Table of contents Introduction.2 Uses of financial statements...2 Uses of ratio analysis4 Other evaluation parameters..7 Conclusion.8 References.

troduction:

Financial information of a company is presented in its balance sheet, income statement and cash flow statement. These reflect a companys well-being in terms of its financial health and state of operations. Both external as well as internal stakeholders use this information to analyze past performance and build-up expectations for future potential. It can be used to assess the risks associated with the firm and thus are very a useful tool when analyzed critically. Here we elaborate some advantages and uses of financial statements analysis from various perspectives. In addition, we examine ratio analysis and other data items that can be useful in decision-making process.

Use of financial statements

Financial statements are used in myriad systems for economic decisions to be made related to a company. Creditors, investors, managers, tax authorities and regulatory bodies among others use the data in these statements to analyze the past performance of a company. The past performance is often seen as a base to build-up future expectations in the wake of market and economic trends.

The level of risk in an investment can be analyzed based on how predictable its future performance is. For instance, if a companys earnings per share is expected to lie between $3.5 to $3.7 and another companys earnings per share is expected to lie between $4 to $5, since the former has lesser variation in its expected earnings it is said

to have lesser risk than the latter. And thus an investor positioning his funds in the latter will command a higher risk premium.

Creditors will gauge the sales, income, return on investment and cash flows of a company before deciding if they wish to lend or not. Other factors that can be critical to creditors are how much of debt a company already has. More the debt in the companys financials, higher is the risk associated with the company. Higher the risk associated with the company, a creditor would like more return for his investment for the additional risk he has assumed and will therefore charge a higher interest rate for the money that is lent. The creditor could also be interested in the liquidity position of the company. This can be judged by looking at the current assets and liabilities on the balance sheet of a firm. Ideally, a firm should have twice as much current asset as much current liabilities it has. But this varies a lot with the nature of industry the firm operates in. Based on industry benchmarks , this value gives an idea about the liquidity position of a firm.

Leasing decision is based on answers to a different set of questions. The lessor (the one who leases to another person) will look at a lesses (person taking t he leased asset) capability to pay monthly rental in case of an operating lease. If the lesse wants the lease to be structured as a financial lease (where the asset is capitalized), the lessor would like to know the lesses capability to pay the initial outlay upfront. In addition,

financial analysis in terms of Net Present Value comparisons using the financial statements can help decide whether leasing is a better decision or the asset should rather be purchased.

In addition to above two scenarios, there are many important business decisions where financial statements and their analysis play a key role in business decisions. They are the window to a firms operations and management efficiency. Based on these numbers one can question company strategy and assess the potential of the same.

Use of financial ratios When an investor intends to pick up stake in a company, they perform due diligence on that company. It is nothing but a detailed examination of the company in various aspects. It can be legal, financial, organizational, forensic, and vendor related. For financial due diligence, the investors scrutinize the financial statements of the target company carefully. It takes care of any issues in short, medium or the long term assets or liabilities of the firm. Ratio analysis is a part of fundamental analysis of a company which looks into a companys financials to evaluate its performance on various parameters such as profitability, liquidity, leverage, efficiency and valuation. Profitability ratios are used to understand the performance of a company by assessing the level of profits it makes. These profits can be at various levels of earnings as a percentage of sales. They include gross profit margin, net income margin etc. Profits are important and the primary source of a companys ability to fund its future investments, it gives an idea about the return an investor can expect out of a company. Profits are an important parameter that shareholder consider in assessment of a firms financial health.

Liquidity ratios are an indication of a companys ability to meet their short-term obligations (defined as debts which are due for payment within one year) as and when they are due. A higher degree of liquidity is desirable as it reflects a companys greater capacity to fulfill its debt obligations and perform its day to day operations smoothly. Leverage ratios which are also known as gearing ratios are a measure of the extent of debt financing used by a company. These ratios hint about the long-term solvency of a company. The companies usually take on debt to reduce their cost of capital as debt financing is cheaper. But at the same time it adds on to the risks and investors gauge the level of this risk before investing in a firm.

Activity or efficiency ratios are a measure of the effectiveness of a firm in using its available resources. These ratios generally gauge the amount of sales a company is able to generate out of a given set of assets. These cab be the amount of inventory, fixed assets, total assets, net worth or working capital.

