Further Considerations in Financial Analysis

There are several advantages to financial statement analysis. Financial statement analysis can:

• Show trends over time. Converting information to percentages or ratios eliminates some of the disparity between competitor sizes and operating abilities, making it easier for stakeholders to make informed decisions.
• Summarize current operations within the business, and identify the shifts that need to occur internally to increase productivity.
• Guide Future Operations by aiding decision-making in budgeting, cost control, revenue maximization, and capital expenditures.

However, some considerations for financial statement analysis are:

• Ratios and other analysis tools are only part of the story. Ratios are useful because they help us quickly and efficiently focus our attention on the most critical parts of an organization’s financial position. But they are never the whole story. They can be used as diagnostic tools to identify areas that require further investigation.
• Always interpret the analysis in context. Ratios and other tools are useful because they help identify trends in an organization’s financial behaviour.  However, multiple years of financial data are needed to provide context. Past performance does not always dictate future performance. Attention must be given to possible economic influences that could skew the numbers being analyzed, such as inflation or a recession. Additionally, the way a business reports information within accounts may change over time. For example, where and when certain transactions are recorded may shift, which may not be readily evident in the financial statements. As long as the business understands the limitations of the information provided, financial statement analysis is a good tool to predict growth and business financial strength.
• Industry comparisons can be difficult to find. It is difficult to conduct financial analysis using industry averages because no one creates an industry average set of financial statements. However, many analysis websites collate firms in the same industry to create industry averages for ratios. Therefore, you can compare the current ratio of one business, to the industry average to determine how the business is performing against the rest of the industry. There are some caveats to this approach. For one, some industries may have very large and very small players. As well, an industry grouping might be very diverse. 
• Past performance. Finance focuses on future expectations and financial statements describe past performance. Things change over time which can make it hard to use past financial information to make forecasts about the future.  It is important to be aware of the limitations and recognize that the numbers are a part of the story and not the story itself.

Asking Questions

The numbers and outputs from financial statement analysis alone cannot tell us exactly what is happening in a business. Instead, it provides users of the financial statements with a way to analyze the data so that they can ask the most appropriate questions. For shareholders, this might be asking a question of management at an annual general meeting. For lenders, this could be probing deeper when they are asked to provide another loan or an alteration to a borrowing contract.

In reality, very few accountants or business people conduct the calculations you are about to learn by hand. Today, most users of such analysis obtain it from websites or service providers who use software and technology to remove the mundane actions of calculating these numbers. The key is to understand HOW the various forms of analysis are constructed so that you can INTERPRET the outputs and then develop good QUESTIONS to ask.

Budgets & Forecasts

The final comparison a business may make is between their ACTUAL performance (based on recorded transactions) and their BUDGET or FORECAST for the same period. Did they do better than their budget? Generate more revenue? Decrease expenses?

We will learn in a later section that budgets can be manipulated, especially when part of a performance measurement or bonus scheme, perhaps artificially. Therefore any comparison to budgets should be made with a healthy dose of scepticism.

Advantages and Disadvantages, and Asking Questions adapted from “Financial statement analysis” and “Comparing business reports to other measures” from Accounting and Accountability Copyright © by Mitchell Franklin; Patty Graybeal; Dixon Cooper; and Amanda White is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.

Budgets and Forecasts adapted from “Chapter 3- Financial Statement Analysis” from Financial Strategy for Public Managers Copyright © 2023 by Sharon Kioko and Justin Marlowe is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.