Financial Statement Analysis and Interpretation
L-2 Financial Statements
2.1 General
The objective of general purpose financial statements is to provide information on the financial situation. These statements also show the results of the dedication and care management of the resources entrusted to the reporting entity. To achieve this objective, financial statements provide information about the company’s:
- Assets
- Liabilities
- Equity
- Income and Expenses
- Cash Flows
The accounts are classified and summarized within structured financial statements. These are:
- Balance Sheet
- Profit and Loss Statement
- Statement of Changes in Equity
- Cash Flow Statement
2.2 Balance Sheet
The balance sheet clearly presents the value of the company’s property and rights, obligations, and capital, valued and prepared in accordance with generally accepted accounting principles.
2.2.1 General Structure of the Balance Sheet
ASSETS = LIABILITIES + EQUITY
2.3 Structure of the Profit and Loss Statement
Sales
– Cost of Sales
= Gross Profit
– Administrative Expenses
– Sales Costs
= Operating Income
– Other Expenses
+ Other Income
= Income Before Taxes and Investments
– Income Tax
– Shares
= Net Income
2.4 Statement of Changes in Equity
L-3 Accrual and Realization, Income and Expenses
3.1 Concepts
Accrual
The economic changes considered in establishing economic results are those pertaining to a year, regardless of whether they are received or paid.
Realization
Financial results are counted only when realized, or when the operation is legally or commercially finalized, and all inherent risks are considered.
Differences
Realization is closely related to accrual, with the key difference being that realization explains that economic performance should be registered once the economic act is concluded from a legal or commercial standpoint.
The relationship between realization and accrual lies in their focus on determining results. Both refer to the point at which economic action occurs and are used to observe the culmination of a year and its results.
3.2 Income and Credits
3.2.1 Revenue Recognition
a) Definition: Income is defined as the monetary expression of goods produced or sold, or services rendered.
b) Timing of Revenue: The intermediate value is used.
3.2.2 Credits
Credits can be classified by:
- Enforceability: Up to one year, or more than one year.
- Origin: Sales credits, other credits.
- Nature: Secured or unsecured.
Credits include:
- Customers (debtors account)
- Removed Documents/Receivable Documents
- Defaulters
- Debtors in litigation
- Debtors – Allowance for doubtful debts
- Other credits
3.3.1 Expenses
An expense is incurred when a real consideration is received from an external party, meaning when goods or services are received.
L-4 Analysis and Interpretation of Financial Statements
4.1 General
4.1.1 Nature of Financial Analysis
Financial analysis involves applying tools and techniques to financial statements and supplementary information to obtain quantitative measures and relationships that indicate the behavior of the economic entity and its significant variables.
Financial analysis is a tool for managers and financial professionals to obtain quantitative indices and relationships between the variables involved in business processes.
4.1.2 Objectives of Financial Analysis
- Evaluate the organization’s financial situation, including solvency, liquidity, and ability to generate resources.
- Inform investment and credit decisions to ensure profitability and recoverability.
- Assist management executives through assessments of asset management, profitability, solvency, and business growth.
The objectives of financial analysis are to measure profitability and assess the financial situation.
4.2 Methods for Analyzing Financial Statements
a) Vertical or Structural Analysis: Percentage analysis shows the relationship of each component to the total within a single statement. While limited to a single statement, vertical analysis can be used to prepare comparative statements.
a.2) Ratio Analysis: The primary method of vertical analysis uses ratios or factors (liquidity, management, solvency, profitability, etc.).
b) Horizontal or Evolutionary Analysis: This analysis examines percentage increases and decreases of related items in comparative financial statements.
b.1) Method of Increase and Decrease: Used to study changes in the company over time.
b.2) Trend Method: Considers constant changes in the company and price fluctuations.
c) Factor Analysis: Combines internal and external components called “operation factors.”
4.3 Interpretation of Financial Statements
Interpretation involves appreciating the content of financial statements based on analysis methods and comparisons.
Elements of Interpretation:
- Liquidity: Indicates short-term solvency.
- Affordability: Availability of funds for normal operations.
- Productivity: Shows the trend of business results.
- Performance: The ability of a business to generate profit.
- Borrowing Capacity: Using borrowed funds to seek higher returns.
4.4 Financial Ratios
Financial ratios express the value of a quantity.
- Liquidity Ratios: Show the level of short-term solvency.
- Management Ratios: Assess the company’s activity level and resource efficiency.
- Profitability Ratios: Evaluate the outcome of resource management.