Financial Statement Analysis: 2014

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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.

How to Make a Financial Statement

Financial Statements are used to find the financial health of a company or of an individual. Financial statements for companies and firms are usually prepared by Certified Public Accountants (CPAs). It does not hurt to understand what goes into the work for a financial statement to give you a good idea of your company's financial health. There are four basic statements to be considered, Balance Sheet, Income Statement, Statement of Retained Earnings, and Statement of cash flow.
The Balance Sheet also referred to as statement of financial position or condition, reports on Assets (anything of value), liabilities (anything owed to others) and Owner's equity. (anything paid in capital and retained earnings) A Balance Sheet only gives you a point in time.
This is an example of a balance sheet is:
Joe's Hotdogs Balance Sheet 1/01/09
Cash $5,000
All other assets $55,000
Total assets $60,000
Liabilities and owners' equity
Liabilities $1,500
Owner's Equity
Paid in capital $50,000
Retained earnings $0
Total owner's equity $8,500
Total liabilities and owners' equity $60,000
Formula for the balance sheet is Assets = Liabilities + Owner's Equity. (note the totals of the Assets = the total of Liabilities plus owners' equity) In this example let's take a look at the net worth of this company. Net worth is simply Net Assets = Assets - Liabilities or Net Assets = Owners' equity. A positive net worth means you have more assets than you have debts. A negative net worth means you have more debts than you have things of worth. This company has $60,000 in Assets and $1,500 in Liabilities which would give the company a net worth of $58,500.
The Income statement also known as Profit and Loses statement is a list all of your revenues and expenses. This can be for a week, month, or year based on the period of time you are trying to prepare your financial statement for. A balance sheet is a point in time whereas the income statement is period of time. So for our example let's do an income statement for a year.
Joe's Hotdogs Income Statement for '09
Revenues $17,500
Expenses $4,000
Total $13,500
Income statement show your Net income, Net Income = Revenues - Expenses. In this example the Revenues $17,500 and the Expenses $4,000 so the Net Income was $13,500.
Statement of Retained Earnings explains the changes in a company's retained earnings over the reporting period. This report is for a period of time and we will make a Statement of Retained earnings for the year of 2009 for Joe's Hotdogs.
Joe's hotdogs
Statement of Changes in Owners' Equity
For the year ended 12/31/09
Paid in Capital
Beginning Balance $50,000
Additional Paid In Capital $0
Balance as of 12/31/09 $50,000
Retained Earnings changes:
Beginning Balance $58,500
Net income for the year $13,500
(Less)Dividends ($5,000)
Ending Balance $67,000
Total owners' equity $117,000
In this example there was no changes in the Paid in Capital it kept the original value of $50,000. Retained Earning changes = Ending Balance = Beginning Balance + Net income - Dividends. The Beginning Balance comes off the first Balance Sheet and the Net income comes off our Income statement for the period. Dividends are a distribution of earning to the owners of a corporation, for our example the company paid out $5,000. Our total change of owners' equity was $117,000.
Statement of cash flows reports on a company's cash flow activities particularly on its operating, investing and financing activities for a period of time.
Joe's Hotdogs
Statement of Cash Flows
For year ending 12/31/09
Cash provided (used) by:
Operating activities $(5,000)
Investing activities $(2,000)
Financing activities $10,000
Net change in cash $3,000
The firm had $5,000 in operating activities and $2,000 in investing activates but financed $10,000 giving them a net change of $3,000 cash for the year. We can then take the beginning balance of cash from our Balance sheet and get our ending balance for cash $5,000 + $2,000 = $7,000.
These are the four primary statements in which a CPA would use for the company to make a financial statement. The purpose for all of this is to provide information about the financial position, performance and changes in financial position of an enterprise to help make financial decisions.

Importance of Financial Statements in Accounting

Financial statements reveal a lot more about a company than what it earned, what it owes and the historical value of its assets. To bring the economics of a firm into focus you need to study and thoroughly analyze its financial statements. It is important to realize that no individual figures on a financial statement are very useful in and of themselves. You might, from time to time, hear (or even have said) something like, "You don't need to throw all those numbers at me. I'm only interested in the bottom line."
There is a big difference between profit and profitability. While Company B made twice the profit, it was less than half as profitable as measured by return on assets. Why? Because, as our ratio makes apparent, it used its assets less efficiently than did Company A. This simple ratio was useful in providing us with a bit more insight into these two companies. Ratios show the relationship of one item to another. We can express this relationship between any two items that can be quantified. In order for a ratio to be relevant, however, there must be a significant relationship between the two items it compares. In a sense, then, our discussion of financial statement analysis is about relationships.
Let's suppose we have calculated the significant ratios and thoroughly analyzed the relationships between all of the relevant items on a firm's financial statements for the current year. We've made a good start. We still, however, don't know as much as we should to make informed judgments about the performance or financial health of the firm. To get a further insight into the firm, we need to compare the results of our computations with some type of benchmark or, better yet, benchmarks. There are generally four benchmarks we might use: past performance of the company (i.e. horizontal, or trend, analysis), the performance of the best-performing companies in the same industry, industry averages, and a pre-set target. The name of the game in financial analysis is comparison, comparison, comparison.
Trend analysis compares this year's results with past years' and is useful in revealing the direction, speed and extent of trends. It allows us to compare trends in related items. For example, we can compare the rate of change in sales with the rate of change in accounts receivable. Under normal conditions we would expect them to change at roughly the same rate. If the rate of change in accounts receivable is significantly greater than the rate of change in sales we should ask why. Perhaps the firm changed its credit policy and is now extending credit to higher-risk customers. Perhaps more accounts receivable are in danger of not being collected. Similarly, the rate of change in cost of goods sold should parallel that of labor costs. If not, we should ask why.

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