Financial analysis is the process or critically examining in detail, accounting information given in financial statements and reports. It is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of a firm’s performance. The measurement and interpretation of business performance is done through the use of ratios. The financial statements published by companies are too general to be used by the various of stakeholders and hence ratios are used to highlight the different aspects of business operations.
A ratio is simply a mathematical expression of an amount or amounts in terms of another or others. A ratio may be expressed as a percentage, as a fraction, or a stated comparison between two amounts. The computation of a ratio does not add any information not already existing in the amount or amounts under study. A useful ratio may be computed only when a significant relationship exists between two amounts. A ratio of two unrelated amounts is meaningless. It should be re-emphasized that a ratio by itself is useless, unless compared with the same ratio over a period of time and/or a similar ratio for a different company and the industry. Ratios focus attention on relationships which are significant but the full interpretation of a ratio usually requires, further investigation of the underlying data. Thus ratios are an aid to analysis and interpretation and not a substitute for sound thinking.
These ratios act as a guide for decision making of the various potential and actual users of the financial information.
These users include:
1. Shareholders- they have invested in the firm and are the owners. Shareholders are interested in the profitability and survival of the firm. They are typically concerned with the allocation of earnings for investment and the residual earnings which may be paid to them as dividends.
2. Lenders- lenders could be long-term or short-term lenders. They could be trade creditors, banks or bondholders. They are interested in the liquidity of the firm which affects the perceived risk of the firm.
3. Potential investors- an analysis of the firms profitability and risk would influence the decision on whether to invest in a company’s stock or not they will make this decision by gauging the expected return on their investment whether it’s in terms of a share price gain(capital gain) or dividends.
4. The government-the government is mostly interested in a company’s tax liability. In the case of government owned corporations, it will be concerned in the survival and the continued ability of the company to provide the services it’s charged with providing especially for public utilities.
5. The company’s management-they are interested in the efficiency of the company in generating profits. The company’s general performance is often regarded as a reflection of the management’s effectiveness. The gearing ratios, profitability, liquidity and investor ratios are important for decision making.
6. Competitors-they use financial statements for comparison to see their competitive strength.
7. Consumers and potential consumers-they are interested in the company’s ability to continue providing for them the goods or services they require. Hence the financial statement analysis serves to aid the above groups of people in decision making.
Sources of Information
The first procedure in financial statement analysis is to obtain useful information. The main sources of financial information include, but are not limited to, the following;
• Published reports
Quoted companies normally issue both interim and annual reports, which contain comparative financial statements and notes thereto. Supplementary financial information and management discussion as well as analysis of the comparative years’ operations and prospects for the future will also be available. These reports are normally made available to the public as well as the shareholders of the company.
• Registrar of Companies
Public companies are required by law to file annual reports with the registrar of companies. These reports are available for perusal upon payment of a minimum fee.
• Credit and Investment Advisory Agencies
Some firms specialize in compiling financial information for investors in annual supplements. Many trade associations also collect and publish financial information for enterprises in various industries. Major stock brokerage firms and investment advisory services compile financial information about public enterprises and make it available to their customers. Some brokerage firms maintain a staff or research analysis department that study business conditions, review published financial statements, meet with chief executives of enterprises to obtain information on new products, industry trends, negative changes and interpret the information for their clients.
• Audit Reports
When an independent auditor performs an audit the audit report-is usually addressed to the shareholders of the audited enterprise. The audit firms frequently also prepare a management report, which deals with a wide variety of Issues encountered in the course of the audit Such a management report is not a public document, however, it is a useful source of financial information.