statement of changes in equity summarizes the changes in equity in a certain period. There are many changes in equity during the year due to the shareholders’ new capital contributions, dividend payments, net profit/loss and other comprehensive income items. Statement of Changes in Equity provides information on the following transactions that caused changes in the company’s equity;
a. Contributions from and distributions to shareholders b. Income earned and retained in the company c. Comprehensive income and expenses d. Transfers among the equity accounts
Relationship of Financial Statements
Companies must present their financial position and changes in their financial positions. Businesses present their financial positions via statements of financial position. Presenting the beginning and ending statements of financial position comparatively will be useful for understanding the changes in financial position. The most important event that feeds the changes in financial position is the operations of the business. The results of these operating activities are presented in the income statement. Events affecting the income statement also affect the statement of financial position. To understand this effect, it will be sufficient to look at balance sheet equation:
Assets=Liabilities+Equity
In this equation, equity is the net difference between assets and liabilities and represents the wealth of the business. Wealth increase of the business depends on its operations. As a result of operating activities, while earning income, business will incur various expenses. When we elaborate balance sheet equation within the framework of this information, equation will take the following form;
Assets=Liabilities+(Capital+Income-Expenses)
That means if the business, for example, makes a sales amounting 100 TL, its income and assets will increase by 100 TL. The income statement is an accrual-based statement such as the statement of financial position.
Need for Financial Statement Analysis
Financial statement analysis is performed to determine the relationship and trend of financial statement elements. Financial statements present financial information about businesses to users of financial statements. Results on the trend of financial information obtained through financial analysis and its relationship with each other is necessary for the purposes of decision makers. Decision makers who use business information for different purposes often examine the results of financial analysis that will help them make the following evaluations;
• Effectiveness and efficiency of business activities • Current and potential profitability of businesses • Short-term liquidity of the business and long- term solvency
Scope of Financial Statement Analysis
Financial analysis can be done by different users, for different purposes and in different scopes. It is possible to classify financial analysis according to the preparers, its purpose, and its scope.
Internal and External Analysis
External analysis is the analysis of non-business groups using the financial statement information of the business. Internal analysis is the analysis made by the internal units and individuals.
Equity, Credit and Management Analysis
According to the purpose of financial analysis, it is divided into three as management, credit and investment analysis. Management analysis is the analysis made to measure the performance of the business. Credit analysis is simply the determination of a business’s credibility (creditworthiness). Equity analysis is applied by existing and potential investors to evaluate the company’s sustainability, profitability and earning power for future periods.
Dynamic and Static Analysis
According to the scope of financial information (statements) to be used in financial analysis, financial analyzes are classified as static and dynamic analysis. Static analysis is the analysis that examines the relationship between the financial information of a single business for a single period. Dynamic analysis examines the relationship between the financial information of multiple successive periods.
Financial Statement Analysis Tools
Financial statement analysis techniques are computational and comparison tools that include comparing financial
statement information with past results or with each other. Three of these tools that are mainly used are;
a. Horizontal analysis b. Vertical analysis c. Ratio analysis
Horizontal Analysis
Horizontal analysis is the comparison of an entity’s statement of financial position, income statement and cash flow statement by periods. This comparison can be done in two different ways. In comparative financial statement analysis, financial item changes in two terms are calculated in percentage and absolute value and necessary evaluations are made. In trend analysis, financial information of more than two periods are compared.
Vertical Analysis
Vertical analysis common size is also called financial statement analysis. In this analysis, the share (rate) of a financial statement item in the group in which it is located is calculated. Vertical analysis is a particularly useful tool that shows how financing resources and resource usage (assets) have changed over time.
Ratio Analysis
Ratio analysis is a frequently used financial statement analysis. The ratio analysis shows the relationship between the two financial statement items. Financial ratios can be classified into four groups. These are; a. Liquidity ratios b. Financial structure (Solvency) ratios c. Activity ratios d. Profitability ratios
Liquidity ratios are the ratios that are used to measure the ability of the enterprise to pay its short-term debts.
Financial structure (Solvency) ratios are also called leverage ratios. Financial structure (Solvency) ratios attempt to measure the long-term debt payment ability and sustainability of the business.
Activity ratios measure how effectively the business converts its operating assets into sales and cash.
Profitability analysis is used to investigate to what extent the resources of the enterprise are used to make profit.
Limitations of Financial Statement Analysis
A successful financial statement analysis depends on certain conditions. These are;
• Preparation of financial statements in accordance with financial reporting statements, accuracy of the information in the report (not being manipulated) • Financial analyst’s knowledge of the preparation of financial statements, features and transactions of the business • Correctly determining the impact of the economic and political environment concerning the business on the business activities
Although the financial statement analysis provides useful information for decision makers, it has some limitations.
• Although businesses prepare their financial statements in accordance with financial reporting standards, the estimates of business management have a significant effect on the financial statements. If these estimates lack consistency and accuracy, the financial statement analysis will not be far from producing meaningful results. • In economies where inflation has a significant impact and magnitude, noninflation adjusted financial information may produce misleading results. • Mandatory and voluntary changes in accounting standards may make it difficult to interpret the results of financial analysis. • An important problem in comparisons with the financial statements of foreign companies is that businesses have different financial periods. • Earnings management and fraudulent financial reporting practices employed impair the financial analysis results. Those practices fictitiously improve the assets and earnings. Thus, leads to better financial analysis results.