Theoretical foundations of the analysis of financial statements

Financial statements

The preparation of the financial statements is not the first step in the accounting procedure, but it is the starting point for the economic and financial analysis. Financial statements are the means by which concise information is provided on the profitability and financial situation of the business.

The main financial statements are intended to report on the financial situation of the company on a given date, and on the results of its operations and the flow of funds for a given period. The main financial statements should serve to:

Make investment and credit decisions, which also requires knowing the growth capacity of the company, its stability and credibility. Assessing the solvency and liquidity of the company, as well as its ability to generate funds. Knowing the origin and characteristics of its resources to estimate the financial capacity for growth. Form a judgment on the financial results of the administration in terms of profitability, solvency, generation of funds and growth capacity.

The Balance Sheet

The balance sheet, or also known as the statement of position, shows in monetary units, the financial situation of a company or economic entity on a given date. Its purpose is to show the nature of the economic resources of the company, as well as the rights of creditors, and the participation of the owners.

Regarding its importance, the balance sheet is a main statement and is considered the fundamental financial statement. If it is comparative, it also shows the changes in the nature of the resources, rights and participation from one period to another. For your better study and understanding, the information it contains is classified or grouped into three main categories or groups: assets, liabilities and capital.

The Income Statement

The income statement shows the effects of a company's operations and its bottom line, in the form of a profit or loss. When the net profit earned by a company is measured, its economic performance, its success or failure as a company is measured; the owner, managers, and major creditors want to know the latest income statement so that they can judge how the company is doing. If the business is organized as a joint stock company, the shareholders and potential investors are also interested in systematically receiving the income statement.

From an objective point of view, the income statement shows a summary of the significant events that caused an increase or decrease in the entity's equity during a given period.

The income statement is dynamic and economic because it cumulatively expresses the figures of income, costs and expenses that arise from the result of a certain period, and also because it shows figures expressed in monetary units of a more or less short time (one year)., in which the fluctuations in the purchasing power of the currency are relatively small and therefore similar in economic content.

State of Origin and Application of Funds / Working Capital

The primary objective of working capital management is to manage each of the company's current assets and liabilities in such a way that an acceptable level of it is maintained.

The main current assets to pay attention to are cash, marketable securities and temporary investments, accounts receivable and inventory, since these are the ones that can maintain a recommended and efficient level of liquidity without maintaining a high number of stocks of each, while the most relevant liabilities are accounts payable, financial obligations and accumulated liabilities, as these are the sources of short-term financing.

Working capital

Working capital can be defined as the part of current assets that is financed with long-term resources and its method of calculation is the difference between the current assets and liabilities of the company. It can be said that a company has a net working capital when its current assets are greater than its short-term liabilities, this means that if an organizational entity wants to start some commercial or production operation, it must manage a minimum of working capital that It will depend on the activity of each one.

The pillars on which the administration of working capital is based are sustained to the extent that good management can be done on the level of liquidity, since the wider the margin between the current assets owned by the organization and its current liabilities the greater the ability to cover short-term obligations, however, there is a major drawback because when there is a different degree of liquidity related to each resource and each obligation, when it is not possible to convert the most liquid current assets into money, the following assets will have to replace them since the more of these they have, the greater the probability of taking and converting any of them to fulfill the commitments made.

Origin and need of Working Capital

The origin and need of working capital is based on the environment of the company's cash flows that can be predictable, they are also based on the knowledge of the maturity of the obligations with third parties and the credit conditions with each one, but In reality, what is essential and complicated is the prediction of future cash inflows, since assets such as accounts receivable and inventories are items that in the short term are difficult to convert to cash, this shows that between the more predictable the future cash inflows, the less the working capital the company needs.

Profitability vs. Risk

It is said that the higher the risk, the higher the profitability, this is based on the administration of working capital at the point that the profitability is calculated by profit after expenses versus the risk that is determined by the insolvency that the company possibly has to pay its obligations..

A concept that is gaining momentum is how to obtain and increase profits, and by theoretical foundation it is known that to obtain an increase in these there are two essential ways to achieve it, the first is to increase income through sales and Secondly, by decreasing costs by paying less for the raw materials, wages, or services provided, this postulate becomes essential to understand how the relationship between profitability and risk is linked to that of effective capital management and execution. of work.

