Introduction to Financial Statements
Definition: Structured representation of an entity’s financial position, performance, and
cash flows.
Main Objectives:
o Provide information about financial position, performance, and cash flows.
o Help assess the probability of future cash generation.
Types of Financial Statements
1. Balance Sheet
o Definition: A snapshot of a company's financial position at a specific point in
time.
o Components:
Assets: Resources the company owns.
Liabilities: Debts owed by the company.
Equity: Owners’ residual interest in the assets after deducting liabilities.
o Formula:
Assets = Liabilities + Shareholders' Equity
o Purpose: Provides investors a snapshot of the company’s health and helps assess
financial risk.
2. Income Statement
o Definition: Shows revenues, expenses, and profit for a specific period.
o Components:
Revenue: Income generated from business operations.
Expenses: Costs incurred to generate revenue.
Net Income: Profit after tax.
o Purpose: Answers questions about the company’s profitability and performance.
3. Statement of Cash Flows
o Definition: Records cash inflows and outflows over a period.
o Categories:
Operating Activities: Day-to-day operations.
Investing Activities: Purchase or sale of assets.
Financing Activities: Borrowing and repaying funds.
o Purpose: Provides insights into the company’s liquidity and cash management.
Financial Statement Analysis
Definition: Process of examining past and current financial data to evaluate performance
and estimate future risks and potential.
Used By: Investors, creditors, and bank lending officers.
Objectives of Financial Statement Analysis
1. Assessment of Past Performance:
o Helps judge management's past performance and predict future performance.
2. Assessment of Current Position:
o Shows the types of assets and liabilities the company holds.
3. Prediction of Profitability and Growth Prospects:
o Helps assess future earnings and growth potential.
4. Prediction of Bankruptcy and Failure:
o Assists in identifying potential financial distress.
5. Assessment of Operational Efficiency:
o Compares actual performance with standards to measure efficiency.
Techniques of Financial Statement Analysis
1. Cross-Sectional Analysis:
o Also known as inter-firm comparison; compares financial characteristics with
similar enterprises during the same period.
2. Time Series Analysis:
o Intra-firm comparison over different years of the same business.
3. Combination of Cross-Sectional and Time Series Analysis:
o Compares multiple firms over several years.
Tools for Financial Statement Analysis
Comparative Statements
Common-Size Statements
Trend Analysis
Ratio Analysis
Funds Flow Analysis
Cash Flow Analysis
Key Tools and Formulas
Dollar and Percentage Changes
Dollar Change Formula:
Dollar Change = Analysis Period Amount − Base Period Amount
Percentage Change Formula:
Percentage Change = (Dollar Change ÷ Base Period Amount) × 100%
Trend Analysis
Steps:
1. Select a base year and assign it 100%.
2. Express subsequent years’ amounts as a percentage of the base year.
Common-Size Analysis
1. Vertical Analysis:
o Each item is shown as a percentage of a total (e.g., total assets or total revenue).
2. Horizontal Analysis:
o Compares financial statement data over multiple periods.
Financial Ratios
Categories of Ratios
1. Liquidity Ratios:
o Assess the company’s ability to meet short-term obligations.
2. Solvency Ratios:
o Measure long-term financial stability.
3. Profitability Ratios:
o Gauge the company’s ability to generate profit.
4. Activity Ratios:
o Indicate how efficiently the company is using its assets.
Key Ratios:
Current Ratio: Current Assets ÷ Current Liabilities
Debt-to-Equity Ratio: Total Debt ÷ Total Equity
Return on Equity (ROE): Net Income ÷ Shareholders' Equity
Conclusion
The three financial statements (Balance Sheet, Income Statement, Cash Flow Statement)
are interconnected.
Financial statement analysis provides a comprehensive understanding of a company’s
financial health, helping stakeholders make informed decisions.
