Financial statements as a source of information - how to read and draw conclusions from the financial statements?
A financial statement is a document containing a lot of valuable information about a company. Financial reporting should present the condition of the enterprise clearly and fairly. By skilful reading of the financial statements, both external and internal recipients can assess the financial condition of the enterprise. In this article, we explain what elements of the report to pay attention to and how to analyze the information contained therein.
Financial statements and the assessment of materiality of individual information
Financial statements contain a lot of useful information that is useful in the decision-making process.They become longer and more detailed, which makes it more difficult to see the relevant data needed to conduct a thorough analysis of the company's financial situation when analyzing them. Financial statements must contain all elements formulated in regulations which, depending on the specific nature of the entity, are not necessarily important both in terms of quantity and quality. Accumulation of this type of information often interferes with the smooth reading of financial statements and focuses attention on unimportant details. Too much data affects transparency and reduces the usefulness of the report itself.
Formally adjusting the report to the specificity of the company or industry would certainly facilitate the analysis and reliable assessment of the company's situation. However, since strict standards regarding mandatory disclosures do not allow entities to assess individual disclosures, first of all financial analysts should assess the materiality of individual information and discard information that is irrelevant to the enterprise. Only data that provide information relevant to the assessment of the entity's financial condition should be selected.
Analysis of the structure of assets
In order to assess the financial situation of an entity, it is necessary to analyze the structure and dynamics of assets. The more current assets there are compared to non-current assets, the greater the entity's liquidity and balance sheet. There is no clear answer as to which asset items should dominate the economic entity's assets. Asset structure indicators inform us about the property resources of a given enterprise and whether the structure of assets corresponds to the specificity and scale of activity. Depending on the type of business, it should be assessed whether the proportion between fixed assets and current assets is appropriate. If, for example, we run a commercial activity, it is justified that the value of current assets outweighs fixed assets, because the products sold are in constant motion. Manufacturing companies, on the other hand, are characterized by the fact that fixed assets usually dominate over current assets, as various types of machines and devices are used in the conducted activity, and the undertaken investments improve the processes of manufacturing products.
Regardless of the type and scale of business, each business entity should maintain financial liquidity. The fact whether the entity has an adequate amount of cash to settle its current liabilities and a reserve of funds for other expenses makes it possible to assess whether the going concern is not at risk. Large reserves of cash may indicate the prudence of the management board of the entity, which on the one hand is desirable, but may contribute to the inhibition of development by not using available assets for possible investments that could increase profits in the future.
Capital situation analysis
Equity and liabilities are the primary source of asset financing. In order to reliably determine the financial situation of an economic entity, it is necessary to take into account not only information about the property owned, but also about the sources of origin of resources. The analysis of the structure of liabilities makes it possible to assess the level of equity, structure and dynamics of debt.
A stable level of equity, reflected in the size of fixed assets and profitability, means a good financial situation of the company. In general, the capital situation of an enterprise is the better, the higher the share of equity in liabilities. In the event of a negative level of equity, the value of liabilities exceeds the property owned, which of course indicates an unfavorable financial situation of the entity.
The level of equity is varied, depending on the type of enterprise and its specificity. For example, trading companies usually show lower equity, which is due to the fact that they have a lot of current assets, and these can be financed by liabilities. However, it should be remembered that short-term liabilities are not a stable source of financing assets. In a situation where we record their excessive share in the structure of liabilities, there may be a risk of losing financial liquidity and, consequently, a threat to the continuation of operations. In manufacturing companies, however, large resources of fixed assets should be financed from equity.
A reliable analysis of the situation of a given enterprise cannot be limited to one reporting period. It is very important to compare the results achieved with previous periods, change them over time and estimate future results, define goals that we would like to achieve in a given period. If we recorded higher profits than in previous periods, it is worth considering whether this increase is sufficient. In the event of a loss, however, it is necessary to analyze in detail the reasons for such a state of affairs, as it may turn out that it was influenced by investments, thanks to which the work efficiency will be increased, which should pay off in future reporting periods. The downward tendency does not always indicate the deterioration of the general situation of the entity, the innovations applied and the investments undertaken are usually a step forward that proves the company's development. If we do not ensure the comparability of data over time, we will not be able to make an objective assessment of the company's financial condition. By relying solely on data from one balance sheet date, we can draw incorrect conclusions. We will get a full picture of the situation of a given entity only when we compare information from the financial statements over several periods, thanks to which we will be able to determine the entity's dynamics.
Analyzing the company's situation is also referring to the general trend in the market and comparing it with what is happening in a specific industry. It may happen that, due to the specific nature of the activity, the sector in which the activity is conducted achieves worse results due to circumstances beyond our control. A difficult time for a given industry may result from random events. In such a situation, you should consider how to survive the worse period, whether we can afford a temporary downtime, or maybe we have to think about new forms of financing, or even suspending or liquidating the company. It is difficult to clearly define which factors to pay attention to when comparing the information contained in the financial statements, because everything depends on the specifics of the business and the industry in which we operate.
Recipients of the financial statements
Financial statements offer many possibilities for the reporting information to be used by external and internal recipients. It can be the basis for making economic decisions by current and potential investors, creditors and other entities from the entity's environment.
The internal recipient of the financial statements is primarily the management board. Persons making management decisions in a given enterprise on the basis of financial statements should answer the questions whether the conducted activity brings the desired profits, develops and whether the further continuation of the enterprise is profitable. The preparation of financial statements should therefore not be treated only as a formal obligation, the responsible management board should use the financial statements to assess the company's financial situation.