Understanding and Analysing Financial Statements

Small business finance & accounting

Accounting is often called the language of business. In this business support module learn about the basics of understanding and analysing financial statements.

Key learning outcomes:

  • What information appears in different financial statements?
  • How can financial statement information be analysed to make better decisions?

Presented by USC Moreton Bay

Video Presentation: Understanding and Analysing Financial Statements

Understanding and Analysing Financial Statements

Hello. My name is Dr. Peter Baxter and I am a senior lecturer in accounting at the new USC Morton Bay campus at Petrie. In my presentation today, I'm going to be speaking to you about understanding and analysing financial statements.

Accounting is the language of Business

Accounting is often called the language of business. So this means that it's the language that's used by managers to communicate information about a firm's financial performance and position to external stakeholders, such as shareholders, customers, suppliers, and employees. Now, whether you're a small business owner, a manager, or just starting out your career, everyone in business needs to have at least a basic understanding of financial information to enable them to interact with the firms accountants, and therefore ultimately reach better financial decisions.

Now, in this presentation today, I'm going to be covering two main areas. First, I'll be explaining the different elements that are contained in the three main financial statements that affirm can produce. Secondly, all identify and briefly discuss some of the tools that can be used by people in business to analyse financial statements to enhance their decision-making within the firm or outside of the firm.

Three most common financial statements

So first let's discuss the accounting elements that appear in financial statements. So what are the three most common financial statements prepared by a business?

First, we have a profit and loss statement, which is also sometimes known as an income statement, or a statement of financial performance. Now this statement provides information on how well a business has performed financially across a specific time period, such as the financial year.

Next we have the balance sheet. Now this is also sometimes known as a statement of financial position. This statement provides information on how the business is positioned financially as at a particular point in time, such as the end or the last day of the financial year.

And thirdly, we have a cashflow statement. Now, as the name suggests, this statement provides information on the inflows and the outflows of cash for the business across a period of time.

1. Profit and loss statement

Let's first look at the elements in the profit and loss statement. This statement provides information on the various sources of revenue that have been earned by the business during the time period, as well as the expenses that the business has incurred.

So common examples of some revenues include things such as:

  • Sales revenue
  • Service revenue
  • Interest revenue

Such items of revenue consist of either an increase in the firm's assets or a decrease in their liabilities, as well as an increase in the equity of the owners in the firm. However, it's important to remember that when the owners contribute or invest cash or other assets in the business, this is specifically excluded from being part of revenue.

Common examples of expenses include things such as:

  • Cost of sales
  • Wages expense
  • Depreciation expense

These items relate to decreases in the assets of the business, or increases in their liabilities. They also result in decreases in the equity of the owners throughout the accounting period.

Whereas payments of cash to the owners by way of things, such as drawings or dividends are specifically excluded from being considered expenses.

Finally, of course, the difference between the revenues, the total revenues and the total expenses of the business is either a profit or a loss, depending on whether the total revenues or the total expenses is larger.

2. Balance Sheet

Next, we will look at the financial elements contained in a balance sheet. A firm's assets are the economic resources that are controlled by the firm that arise from various different events or transactions that have occurred in the past, and they also have the potential to produce or create economic benefits for the firm in the future.

Common examples of assets include things such as:

  • cash at bank
  • inventory
  • accounts receivable
  • property plant and equipment.

A firm's liabilities represent obligations that currently exist arising from various different events that have occurred in the past. And that will result in an outflow or the payment of resources. Normally involving cash or economic benefits sometime in the future.

Liabilities include things such as:

  • accounts payable, or also sometimes known as creditors
  • provisions for annual leave
  • loans payable

Finally, the equity of the owners in the firm comprises the owner's interest in the assets of the firm, less or after subtracting its liabilities.

So overall, the balance sheet basically shows how the assets of the firm are funded by a combination of the liabilities or external sources of finance, and owners equity or internal sources of finance.

3. Cashflow Statement

The third financial statement that affirm can prepare is a cashflow statement. So understanding the cash flows of a business is absolutely important, particularly for small to medium-sized firms, because they need to ensure that they have sufficient cash coming into the business to be able to meet their various financial obligations, as well as to fund their future growth.

