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Spotlights of Financial Statements Analysis

Category: Financial Control Management

The Profit and Loss Statement represents in summarized fashion the results of operations, investment, and financial activities of an enterprise. In almost all other aspects of financial analysis, the evaluation and projection of operating results assume great importance.

In the evaluation of the income of an enterprise, the analyst is particularly interested in an answer to the following questions:

What is the relevant net income of the enterprise and what is its quality (the compromise between the allocation of revenues and costs as between the present and the future)?

What elements in the income statement can be used and relied upon for purposes of earnings forecasting?

How stable are the major elements of income and expense and what is their trend?

What is the «earning power» of the enterprise?

The analysis of sales and revenues is centered on answers to these basic questions:

What are the major sources of revenue?

How stable are these sources and what is their trend?

Knowledge of major sources of revenues (sales) is important in the analyses of the income statement particularly if the analysis is that of a multimarket enterprise. The best way to analyze the composition of revenues is by means of a common-size statement that shows the percentage of each major class of revenue to the total.

The importance of common-size statement analysis derives from the fact that each product line is characterized by different growth rates, profitability ratios, and future.

Both ways of P&L Statement analysis are important:

The «vertical» analysis determines the share and the dynamics of each product to total sales;

The «horizontal» analysis is concerned with the relative trend for each product line. Sales indexes of various product lines can be correlated and compared to composite industry figures or to product sales trends of specific competitors.

The analysis of variation in Gross Margin is useful in identifying major causes of change in the gross margin. These changes can consist of one or a combination of the following factors: (1) increase or decrease in sales volume, (2) increase or decrease in unit sales price, (3) increase or decrease in cost per unit.

The analysis of Balance Sheet and Cash Flow Statements are illustrated in the Use of Financial Ratios from Managerial Perspective, Working Capital Management, and in Cash Flow Analysis sections.

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