The goal of financial statement analysis is to explore the results of these activities and help internal and external users of financial information.

The general purpose of financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions.

Accrual accounting is used to measure the full effects of an economic transaction which takes place within an accounting period regardless of the timing of cash outcomes. The use of accrual accounting creates complexities in corporate financial reporting. Since accrual accounting reports expectations of future cash outcomes of current economic transactions, it needs to rely on assumptions and estimations. Management is responsible of making assumptions and estimations that correspond to the economic realities of the business when preparing financial statements.

Statement of financial position is made up of assets (what a company has), liabilities (what accompany owes) and owners’ equity (capital) sections reflecting the “accounting equation”.

A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. Similar to asset classification, liabilities are also classified as current and longterm. The exact amount and payment date of some liabilities may not be known or may depend on an event. 

The Shareholders’ Equity section of the statement of financial position includes the amounts invested in the business by the owners or investors, the earnings (losses) that are retained in the business from previous years’ income (losses), and current year income or loss.

Earnings Quality is the extent which the reported income reflects the true financial condition and performance of the company.

The statement of cash flows reports the cash inflows and outflows from operating, investing, and financing activities during a period, and reconciles the beginning and ending cash balances reported in consecutive statement of financial positions. The information provided in the cashflow statement help analysts to predict future cashflows, determine the ability to fulfill obligations to shareholders and creditors, and understand investing and financing policies of the company.

A statement of cash flows has three sections; cash-flows from operating, investing, and financing activities.

1. Operating activities include the cash effects of transactions that are related to a firm’s operations.

2. Investing activities include the cash effects of transactions that involve the purchase or disposal of investments and property, plant, and equipment.

3. Financing activities include cash effects of transactions that involve obtaining cash from creditors and stockholders and payment of existing debt dividends.

Reliability is secured by the auditing process. So, before starting analytical analysis, auditor’s report should be reviewed. After the review of audit report comparative financial statements are examined.

There are two types of analytical analysis employed for inter-company and intra-company comparisons. One of them main analyses used for comparison purposes is the vertical analysis where each item is expressed as percentage of revenues in income statement and as percentage of total assets in the statement of financial position. The other available method is horizontal analysis, in which a base year is selected and the changes over time are expressed as a percentage of the base year figures. 

The main advantage of vertical analysis is that such an analysis is not much affected by price fluctuations and that it lets industry-wide comparisons.

Having a high percentage of receivables could be risky due to collection risk but, referring to the notes, most of the receivables are from related parties. This can be viewed as a good sign if the parent company is financially sound but it can be a very bad signal if the parent company has financial problems.

When financial statements are analyzed, items that have low monetary values can be regarded as immaterial. Especially in horizontal analysis big changes in low value items can be ignored in analysis.

Horizontal analysis is also known as trend analysis. This analysis performs better for longterm analysis within the same company. However, selection of the base year is crucial. Depending on the base year, some items might be given more weight than the others. Care must also be taken to incorporate any accounting policy changes during the analysis period, because horizontal analysis is affected by changes in accounting methods.

Interpretation of the results of the trend and static (vertical) analyses might be difficult in some cases. For example, a user might want to know whether the assets are used efficiently – in other words, might want to assess the profitability of the firm as measured by the relationship between profits and assets, and profit and sales. Such a relationship can be expressed as a ratio. Ratios are easy to compute and they provide signals for possible difficulties, so all financial analysts use ratio analyses. However, ratios are hard to interpret by themselves.

• liquidity ratios

• solvency/capital structure ratios

• working capital management ratios

• profitability ratios

• market ratios

The most common ratios in this category are:

• debt ratios

• equity measures

• number of times interest charges are covered

Financial leverage is the extent which the company uses debt in financing its assets. As long as the cost of debt financing is lower than equity financing financial leverage is beneficial for the company