All financial statements are essentially historically historical
documents.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financial statements are historical documents, they can still provide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.