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MAKING FINANCIAL DECISIONS USING FINANCIAL STATEMENTS
PURPOSE OF FINANCIAL ANALYSIS
Financial statements attempt to show in condensed form the operating results and financial position of a business. The process of breaking down complex accounting data into components and relating these components to each other is called financial analysis; the ability to bring out their meaning is called interpretation.
Application of analytical tools and techniques to financial data results in the emergence of meaningful measurements and relationships useful in decision making. Although each of the measurements and relationships is of value in the analysis of financial conditions and operating results, some of them will be of greater importance for certain groups of users than for others. Thus the type of financial analysis undertaken will vary according to the particular interest of the user.
Owners of small enterprises and management use analysis and interpretation of financial data as a tool for planning, executing and controlling an enterprise’s operations, financial position and progress. The advantages that management derives from systematic monitoring of financial data include the recognition of changes that have taken place or are taking place, an indication of the cause, effect and importance of each change, continuous reappraisal of strength and weaknesses and the opportunity for prompt and effective action. ...
Long term lenders focus their attention on the ability of the business to meet regular interest payments and on the financial position of the business, indicating the degree of certainty with which loans will be repaid on due date. ...
Profitability
Thus, profitability, financial strength and efficiency of operations are the most important aspects of a business to the users of financial statements. ... The information yielded by the analysis of profitability indicates the effectiveness with which funds invested in the business have been used
Solvency and Liquidity
Financial strength concerns both solvency and liquidity. Solvency focuses on the excess of assets over liabilities and on the potential ability of a business enterprise to meet interest and principal payments on long-term debt and other financial obligations. ...
Efficiency of operations deals with the manner in which a business enterprise uses its fixed assets and working capital to generate income and to maintain or improve its financial strength.
Financial Analysis
The first step in financial analysis must be to establish a clear definition and understanding of the objectives in each investigation. This will enable the analyst to concentrate on relevant data in the financial statements.
Once the objectives of the analysis have been defined the next step is to carry out a thorough review of the profitability and financial strength of the enterprise. This will provide the owner with the information required for a meaningful interpretation of the financial statements.
In the analysis of financial statements it is often informative to determine the proportion which a single item or group of items represents of a total of which it forms a part. ...
This analysis is used to provide indicators of past performance in terms of profitability and operational activity and of financial strengths and weaknesses in terms of solvency and liquidity.
Income Statement Analysis
Using the percentage presentation format or common-size statement presentation is particularly useful in the case of income statements because most expensive items are, directly or indirectly, affected by the level of sales. ...
Using this method it is extremely useful to list the financial statements side by side, covering a number of consecutive accounting periods. You may recall that this was recommend in the previous lessons as such a presentation has the advantage that the structural relationships in each of the statements are shown in the vertical columns whilst the trends are analysed horizontally. ... turnover, sales, profit etc of financial statements that would be expected to conform to a predictable pattern based on the enterprises’ own experience. ... The enterprise will incur certain expenditure and make certain payments in the process of making an income. ... Liquidity refers to the business’s ability to keep making all these payments regularly and on time. ... It is necessary to consider the cash on hand plus expenses as well as the current assets which are easily disposed of to determine the financial viability of an enterprise. ...
Activity 1
Let us analyse the financial strengths and weaknesses of an entity and make suggestion of ways to improve income and reduce costs.
We will compare the financial statements of an enterprise covering to consecutive accounting periods by placing the data contained in the statement in columnar form or side by side. ... 3% increase
However, using the same calculation consider the following decreases:
Gross profit for Year 2001 less Year 2000:
R 16000 – R 16500 = (R500) this negative amount indicates a decrease in profits in Year 2001 compared to the previous year. ...
COMPARATIVE INCOME STATEMENTS
Year Year Increases
2001 2000 (Decreases)
R R R %
Sales 52000 48000 4000 8. ... Although sales or revenue has increased this has not had the desired effect of improving the financial viability of the organisation. ... An Expenditure and Income Statement of this nature would discourage would-be investors and financial institutions and any loans necessary may not be approved. ... Using the above example we see that the sales figure for 2001 is R52000. ...
Activity 2
Let us analyse the strength and weaknesses on an entity using the balance sheet.
Approximate Word count = 4305
Approximate Pages = 17.2
(250 words per page double spaced)
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