Investors use valuation ratios to assess how the company is valued in the market. It compares the current share prices which reflect the market value to a companys true value. Share prices are indicative of a companys future earning expectation by the investors. So companies which are assumed to perform well in future will have a higher share price. And thus will have a higher valuation. Usually, ratios are not significant as a stand-alone metric. They need to be analyzed in comparison to another company in the same industry or previous years ratios of the same company or some predetermined standard. They then help in benchmarking performance and provides insights related to operations of businesses.
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However, like any other metric, ratios should be cautiously used. They cannot be used as the only basis of decision making process. It can be a useful add-on to other analysis criteria. Moreover, ratios can be relied only as much as the data that goes into calculating them. Financial statements are prepared in accordance with generally accepted accounting principles (GAAP) and thus may present a somewhat skewed report of numbers. Ratios reflect book values in place of actual economic values and they are not a standardized measure of evaluation. They are defined differently according to different accounting policies and presentations. Also, they make comparison difficult of companies have different risk profiles or are diversified into many unrelated segments. Consequently, ratio analysis is a powerful tool but should be analyzed keeping in mind the limitations it has. The financial statements of a firm can be manipulated. This will have a spill-over effect on the financial ratios of the firm. Companies, in an event of a bad performance, might attempt to window dress the financials to make them look appealing to the investors, especially in public limited companies where a big chunk of small shareholders do not have much information or the exp3rtise to understand the nuances that have been manipulated. For instance if a company manages to delay its payments to its suppliers for a period of time, it might enhance the cash balance towards the end of a given reporting period, or a company might change its depreciation method to reduce its expenses. Such subtle actions often go unnoticed by investors, but keeping a track for longer terms can provide valuable insights and improve understanding. It is highly advisable,

therefore, for an investor to look at the holistic view and consider qualitative information while analyzing the companys performance.

Other evaluation parameters In everyday operations of a company, the current assets and liabilities need to be managed to ensure uninterrupted flow of work. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Three main components of working capital are accounts receivable, accounts payable and inventory Accounts Receivable turnover is the ratio of amount of accounts receivable and net sales per month. It gives an indication about how much time it takes for a company to collect its receivables and how do the credit terms of a company work, as a standard measure this number should be around 3. If this value is more than three it may lead to credit risk for the company. It means the company can think of revisiting its credit policy for its customers. Accounts payable turnover is the ratio of accounts payable to the average purchases per month. It is the time of credit given by suppliers to the company. If maintained at a very low value, the company should try to adjust the credit terms so as much they can improve the cash flow. On the other hand if the number is too high it might be a sign of liquidity crunch which can affect relationship with suppliers in the longer term. Inventory turnover is calculated by dividing the cost of goods sold by average inventory. It is a useful metric to gauge how quickly inventory is being converted to sales. It is a

variable parameter and largely depends on the nature of the industry. Fast moving consumer goods (FMCG) companies have a very quick inventory turnover, whereas the same for the automobile industry is relatively low. This value needs to be assessed closely in comparison to the industry benchmark. Besides, it is crucial for a firm to manage its cash position to maintain sufficient liquidity. For a short-term analysis of cash, three months trend can help in identification of warning areas. Short-term management is important for efficient running of businesses in the longer run. Conclusion: There are a variety of ratios which can be calculated from a companys given set of financial information. The selection of type of ratios that will achieve the objective of analysis will depend on the nature of the company and the industry as well as the purpose of analysis. In addition to financial statements, the overall health of the company can be improved by managing efficiency and planning strategically. These initiatives can translate into cost saving and growth opportunities respectively. Finally, the financial performance of a company can improve significantly by keeping the larger view in mind. Also, as investors we need to assess firms on parameters which might not be directly linked to financial outcome. Hence, in addition to the financial assessment tools and ideas we discussed in the paper, ideally, an investor should dive deeper into the critical issues faced by the company.

The best way to understand a company's financial situation is to use both current and long range metrics. A mix of both should be taken from financial as well as the operational side of businesses. References: Sana Research Quantitative Analysis: 6 things to remember when using financial ratios Retrieved from http://www.sanasecurities.com/quantitative-analysis-6-

things-remember-when-using-financial-ratios The Institute of Charted Accountants of India date n.a. Leasing decisions Retrieved from http://220.227.161.86/21569sm_sfm_finalnewvol2_cp3.pdf Darren Dahl 30 August 2010, How to Evaluate Your Companys Financial

Position Retrieved from http://www.inc.com/guides/2010/08/how-to-evaludateyour-financial-position.html ET Bureau 15 March 2013 ET classroom: Why due diligence is a must-do Retrieved from http://articles.economictimes.indiatimes.com/2013-03-

15/news/37744647_1_due-diligence-forensic-vendor Pamela Peterson Drake n.d. Financial Ratios Retrieved from

http://educ.jmu.edu/~drakepp/principles/module2/fin_rat.pdf Phil Thompson n.d Ratio analysis: a primer for owner managers Retrieved from http://www.thompsonlaw.ca/pdf_folder/ratio_analy.pdf