Evaluating Financial Statements

Evaluating Financial Statements

Analysts use financial ratios to compare industries, for benchmarking, and for trend analysis. Before we get into the details of different types of ratio analysis, read this text for an overview of how business managers, investors, and other stakeholders use financial ratios to see what is going on within a company and make predictions about the future.

The text includes a discussion of some limitations of financial ratio analysis to consider when evaluating firms. Why are financial ratios and their analysis important? To answer this question, pay particular attention to the firm's profitability and allow comparisons between the firm and its industry. Make sure you can summarize how to use financial ratios to analyze a company's financial statement.

With a few exceptions, the majority of the data used in ratio analysis comes from the evaluation of the financial statements.

Ratio analysis is a tool for evaluating financial statements. It also relies on the numbers in the reported financial statements being arranged to be used as ratios for comparison over time or across companies. Financial statements are used to discover a business's financial position and financial results. With a few exceptions, such as ratios involving stock price, most of the data used in ratio analysis comes from the financial statements. Ratios put this financial statement information in context.

Putting Numbers in Order Evaluating financial statements involves getting the numbers in order and then using these figures to perform ratio analysis.

Before the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies. In terms of reformulation, one common reformulation is to divide reported items into recurring or normal items and non-recurring or special items.

In this way, earnings could be separated into normal or core earnings and transitory earnings with the idea that normal earnings are more permanent and, hence, more relevant for prediction and valuation. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

The evaluation of a company's financial statement analysis is a form of fundamental analysis that is bottoms up. While analysis of a company's prospects can include a number of factors, including understanding the economic situation or the industry or sentiment about the company or its products, ratio analysis of a company relies on the specific company financials.

Key Points

• Ratio analysis is a tool for evaluating financial statements but also relies on the numbers in the reported financial statements being put into order to be used for comparison. With a few exceptions, the majority of the data used in ratio analysis comes from the financial statements.
• Prior to the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies.
• In terms of reformulation, earnings might be separated into recurring and non-recurring items. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

Terms

• Valuation – The process of estimating the market value of a financial asset or liability.
• Earnings Management – A euphemism, such as creative accounting, to refer to fraudulent accounting practices that manipulate reporting of income, assets or liabilities with the intent to influence interpretations of the income statements.

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