"The greater the amount of working capital that a company has, the less the risk that it will be insolvent", this is based on the fact that the relationship between liquidity, working capital and risk is that if the first is increased or the second the third decreases in an equivalent proportion.

Having considered the previous points, it is necessary to analyze the key points to reflect on the correct administration of working capital in the face of maximizing profit and minimizing risk.

Nature of the company: It is necessary to locate the company in a context of social and productive development, since the development of financial administration in each one is of different treatment.

Asset capacity: Companies always seek by nature to depend on their fixed assets in a greater proportion than on current assets to generate their profits, since the former are the ones that actually generate operating profits.

Financing costs: Companies obtain resources through current liabilities and long-term funds, where the former are cheaper than the latter.

Consequently, the administration of working capital has variables of great importance that have been analyzed previously in a quick but concise manner, each of them being a key point for the administration carried out by managers, directors and those in charge of financial management.

This state has two main objectives:

Report on changes in the entity's financial structure, showing the generation of resources from operations for the period. Reveal complete financial information about changes in the organization's financial structure that do not show the balance sheet and the income statement.

Cash flow statement

This financial statement organizes the data offered by other states, showing the inflows and outflows of cash that have occurred in a given period of time, which provides elements on corporate financial health.

This financial statement shows the cash generated and used in the operation, investment and financing activities of an entity. For this effect, the change in the Balance Sheet items that affect the cash must be determined.

The statement of cash flows must present a detail of the cash received or paid during the accounting period, classified by activities of:

Operation: that is, those that affect the income statement Investment: changes in assets other than operational Financing: refers to changes in liabilities and equity, different from operational items.

Objectives of the Cash Flow Statement:

The objective of this statement is to present pertinent and concise information, relative to the cash collections and disbursements of an economic entity during a period, so that the users of the financial statements have additional elements to:

Examine the capacity of the economic entity to generate future cash flows. Evaluate the capacity of the economic entity to pay its obligations, pay dividends and determine the necessary internal or external financing. Analyze the changes experienced in cash derived from operating activities, investment. and financing. Establish the differences between net income and the associated cash collections and disbursements.

There are two ways or methods to present the operating activities in the statement of cash flow: the direct method and the indirect method. The use of one or the other method is optional. In this work, the indirect method was used.

Analysis tools

Financial ratios method: theoretical support

Analyzing a company's financial ratios has generally been the first step in financial analysis. Its function as a method of financial analysis is limited to serving as an aid to the study and interpretation of business figures, indicating where to locate probable weak points.

Some of the reasons best known for their usefulness are discussed in this paper. Next, the four general groups of reasons and the reasons in question that are covered in this investigation will be disclosed.

The four fundamental groups of reasons are:

Liquidity ratios Activity ratios Debt ratios Profitability ratios.

Liquidity ratios : They measure the possibility of the company to satisfy its short-term obligations. The liquidity tests refer to the amount and composition of current liabilities, as well as their relationship with current assets; that is, the source of resources that the company has to meet the obligations contracted during the financial cycle.

The main objective of the liquidity ratios is to determine the financial conditions in which the entity is at a given moment to face the payments originated by its exploitation cycle; that is, its financial cycle.

Debt or solvency reasons: The company's debt situation indicates the amount of third-party money that the company uses to generate profits. They indicate to what extent the company is financed by assets of third parties, understood by means of debts; They also show the ability of the company to take on long-term debt and cover the costs associated with it.

Investors pay special attention to the level of indebtedness in which the company is, taking into account that the higher the level of this, the company would not be in a position to pay its creditors and, if it achieves better management of these funds, it may obtain greater benefits after paying the debt services (interest). Financial leverage is the extent to which a company uses debt financing. The importance of financial leverage is given when the company is able to generate profits to pay the interest on the debt and that there is profit. Solvency refers to the ability of the company to cover both its long-term obligations as well as the costs and interests that accompany them.

Profitability Ratios: Shows the combined effects between liquidity, asset management, and debt management on results of operations. These reasons

they relate the company's returns to sales, total assets and stockholders' equity.

