Financial analysis allows to determine the current situation and future decision making in the search to improve the performance of an organization.
The basic purpose of accounting is to provide useful information about an economic entity, to facilitate the decision making of its different users (shareholders, creditors, investors, clients, administrators and government). Consequently, since accounting serves a set of users, various branches or subsystems originate. Based on the different information needs of the different user segments, the total information that is generated in an economic entity for different users has been structured in three subsystems:
- The financial information subsystem. The tax information subsystem. The administrative information subsystem.
The financial information subsystem is made up of a series of elements such as registration rules, accounting criteria, forms of presentation, etc. This information subsystem is known as financial accounting, since it expresses in quantitative and monetary terms the transactions carried out by an entity as well as certain economic events that affect it, in order to provide useful and safe information to users. external for your decision making.
The final product of the accounting process is financial information, an essential element for the various users to make decisions. The financial information that these users require is primarily focused on:
- Assessment of the financial situation Assessment of profitability Assessment of liquidity
The adjusted trial balance provides the information necessary to prepare the basic financial statements.
Accounting believes that every business must submit four basic reports. Thus, there is the income statement that reports on the profitability of the operation, is a statement of financial position or balance sheet, the purpose of which is to present a list of resources (assets) of the company as well as sources of financing (liabilities). and capital) of said resources, the statement of changes in stockholders' equity, the objective of which is to show changes in the investment of the owners of the company, and the statement of changes in the financial situation, whose objective is to provide information about liquidity of the business, that is, present a list of cash sources and cash disbursements, which constitutes a basis for estimating future cash needs and their probable sources.
The income statement determines the amount of income and expenses, as well as the difference between them, which is called profit or loss.
Once the closing entries have been made and the financial statements have been prepared, an additional step is still necessary: their analysis. Indeed, analyzing the information contained in the financial statements is an excellent basis for making appropriate decisions in the business world.
Financial analysis
There are various techniques to perform financial analysis, all of them require a basic but comprehensive knowledge of accounting. It is part of the accounting cycle of an economic organization.
Financial analysis is a key point at the end of the accounting cycle. This analysis is based on ratios or relative values. The ratio analysis comprises two aspects: calculation and interpretation with the aim of trying to know the performance of the company.
Cash items and temporary investments are closely related to the financial analysis of an entity's liquidity, basically with the calculation of liquidity ratios, more specifically with the current ratio and the acid test.
It is very important for users of the financial report to know non-financial data of the company, since this allows them to broaden the user's vision and understand in an analytical and logical way the behavior of the financial data presented in the annual report.
The financial analysis consists of the study of the information contained in the basic financial statements through indicators and methodologies fully accepted by the financial community, with the aim of having a more solid basis for decision-making.
Financial indicators
Financial indicators are used to weight and evaluate the results of the company's operations, these indicators are the relationship of one figure to another within or between the financial statements of a company that allow to weigh and evaluate the results of the company's operations..
There are different financial reasons that allow users to meet their needs. Each of these reasons has certain purposes. Below are examples of the most typical financial ratios used by different stakeholders.
- A banking institution may be interested in short-term liquidity reasons, to assess its client's ability to pay. A creditor may be interested in profitability reasons, which reflect the ability to generate profits, since in this way Your debtor will have available resources to pay off your debts. A shareholder may be interested in the short and long-term profitability reasons of the company of which he is a shareholder.
Classification of financial indicators
The main financial indicators are classified into four categories:
- Profitability indicators:
- Profit margin. Return on investment. Return on stockholders' equity.
- Current ratio. Proof of liquidity.
- Accounts receivable turnover Average collection period Inventory turnover Total assets turnover
- Total liability to total asset ratio.
The first group of financial indicators, referring to profitability, tries to evaluate the amount of profits obtained with respect to the investment that originated them, either considering total assets or stockholders' equity.
The second group, which refers to the liquidity of a company, aims to analyze whether the business has sufficient capacity to fulfill the obligations contracted by and for its operations. Obligations being understood as debts with creditors, suppliers, employees, etc.
The third group refers to the use of assets and indicates situations such as how many times a year a company sells its inventories or collects its entire amount from its clients. Regarding assets, the utilization ratio expresses how productive assets have been in terms of sales generation.
The group that refers to the use of liabilities consists of evaluating the general indebtedness situation with respect to its assets and the ability to cover its debts.
Profitability indicators
Profit margin
This financial indicator measures the percentage of sales that manage to become available profit for shareholders. Net income is considered after financial expenses and taxes.
Profit margin = Net profit / Net sales
Return on investment
This indicator reflects the efficiency of management to obtain the maximum return on investment, which is made up of total assets. This indicator can also be obtained by combining the profit margin on sales and the turnover of total assets.
Return on investment = Net profit / Total assets
or
Return on investment = Net profit / Net sales X Net sales / Total assets
Return on stockholders' equity
This indicator measures the return on net investment, that is, stockholders' equity. Through it, the net profit generated by an organization during a period is related and compared with the investment corresponding to the shareholders. Return on shareholders' equity is a fundamental indicator that determines to what extent a company has generated returns on the funds that shareholders have entrusted to management.
