For all financial professionals, the truth is that they really need to know how to analyze a firm’s financial statements effectively. This will require a comprehension of three particular areas:
1) How the financial statements are structured
2) The economic characteristics of the sector or industry that this firm operates in
3) Any strategies the firm is pursuing to distinguish itself from competition
It is imperative that the translation of financial reports is done professionally to ensure that they remain accurate.
Generally speaking, there are six steps in developing an effective analysis of a firm’s financial statements.
1) Identify The Economic Characteristics Of The Industry:
First, ascertain a value chain analysis in regards to this industry, which is the chain of activities which are involved in creating, manufacturing, and distributing the services and/or products of the firm. Techniques like Porter’s Five Forces or an analysis of economic attributes generally get used for this step.
2) Identify Corporate Strategies:
Next, you want to look at the nature of the service/product the firm offers, including things like the profit margin levels, cost controls, brandy loyalty, and how unique the product is. Also, other factors that need to be considered include supply chain integration and geographic and industry diversification.
3) Assess the Caliber Of the Financial Statements of the Firm:
Review any key financial statements in the context of any related accounting standards. Issues like classification, valuation, and recognition are crucial components to an appropriate evaluation when examining the balance sheet accounts. The primary question has to be whether a balance sheet is actually a total representation of the economic position of the firm. When you evaluate an income statement, the central point is properly assessing the quality of earnings as a total representation of how the firm stands in terms of economic performance. Evaluating the statement of cash flow should help understanding what impact the firm’s liquidity position has from its financial activities, operations, and investments over a period of time, basically where funds have come from, the places they went, and how the broader firm liquidity was impacted.
4) Analyze Existing Risk And Profitability:
This is the time when financial professionals get to really add value into the evaluation of the firm as well as its financial statements. The most frequent analysis tools are the key financial statement ratios which relate to things like liquidity, profitability, risk/market valuation, debt management/coverage, and asset management. In regards to profitability, there are several broad questions needing to be asked. One is how profitable the firm operations are in relation to its assets, and this is independent of how a firm finances its assets. The second is how profitable a firm is as viewed from the perspective of its equity shareholders. It’s also crucial to learn how return measures can be disaggregated into their primary impact factors. Finally, it’s crucial to analyze any available financial statement ratios in a very comparative manner, which means looking at current ratios that relate to those from industry averages, earlier periods, or other firms.
5) Prepare The Forecasted Financial Statements:
While often challenging, it’s necessary that financial professionals make reasonable assumptions regarding both the future of the specific firm and its industry in order to determine how their assumptions are going to impact funding and cash flows. This will often take the form of various pro-forma financial statements that can be based on techniques like the percent of sales approach.
6) Value The Specific Firm:
While many valuation approaches exist, the most frequently applied kind is a form of discounted cash flow method. Such cash flows might come in the form of things like projected dividends, or there might be more detailed techniques using things like free cash flows towards either any equity holders or on an enterprise basis. Alternative approaches might include the use of relative valuation or even accounting-based measures such as economic value added.
The Following Steps
Once a firm is analyzed and the financial statements are finished, then there are still additional questions which need to be answered. Among the more crucial ones is whether or not the numbers being reported can be truly trusted. Many reported instances of various accounting irregularities do exist. Whether it’s labeled earnings management, aggressive accounting, or just downright fraudulent financial reporting, it’s essential for financial professionals to know both how these kinds of manipulations get perpetrated, as well as how they can be detected.