Interpretation of Financial Statements

Introduction

Financial statements on their own are of limited use. For example: if you were to identify that a business has made profits of $1 million what does that tell you about the business? Does it suggest the business is a success? It might, but not if in the previous year they made profits of $50 million and their closest rival earned profits of $60 million.

It is important that users of financial statements can interpret the financial statements to be able to draw out valid conclusions. Typically this involves the use of comparisons to prior years, forecasts and competitors. Users can compare sales and expense figures, asset and liability balances and cash flows to perform this analysis.

Ratio analysis is widely used to support this process of comparison. Don't forget though that ratios are calculated using the figures already present in the financial statements. The raw data is equally useful when performing analysis. Ratios are simply a tool to try and assist understanding and comparison.

Users of financial statements

When interpreting financial statements it is important to ascertain who are the users of accounts and what information they need:

• shareholders and potential investors – primarily concerned with receiving an adequate return on their investment, but also with the stability/liquidity of the business
• suppliers and lenders – concerned with the security of their debt or loan
• management – concerned with the trend and level of profits, since this is the main measure of their success.

Other potential users include:

• financial institutions
• employees
• professional advisors to investors
• financial journalists and commentators.

Ratio analysis

Ratios use simple calculations based upon the interactions in sets of data. For example; changes in costs of sale are directly linked to changes in sales activity. Changes in sales activity also have an effect upon wages and salaries, receivables, inventory levels etc. Ratios allow us to see those interactions in a simple, concise format.

Ratios are of limited use on their own, thus, the following points should serve as a useful checklist if you need to analyse data and comment on it:

• What does the ratio literally mean?
• What does a change in the ratio mean?
• What is the norm?
• What are the limitations of the ratio?

Focus of analysis

Traditionally financial statements analysis focuses on four key areas:

• profitability,
• liquidity,
• efficiency, and
• financial position.

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