Reasons For Evaluating Financial Statements

Reasons for Evaluating Financial Statements

 

The primary reason we looking at financial statements is that we do not have enough market information to make a decision.  As mentioned in week one, financial statements are the “lens” of the business, but they take a rear view look at performance.  There are no guarantees that past performance reflects future performance, but the past can be a good predictor of future performance.  Managers can look at financial statements for the company as a whole, but also at each division.  Financial Statement Analysis is essentially an application of “management by exception.”  Financial Analysis will boil down to comparing ratios from one business to another with some kind of average or representative ratio.  Ratios that seem to differ the most from the averages are tagged for further study.

 

Financial Statements are used for internal and external purposes.  These purposes are highlighted below:

 

Internal Uses

 

  • Performance Evaluation – Managers are frequently evaluated and compensated on the basis of accounting measures of performance such as profit margin and return on equity.  Multiple divisions frequently compare the performance of those divisions using financial statement information
  • Planning for the future – Historical information is very useful in generating projections about the future and checking the realism and assumptions for the projections.

 

External Uses

 

  • Evaluation of the firm by creditors, outside credit agencies and investors – Creditors would want financial statements in order to make decisions to grant credit or to invest in the firm.
  • Evaluate suppliers – Because of supply chain risks, companies use financial statements to ensure suppliers and other supply chain partners have adequate financial health.
  • Evaluate main competitors – We could evaluate competitors to see their financial strength, which could let a firm know formidable a competitor could be in the market place.
  • Acquiring another firm – Financial statement can help identify future targets and let us know the estimated appropriate price to pay for an acquisition.

 

Benchmarking Financial Statements and Ratios

 

While we want to evaluate a firm based on its financials, how do we choose a bench mark or a standard of comparison?  Here are some methods we can use:

 

  • Time-trend analysis – One can look at financials of companies during the same time frame to get a meaningful comparison.
  • Peer Group analysis – One can benchmark using firms in the same markets, having similar assets, and operating in the same manner.  One can identify firms using their standard industrial code (SIC), the North American Industry Classification System (NAICS), specific industries, competitors, etc.  By looking at peer analysis, one get a better picture of how a firm is doing relative to its industry and its competitors.  This is huge from a supply chain standpoint because it can give some revelation of which supply chains are performing better.

 

Problems with Financial Statement Analysis

 

The biggest issue with financial statement is that we do not have preferred theory of what way is best for us to conduct the analysis or set up benchmarks.  It will be up to the managers and the finance people who best understand the business to set up the appropriate metrics.  Another reason is that ratios provide a guide but they do not necessarily indicate if something is good or bad.  One needs a point of reference or comparison to ensure ratios give the appropriate information.  Another reason is that it is difficult to compare firms in different countries.  Many countries do not use US GAAP, so one may not be comparing apples to apples.