All the financial statements are essentially historical documents. They report what has happened over a given period. However, most users of annual accounts are worried about what will happen in the future. Shareholders are worried about future earnings and dividends. Creditors are concerned about the company’s future ability to repay its debt. Managers are concerned about the company’s ability to fund future expansion. Despite the fact that financial statements are historical documents, they can still provide important information that will affect all of these concerns.
Accounting analysis involves careful selection of accounting data for the purpose of predicting the financial health of the company. This is done by examining trends in key financial data, comparing financial data between companies and analyzing key ratios.
Managers are also very concerned about the financial ratios. First, key ratios provide evidence of how well the company and its business units are performing. Some of these ratios would normally be used in a balanced scoreboard method. Specific ratios selected are determined by the company’s policy. For example, companies that want to focus on customer response may closely monitor inventory turnover rates. Since executives must notify shareholders and may want to raise funds from outside sources, managers must adhere to the ratios used by external inventories to assess the firm’s investment capacity and creditworthiness.
Although accounting analysis is a very useful tool, it has two limitations. These two constraints include comparing financial data between companies and the need to look proportional. Comparing one company to another can provide valuable clues to the financial health of an organization. Unfortunately, the difference in accounting practices between companies makes it difficult to compare companies & # 39; financial data. For example, if one company evaluates its stock using the LIFO method and another company with the average cost method, direct comparison of financial data such as inventory valuation and cost of goods sold between the two companies may be misleading. Several times sufficient data are presented in the notes to the annual financial statements to recalculate data on a comparable basis. Otherwise, the expert should consider the lack of comparability of the data before drawing any clear conclusion. Nevertheless, even with this limitation in mind, comparing key ratios with other companies and industry averages often leads to further investigation.
An inexperienced expert may think that proportions in themselves are sufficient as a basis for a judgment on the future. Nothing could be further from the truth. Conclusions based on the proportional analysis must be considered as preliminary. End ratios should not be regarded as starting points, but should be regarded as starting points as indications of what to pursue. They raise questions, but rarely answer questions themselves. In addition to the ratios, other sources should be analyzed to judge the future of an institution. Those experts should look at, for example, industry developments, technological changes, changes in consumer tastes, changes in broad economic factors and changes within the company itself. A recent change in key management position, for example, could provide a basis for optimizing the future, even if the company’s past performance may have been moderate.
Few figures that appear in the financial statements are very significant. There is a relationship between one number and another and the amount and change of policy over time that are important in accounting analysis. How does the analyst gain important relationships? How does the analyst uncover important business developments and changes? Three methods of analysis are widely used; dollars and percentage changes in statements, statements of common size and recipes for key figures .