Techniques and limitations of financial statement analysis
Beginner Stock Market Investing, Stock Market Investing Strategies
Analyzing the performance of a business with the use of financial statements can be a demanding task and requires that you should systematic be collected and examine the relevant financial data. The three principal statements that are used the income statement, the balance sheet and the cash flow statement. Here are some of the techniques that you can use:
- In vertical analysis, the statements for a single financial period are analyzed. On the income side, each separate income item is calculated as a percentage of the net revenue. The net income is the income that is left after expenses have been met. If expenses account for 70% of your income then your net income will be 30% of your total income. Similarly, if you are looking at a balance sheet, individual figures for assets and liabilities complaint to the totals for assets and liabilities.
- In horizontal analysis, data for at least a two periods is used in carrying out the analysis. The changes in the figures over the two periods are used like indicators that show the changes in the business. Useful changes to be looked at are changes in revenues, net income and operating assets as well as changes in expenses and liabilities. The calculation can be done either in terms of absolute dollar figures or in terms of percentage changes over the base figure.
- The continuation of horizontal analysis is called trend analysis and normally involves along a timeframe of at least three more financial periods. Long-term trends are established by using the figure for the earliest period as the base figure and then calculating the changes over the subsequent periods. These changes are mostly expressed in percentage terms. The incremental change figures will enable you to determine whether the position of the business is improving or deteriorating.
You should bear in mind that there are limitations to the utility of financial statements and their analysis and here are some of the more important ones:
- Financial statements can only provide you with past historical data and past performance is certainly no guarantee of future performance. This is why it is important to examine past numbers for a period of say five years so that trends are clearly established on the basis on which you can forecast future performance. For instance, if a company has achieved sustained sales growth in the past few years, there is a reasonable chance that the performance will be sustained.
- Financial statements concern themselves with the numbers and provide very little qualitative data such as the quality of management. You can easily get trapped into going by numbers alone without evaluating the quality of the management and the sustainability of the business. One possible source for you to gather the information for evaluation as to look at the section of the quarterly report that contains the management perception of the business and its prospects.
In conclusion, it would be fair to say that the limitations do not take away from the utility of the analysis of financial statements. On the other hand, if you are aware of these limitations, you can structure your analysis to take them into account while arriving at an accurate conclusion.
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