Financial Statement Analysis

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Analysis of Financial Statements - Gross Profit - Gross Margin Trends and Operating Expense Analysis

Gross profit usually reflects the type of industry in which the company operates. Once the net sales and cost of goods sold are calculated, it is a simple matter to determine the gross profit which is the difference between the two.
Gross margin trends: The credit analyst should investigate sharp changes in gross margin levels. Deteriorating margins indicate purchasing difficulties, manufacturing inefficiencies or inventory accumulation. Acceptable gross margin levels vary among industries, so as to assess the sufficiency of margins which, includes a comparison with others in the particular market or industry. Gross margin trends usually are best compared as percentage trends and not rupee trends.
Operating expense analysis: Operating expense represents costs not directly related to the production of goods and services. Wages paid to a laborer to shipping products, for example, are considered as cost of goods sold expenses. On the income statement, operating expenses include salaries, selling expenses and general and administrative expenses. However, the borrower usually can supply a more detailed breakdown of operating expenses, listing among other things, salaries by type of personnel, auto expenses, insurance, repairs and maintenance, telephone and entertainment, profit sharing, legal, accounting, advertising and postage costs.
Operating expenses are a reflection of management decisions, because the owner has more control over operating expenses than cost of goods sold. Trends in this area give the credit analyst some insight into management's style and ability to adjust to change.
Operating income(loss) is calculated by subtracting the total operating expenses from the gross profit. An operating loss occurs if the total operating expenses exceed the gross profit.
Non controllable and controllable expenses:
Operating expenses are subdivided into non controllable and controllable expenses. Non controllable expenses include rental payments, long term lease obligations, salaries, marketing costs and office expenses including rental payments, long term lease obligations, salaries, marketing costs and office overhead expenses. For example, once a decision is made about as to where to rent or lease space, there is little a company can do to control that cost.
Controllable costs include bonuses, profit-sharing plan costs, the travel and entertainment budget and automobile or other short term leasing costs. Segregating non controllable and controllable expenses helps the credit analyst to identify the costs that must be covered for the company to remain in business and the costs that could possibly be reduced in order to improve the profitability.
Another way of measuring as to whether costs are reasonable is to calculate the operating expenses as a percentage of sales and compare them to a similar company or to the industry average.
Interest expense:
Interest expense is a recurring expense that fluctuates in coordination with market interest rates and the amount of company debts.
Interest expense: Interest expense is a recurring expense which fluctuates in coordination with market interest rates and the amount of company debt.
Other income and expense analysis:
Income and expenses falling outside the normal business operations are listed in the other income and other expense accounts on the income statement.
The possible sources of other income are the profit from the sale of fixed assets, interest income and renting excess facilities and equipment. Other expenses include the losses on the sale of fixed assets, losses on the sale of stock of discontinued operations and interest expense.

Meanings and Importance of Financial Statement Analysis

All financial statements are essentially historically historical documents. They tell what has happened during a particular period of time. However most users of financial statements are concerned about what will happen in the future. Stockholders are concerned with future earnings and dividends. Creditors are concerned with the company's future ability to repay its debts. Managers are concerned  with the company's ability to finance future expansion. Despite the fact that financial statements are historical documents, they can still provide valuable information bearing on all of these concerns.
Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company. This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios.
Managers are also widely concerned with the financial ratios. First the ratios provide indicators of how well the company and its business units are performing. Some of these ratios would ordinarily be used in a balanced scorecard approach. The specific ratios selected depend on the company's strategy. For example a company that wants to emphasize responsiveness to customers may closely monitor the inventory turnover ratio. Since managers must report to shareholders and may wish to raise funds from external sources, managers must pay attention to the financial ratios used by external inventories to evaluate the company's investment potential and creditworthiness.
Although financial statement analysis is a highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Comparison of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometime makes it difficult to compare the companies' financial data. For example if one company values its inventories by the LIFO method and another firm by average cost method, then direct comparisons of financial data such as inventory valuations are and cost of goods sold between the two firms may be misleading. Some times enough data are presented in foot notes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.
An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgment about the future. Nothing could be further from the truth. Conclusions based on ratio analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as a starting point, as indicators of what to pursue in greater depth. They raise may questions, but they rarely answer any question by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization. They analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself. A recent change in a key management position, for example, might provide a basis for optimism about the future, even though the past performance of the firm may have been mediocre.