Financial Statement Analysis

Financial Statement Analysis

In this short introduction, financial statement analysis will be defined and explained. It is one of the steps used in our review of a company’s potential when considering investment.

Financial Statement Analysis

Financial statement analysis is also referred to as ‘Quantitative Analysis’. It is one of the most important steps while analyzing a company from an investment perspective. Massive amounts of numbers in a financial statement analysis may bewilder or intimidate a novice investor. Financial ratio analysis enables an investor to understand these numbers in an organized fashion. Balance sheet, income statement and cash flow statements are the most important financial statements and if properly analyzed and interpreted can provide valuable insights into a company’s performance.

Financial ratios are used by both current and potential investors, creditors and financial institutions to identify the strengths and weaknesses of a business, and to justify investment in the business. Internally, managers use these ratios to monitor performance and to set specific goals, objectives, and policy initiatives. The following articles discuss some of the important financial ratios used in determining the value of investments. It also discusses the limitations of these ratios that every analyst should bear in mind before interpreting these ratios in financial statement analysis.

Financial Ratio Analysis

Financial ratio analysis is a study of ratios between various items in financial statements. It enables investors and analysts to spot trends in a business and to compare its performance with the average performance of similar businesses in the same industry. Ratios can be classified as profitability ratios, liquidity ratios, asset utilization ratios, leverage ratios and valuation ratios based on the indications they provide.

Financial Ratios Liquidity Ratios

Financial Ratios – Liquidity Ratios

When investigating whether or not an organization is a worth while, or potentially profitable investment, it is crucial to consider the following financial ratios in your research.

Liquidity financial ratios are sometimes referred to as balance sheet ratios since most of the variables are taken from the balance sheet. Liquidity ratios measure the short-term solvency of a company. In other words, they indicate a company’s ability to meet its short-term financial obligations. These financial ratios are generally based upon the relationship between current assets and current liabilities.

Current Ratio

The current ratio is one of the most commonly used financial ratios to measure a company’s short-term financial strength. An industry where the current ratio is very valuable is the renewable resources sector. It is arrived at by following the formula shown below:

Current Ratio = Total Current Assets / Total Current Liabilities

Current assets are the assets that are expected to be converted into cash in the next operating cycle. The cash from current assets is used to pay off current liabilities, which are scheduled for payment during the next operating cycle. A company should have enough current assets to meet its current liabilities. The higher a company’s current ratio, the higher their margin of safety is since there is a possibility to lose some current assets, such as inventory write-offs or bad debts. If a company has a low current ratio, or less than 1x it indicates a potential short term liquidity crunch, and a possibility that they will not be able to meet their short term obligations.

While a generally acceptable current ratio is 2x, current assets should be twice the current liabilities, a satisfactory ratio is relative to the nature of the business. Moreover, while judging the current ratio, it is important for an analyst to look at the composition of current assets and liabilities. A company may have a very high current ratio of 3x, but if most of the current assets are locked in the form of inventory, a high current ratio may not indicate a good liquidity position. In this case, it is crucial to know the characteristics of the inventory. If the inventory consists of old product that is not selling well, the company may have to write off the inventory and the current ratio may drop significantly. However, if a large portion of their inventory consists of new products that the company is expecting to sell during the next business cycle, a high current ratio is a sign of healthy short-term liquidity position. Similarly, a high current ratio may also indicate a large amount of idle cash being accumulated and not reinvested into the business.

Quick Ratio

The quick ratio is also referred to as the ‘Acid-Text ratio’. It is considered to be one of the best financial ratios for judging a company’s ability to pay off its short-term debts and is a more difficult test for a company to pass. As mentioned above, inventories are subject to write-offs in certain cases and are therefore considered to be the least liquid component of current assets. While these financial ratios are similar to the current ratio, it excludes inventories from current assets.

Quick Ratio = (Total Current assets – Inventories) / Total Current Liabilities

By excluding inventories, the quick ratio concentrates on the most liquid assets, including cash, government securities and receivables. A higher quick ratio indicates that even if sales revenue were to disappear, the company would still be in a position to meet its current obligations with readily available assets. A quick ratio of 1x is considered acceptable, unless the majority of the quick assets are in the form of accounts receivable. In this case, the pattern of accounts receivable collection needs to be studied to find if the average collection period lags behind the schedule for paying current liabilities. The quick ratio is one of the utmost important financial ratios used to review an organization’s attractiveness when considering investment.

Filing with the SEC

Filing with the SEC

To protect investors

The Securities and Exchange Commission (the SEC) requires that companies file a registration statement with them before they issue public offering shares. This registration statement contains detailed information about the issuing company and its business. The Securities Exchange Commission will review the registration statement and an accompanying prospectus to ensure that they conform to certain legal requirements. Once the SEC has reviewed these documents, the issue can be cleared for sale. (The SEC will neither approve nor disapprove an issue, nor will it guarantee the accuracy of disclosures; it will only clear it for sale.)

Only when the issue has been cleared for sale (when registration has become “effective”) can the shares be priced and firm orders for them are accepted

The SEC is part of the US procedure, but the process in Canada is very similar. One snag Canadian business would like to see changed is a move to a more uniform system such as the US has deployed. Presently, provincial legislation governs securities and the premier jurisdiction is the Ontario Securities Commission (the SEC equivalent) which administers and enforces the legislation. Ontario is home to the TSX and TSX Venture markets so most IPOS go through the Ontario Securities Commission to gain approval. Thanks mainly to mining stocks and the Vancouver Exchange, British Columbia is also a very active jurisdiction.

The guideline most companies follow is to conform to SEC requirements because they may one day wish to trade on a US market, and in so doing, the stringent US filings will meet or surpass most Canadian disclosure demands.