Return on Stockholders 'Equity = Net Income / Stockholders' Equity
Liquidity indicators
Circulating ratio
This indicator tries to reflect the relationship that exists between the financial resources that a company has in the short term to meet the payment obligations contracted in the same period, which allows determining if it has sufficient resources to cover its commitments. The greater the result of the current ratio, the greater the possibility that the liabilities will be paid, since there are sufficient assets that can be converted into cash when required. However, having a very high circulating ratio can also mean the existence of idle resources.
Current ratio = Current assets / Short-term liabilities = n times
Liquidity test (or acid test)
This indicator includes only those items whose conversion into cash is immediate; therefore, inventories are not considered, since they require more time and effort to be converted into cash. Therefore, this is a similar indicator more demanding unemployment than the current asset indicator. In the current assets section there may be other losses that are not as easy to convert into cash or that do not represent cash flow as in the case of prepayments. These items can also be considered for liquidity analysis, since the important thing is to maintain the same criteria to analyze and compare this information with that of other entities.
Liquidity test (or acid test) = Current assets - Inventories / Short-term liabilities = n times
Asset utilization indicators
Accounts receivable rotation
It is indisputable that the accounts receivable are in relation to the sales made by a company, since they are conditioned based on the credit period that is granted to customers. The greater the number of times that credit sales represent accounts receivable, that is, of rotations, the better, since this indicates that collection is efficient or that there are better clients. A variant of this financial ratio is to use credit sales as the numerator, since these are directly related to accounts receivable from customers. However, this data is not usually presented in the financial reports of the companies and for practical purposes, the data on net sales for the period is used. As with the acid test,for comparison purposes, the same analysis criteria must be maintained.
Accounts receivable rotation = Sales / Accounts receivable = n times
Average collection period
This indicator suggests how long it takes on average for customers to pay their bills.
Average Collection Period = Accounts Receivable / Average Daily Sales = Average Days
Inventory rotation
The inventory turnover indicates the speed with which the merchandise is bought and sold, so the result is expressed in how many times the investment in this type of asset is sold during a period.
Inventory turnover = Cost of sales / Inventories = n times
Rotation of total assets
This indicator reflects the ratio of total assets to sales, because it shows the number of times the company uses them to generate the income for the items it produces.
Rotation of total assets = Sales / Total assets = n times
Indicators related to the use of liabilities
Ratio of total liabilities to total assets
This indicator indicates the proportion in which the total resources existing in the company have been financed by people or institutions outside the entity, that is, creditors.
Ratio of total liabilities to total assets = Total liabilities / Total assets = amount owed for each weight of assets
These indicators or financial ratios, mentioned above, are used to assess the financial situation of any company. Likewise, as mentioned above, based on the financial information provided by companies belonging to the same industry or economic sector, the average values of financial indicators by type of industry or sector are calculated, with the aim of using them as a reference. to evaluate the financial performance of a company compared to others of the same line of business. In this way it can be determined which aspects of the entity are consistent with the average or above or below the industry average. You can also use the information to compare it with a specific company in the same line of business or industry.
Limitations of the analysis of financial indicators
Although indicators are extremely useful instruments, they are not without limitations, which is why their application requires great care. The indicators are elaborated from accounting data, which are sometimes exposed to different interpretations and even manipulations.
The financial manager should also be careful when judging whether a particular financial indicator is good or bad, and also when making a complete judgment about a company from a set of such indicators.
Adherence to the average financial indicators of the industry does not establish with certainty that the company operates normally and that it is well managed. The analysis of financial indicators is a useful part of the investigation process, however, considered in isolation, they are not sufficient answers to make judgments about the performance of companies.
Vertical analysis
Vertical analysis is an extremely useful financial analysis tool because it allows comparing a specific item with respect to the total to which it belongs. In the case of the statement of financial position, the total assets for each year is 100% as well as the total liabilities and capital. From there, all the asset and liability and capital items, respectively, are calculated the percentage they represent with respect to the total they belong by dividing the amount of the item by the total assets or the sum of liabilities and capital. Vertical analysis is also applied to the income statement. In this case, the sales of each year are considered as 100% and from there, all the other items are calculated by dividing their amount by the total sales in the period.
Horizontal analysis
Horizontal analysis is extremely important when it comes to detecting trends in the behavior over time of the items that are part of the financial statements. Unlike the vertical analysis, in the horizontal analysis a base year is taken as a reference to which 100% is assigned and from it the increases or decreases that each of the items in the income statement and the income statement have suffered are calculated. financial situation over time.
This same procedure can be applied to the statement of financial position to determine trends with respect to a base year.
conclusion
In conclusion, financial analysis is the method developed by which financial statements are used and information is evaluated in such a way that the current state of a company can be determined. By studying the financial statements, we seek to identify the deficiencies and potential problems of a company, and thus be able to take measures that can correct them. Not only does financial analysis allow us to assess current events, but it also gives us the possibility to make future decisions related to the administration of a company and maximize its profit. Such decisions may include investment plans, debt, operations, etc.
