Financial Statement Analysis
Financial statement analysis the procedure of understanding the risk and economically yielding material profit of a company such as business or project via analysis of reported financial information, in particular annual and quarterly reports.
Financial statement analysis comprises of
i) Reformulating reported financial statements
ii) Analysis and adjustments of measurement errors
iii) Financial ratio analysis on the basis of reformulated and adjusted financial statements.
The two first steps are often dropped in practice, intending that financial ratios are just computed on the basis of the reported numbers, perhaps with some adjustments. Financial statement analysis is the cornerstone for evaluating and pricing credit risk and for doing fundamental company valuation.
1) Financial statement analysis generally starts with redeveloping the reported financial information. In relation to the income statement, one common reformulation is to divide reported items into recurring or normal items and non-recurring or special items. In this manner, earnings could be separated in to core or normal earnings and transitory earnings. The theme is that normal earnings are more permanent and hence more relevant for prediction and valuation. Normal earnings are also classified into net operational profit after taxes known as NOPAT and net financial costs. The balance sheet is grouped, for instance, in net operating assets called as NOA or net financial debt and equity.
2) Analysis and adjustment of measurement faults question the quality of the reported accounting numbers. The reported numbers can, for instance be a bad or noisy representation of invested capital, for illustration, in terms of NOA, which means that the return on net operating assets (RNOA) will be a noisy measure of the underlying economically yielding material profit (the internal rate of return also termed as IRR). Expense in Research and Development is an instance, when such investment expenditures are anticipated to yield future economic benefits, suggesting that R&D makes assets which should have been capitalized in the balance sheet. An illustration of an adjustment for measurement errors is when the analyst gets rid of the Research and Development expenses from the income statement and put them in the balance sheet. The R&D consumptions are then replaced by amortization of the Research and Development capital in the balance sheet. Another instance is to adjust the reported numbers when the analyst distrusts earnings management.
3) Financial ratio analysis should be grounded on regrouped and adjusted financial statements. Two types of ratio analysis are executed:
a) Analysis of risk
b) Analysis of profitability
i) Analysis of risk:
It typically aspires at detecting the inherent credit risk of the firm. Risk analysis comprises of liquidity and solvency analysis. Liquidity analysis aspires at analyzing whether the company has adequate liquidity to meet its indebtedness when they should be paid. A common technique to analyze liquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also practicable. Solvency analysis aspires at analyzing whether the company is financed hence that it is able to recover from a losses or a period of losses. A common technique to analyze insolvency risk is to focus on ratios like the equity in percentage of total capital and other ratios of capital structure. Based on the risk analysis the analyzed company could be rated, i.e. given a grade on the risk, a procedure cited as synthetic rating.
Ratios of risk like the current ratio, the interest coverage and the equity percentage have no theoretical bench marks. It is thus common to compare them with the industry average over time. If a company has a higher equity ratio than the industry, this is looked at less risky than if it is above the average. Similar to, if the equity ratio increases over time, it is a good sign in relation to risk linked with the lack of financial resources.
ii) Analysis of profitability:
It involves analysis of economically yielding material profit refers to the analysis of return on capital, for illustration return on equity or ROE is outlined as earnings divided by average equity. Return on equity or ROE, could be decomposed as:
Return on equity= RNOA + (RNOA - NFIR) * NFD/E,
Where RNOA is return on net operating assets.
NFIR is the net financial interest rate.
NFD is net financial debt and E is equity.
In this manner, the sources of Return on equity could be elucidated.
Not like other ratios, return on capital has a theoretical bench mark, the cost of capital is also cited as the requisite return on capital. For instance, the return on equity, ROE, could be compared with the requisite return on equity, kE, as estimated, for example, by the capital asset pricing model. If Return on equity< kE (or RNOA > WACC, where WACC is the weighted average cost of capital), then the company is economically yielding material profit at any given time over the period of ratio analysis. The company makes values for its owners.
Insights from financial statement analysis could be utilized to make forecasts and to measure credit risk and value the firm's equity. For instance, if financial statement analysis discovers increasing superior performance Return on equity- kE > 0 over the period of financial statement analysis, then this trend could be generalized into the future. But as economic theory suggests, sooner or later the competitive forces will work - and Return on equity will be driven toward kE. Only if the company has a sustainable competitive reward, Return on equity- kE > 0 in "steady state".
Financial Statement Analysis - Online Tutoring - Assignment Assistance
We at Expertsmind.com offer Financial Statement Analysis homework help, Financial Statement Analysis free tutorials and assignment assistance and Financial Statement Analysis based question's answers by help of qualified and experienced finance tutors. We make easy Financial Statement Analysis based assignments and homework for you with conceptual Financial Statement Analysis theory.
ExpertsMind.com - Financial Statement Analysis Assignment Help, Financial Statement Analysis Homework Help, Financial Statement Analysis Assignment Tutors, Financial Statement Analysis Solutions, Financial Statement Analysis Answers, Finance Terms Assignment Tutors