This statement basically explains how the balance of the business's cash at bank account has changed, whether it's increased or decreased between the start of the accounting period and the end of the accounting period. And there are three main activities or categories of cash flows that are shown on this statement.

a) Operating activities

First of all we have the operating activities. Now the operating activities relate to the main revenue producing activities of a business that are usually derived through either selling inventory to customers, or providing services to customers. Specific cash flows include cash received from the customers, as well as cash payments to the suppliers of goods and services, as well as the employees that work within the firm.

b) Investing activities

Next we have investing activities. Now these involve the firm either buying or selling long-term assets and other investments. Examples of such cash flows include cash received from selling equipment for cash, and also cash paid when a business purchases a motor vehicle or some other particular type of asset.

c) Financing activities

And the third category on a cashflow statement are the financing activities. These activities relate to changes in the size or the composition of the firms financial structure. Such cash flows include things such as cash received from the owners (when the owners invest cash into the business), and also cash that is repaid on loans from banks or other particular financial institutions.

How to analyse financial statement information

Now having discussed the contents of the three main financial statements that businesses can produce. We'll now talk about how the information in these statements can be analyzed by both internal stakeholders and also external stakeholders to enhance or improve their decision-making.

The three financial statements that we discussed today are really important sources of information for both the internal and the external stakeholders to use when they make different types of decisions. There are a wide variety of different types of financial decisions that these stakeholders could be making.

This could include:

  • a manager assessing whether a business is generating sufficient profits throughout the time period
  • an investor, when they're considering whether or not they should invest money in the company or the business
  • a supplier deciding whether or not to sell inventory on credit to a customer

Financial statement information can also be used as the basis for various agreements between a firm and its stakeholders.

These agreements include:

  • Management compensation contracts, where bonuses may be linked to reported profits on the profit and loss statement.
  • Bank loan contracts that contain conditions restricting the proportion of debt in the firm's capital structure.

What tools are available to assist analysing financial information?

There are various tools available to businesses and other stakeholders to use when they're analysing financial statement information.

1. Horizontal analysis

Horizontal analysis involves calculating percentages or percentage changes in individual financial statement items from one year to the next year. This enables the identification of changing trends in financial performance and position of the firm over a period of time.

2. Vertical analysis

Vertical analysis involves calculating individual financial statement items such as cost of sales as a percentage of a particular base item, such as sales revenue. Trends in these percentages can also be analysed over a period of time to see how they've changed, whether they've increased or whether they've decreased.

3. Ratio analysis

Thirdly, ratio analysis involves calculating relationships between two or more financial statement items. Often ratios will compare, an item on the income statement or the profit and loss statement to an item on the balance sheet.

When performing ratio analysis, it's really useful and important to compare the results for the particular firm being analysed with some other appropriate benchmark or point of comparison. These benchmarks can include, for example, key competitors in the same industry or averages for the industry in which the business operates.

What to analyse in financial statements

When analysing financial statements there are various aspects that can be examined.

1. Profitability

Profitability refers to the ability of the firm to generate profits. It can be evaluated by a range of different ratios. One of the common ratios for profitability is the return on assets ratio, which provides a measure of how well the firm is at generating profits from the assets that it has at its disposal.

2. Financial gearing

We can also analyse the financial gearing or the financial structure of a business, which relates to the extent to which affirm is funded via debt versus equity. The debt to assets ratio is a very common example of a ratio that's used. It calculates the percentage of assets that are funded by debt or external sources of finance. It’s generally accepted that for businesses, the higher the proportion or percentage of debt in their capital structure, the higher will be the firm's financial risk.

3. Operating efficiency

We also have operating efficiency, which measures how efficiently affirm is at managing its assets and its liabilities.

An example of such a ratio is the inventory turnover ratio, which assesses how quickly a firm is turning over or selling their inventory during a given time period, whether that be six months or whether that be 12 months.

4. Liquidity

Finally we have liquidity. Liquidity describes or assesses the ability of a firm to repay its debts as, and when, they fall due. The current ratio is one of the more popular ratios use to assess liquidity. It provides a measure of the ability of a firm to repay its current liabilities out of its current assets. And current liabilities are those liabilities that are due to be paid within the next 12 months after the end of the financial year. Whereas current assets are those assets that are expected to be converted into cash within the next 12 months after the end of the accounting period.

So that concludes this short presentation on understanding and analyzing financial statements. This material is based on the first year of the USC’s Bachelor of Commerce Accounting Program. I hope that this presentation has provided you with some useful information and guidance that you can perhaps utilize in your business moving forward.

USC is firmly committed to helping you reach your career goals, whatever they may be. If you would like to learn more about studying at USC, please visit www.usc.edu.au.

Thank you very much for listening to the presentation and all the best for the future.

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