One way of looking at a set of financial statements is in terms of the information they convey about an organization's financial strengths and weaknesses. In particular, properly analyzed, the income statement, balance sheet, and statement of cash flows can convey a great deal of information about an organization's day to day operations and financial management activities.
In this regard, it is important to emphasize that the purpose of financial statement analysis is not to determine how well or poorly an organization has followed generally accepted accounting principles, although this occasionally will be a necessary ingredient in such an analysis. Rather, the purpose is to determine the overall quality of an organization's operational and financial management activities in four separate but related areas: profitability, liquidity, asset management, and solvency.
Recall that the asset side of the balance sheet contains those items that an organization owns or has claim to, whereas the liability and equity side shows how the assets have been financed. Since the balance sheet is the result of all of the organization’s historical financial activities, viewed at a given point in time, it provides what might be thought of as the “long-run” view of an organization's asset acquisition and financing decisions.
This long-run view can be supplemented by an analysis of the statement of cash flows, which shows management's specific financing choices and activities over the course of a given accounting period. The SCF gives information about the sources of funds during a year and the uses to which those funds were put. Thus, by using the SCF, a reader of financial statements can determine the extent to which an organization acquired more fixed assets or current assets during a year, and how those assets were financed (e.g., operations. short-term debt, long-term debt, additional stock sales).
Consequently, the SCF and the balance sheet provide a reader of financial statements with some indication of the financing decisions made by an organization's management, both over time and during the course of the most recent accounting period. By contrast, the income statement lets readers look at the quality of the organization's profitability during a given accounting period. As we will see, ratios involving both the income statement and the balance sheet can help financial statement readers assess relationships among net income, assets, and liabilities.
This Note examine both operations and financial management. In particular, it focuses on four separate but related matters: profitability, liquidity, asset management, and long-term solvency. These terms will be defined and examined in some detail, and the characteristics of a “good” set of financial statements will be examined.
One technique used to assess these relationships is ratio analysis, which focuses on mathematical comparisons between or among different sets of financial statements. Part I of this Note discusses ratio analysis.
Clearly, the utility of ratio analysis depends to on the quality of the data entering the numerator and denominator of the calculations. The purpose of Part II of the Note is to examine the data quality issue, and build on ratio analysis by considering some additional aspects to analyzing a set of financial statements. Although there is no one “right” set of financial statements for an organization, some standards can be employed to determine if and where potential problems exist. Part III of the Note looks at two issues of particular importance to all organizations: leverage and the role of profits. A summary of the Note’s learning objectives is contained in Exhibit 1.
Exhibit 1. LEARNING OBJECTIVES
Upon completing this Note, you should know about:
- The role of ratios in financial statement analysis
- The four categories of ratios that typically are used—profitability, liquidity, asset management, long-term solvency—and how to calculate several ratios in each category
- The three standards that typically are used for comparison of ratios: industry, historical, and managerial, and their use for understanding of how an organization has managed its profitability, liquidity, assets, and long-term solvency
- The distinction between accounting and financial management issues, including the role of the notes to the financial statement
- The importance of leverage and its drawbacks, including the distinction between financial risk and business risk
- The role of profit, and its importance for financing fixed assets and providing for the cash needs associated with growth
- The general process for analyzing a set of financial statements, including making a strategic assessment, identifying accounting issues, and analyzing financial management issues