Financial Statement Analysis – Introduction

Financial statements

Entities around the world prepare financial statements following certain accounting framework. Two of the widely used are US GAAPs and IASs/IFRSs. As you are reading the convergence of these two accounting frameworks is already in process for several years to have universal accounting framework around the world. Accountants follow the rules and requirements of the applicable financial reporting framework and prepare financial statements using the financial information that has already been classified and summarized in an appropriate manner called bookkeeping.

Bookkeeping is a process that helps process the day-t0-day business transactions by identifying, classifying and summarizing the transaction details in a manner that it is precise yet keeps the financial integrity of transaction intact that is not lost in the process of summarization.

To increase the credibility and to gain more trust of users, financial statements are almost always get audited by the external auditor. External auditor is a person who is independent of entity and its management and expresses his opinion on financial statements if they are presenting true and fair picture of financial position and performance of the entity.

Entities prepare and publish these financial statements annually, semi-annually and quarterly depending on the requirements, local legislation etc.

Statement of financial position / Balance Sheet

Statement of financial position reflects the financial position of the entity by reporting entity’s resources and obligations. By looking at these two variables i.e.:

  1. available resources known as assets that are either owned or controlled by the entity
  2. entity’s obligation known as liabilities that are either long-term or short-term

Comparison of the above two help determine the residual interest of investors in the entity called equity. Equity or Owners’ equity is simply the amount of asset over and above liabilities. This measurement is simple yet very effective as it gives the idea of the value of interest the shareholders are left with once all the liabilities of are met. Owners’ equity in mathematical term is presented as follows:

Owner’s equity = Assets – Liabilities

This is the same basic accounting equation but in a different form and thus it remains balanced after every business transaction.

Financial position of the entity is a perceived value of business that is derived by looking at what resources entity currently holds, their condition, the way they have been deployed and used in the business, their demand and financial efficiency in generating cash flows and their prospective potential to generate cash. Once the rate at which resources are capable of generating cash flows analysts or users or investors determine whether such rate of cash flows is enough to cover entity’s future liabilities plus the returns expected by the investors. As entity needs to generate enough cash that is not just enough to cover expenses and liabilities but also needs to accumulate enough returns for investors that will be paid out directly as dividends or indirectly as increased share price.