Activity or asset management reasons : Set of reasons that measure the effectiveness with which a company is managing its assets; These reasons were designed to answer questions such as: Would the total amount of each asset seem reasonable, too high or too low, as shown in the statement of situation.

These four groups at the same time are divided into two types of analysis (economic and financial). TO

We will propose this analysis below.

ECONOMIC ANALYSIS

Study the economic entity in its dynamic aspect. Observe the evolution of the different components of results and margins; It also analyzes the company's average maturity period, factor productivity, and business efficiency. Their study is supported by the income statement and the balance sheet.

Economic profitability: It measures the generation of benefits as a consequence of the assets without considering the way in which they have been financed. Refers to operating profit (profit before interest and taxes, thus eliminating the influence of different forms of financing and, in addition, companies subject to different tax regimes can be compared) with which all capital must be remunerated made available to you. It gives a measure of investment efficiency. It is calculated as follows:

Earnings before interest and tax

ECONOMIC PROFITABILITY =

Total Net Assets

R e n t a b i l i d a d comercial : Shows the profit obtained for each sale weight. This indicator shows the ability of sales to generate profits, its calculation can be applied to both gross and net profits.

Earnings before interest and tax

COMMERCIAL PROFITABILITY =

Sales

Ro t ac i or n of the total net assets: indicates the number of weights sold by each invested in active and expresses therefore the relative efficiency with which a company uses its assets to generate revenue. It is about obtaining maximum sales with the least investment.

Sales

TOTAL ASSET ROTATION =

Total active

Ro t ac i or n asset: This index measures the effectiveness with which the company using plant and production equipment. Its calculation base is the ratio of sales to fixed assets.

Sales

FIXED ASSETS ROTATION =

Net Fixed Assets

Ro t ac i or n current asset: Indicates how many times the current assets rotate during the study period; it is calculated as follows:

Sales

CIRCULATING ASSETS ROTATION =

Current Assets

Ro t ac i or n Inventory: is defined as the ratio of sales from existing inventories or the cost of goods sold by the average inventory. A high turnover in principle is positive because inventories take less time to become liquid and the current liabilities necessary to finance them will be less. Slow rotation hurts profitability.

Sales

INVENTORY ROTATION =

Inventory

Ro t ac i or n accounts receivable: Used to measure how effectively treated and credit sales of the company are handled. It is a measure of activity that influences liquidity. The higher the better, the more favorable, but everything depends on the credit policy adopted by the institution. It is defined as follows:

Credit sales

ROTATION OF ACCOUNTS RECEIVABLE =

Accounts receivable

Ro t ac i or n accounts payable: Measures the effectiveness with which purchases are handled.

Purchases

ROTATION OF ACCOUNTS PAYABLE =

Debts to pay

FINANCIAL ANALYSIS

Studies the evolution of the profitability of investments and own resources, as well as the cost of the financial resources used. It is responsible for the valuation of the company as a whole, it is supported by the balance sheet, the income statement and the statement of origin and application of funds, whether based on cash or working capital, among others. To carry out this analysis, the following scheme will be followed, considering only a few elements:

R e n t a b ili d a d financial: Measures the ability of the company to remunerate equity owners. For them it represents the opportunity cost of the capital they have invested in the company; it is used many times to compare the return on capital if it had been placed on other investments. It is calculated as follows:

Profit After Tax

FINANCIAL PROFITABILITY =

Stockholders' equity

Financial profitability is proportional to economic profitability; It is essential that the economic profitability is good for the shareholder to obtain adequate remuneration.

R to circulating zon: Its calculation is based on the division between current assets and current liabilities. It is used to measure the liquidity of the economic organization in the short term and

indicates to what extent the rights of the creditors are covered by the assets that will become liquid in a period similar to that of the maturity of the obligations contracted by the organization.

Current Assets

CIRCULATING REASON =

Current Liabilities

The result of this quotient will indicate the number of times that the current liabilities are within the current assets. It expresses the amount of pesos that is available in the short term to meet each peso of debt due in the same period. Although a ratio of 2.0 is generally considered to be the most satisfactory, up to 1.5 is supported. The most favorable proportion will vary from one industrial activity to another and, in companies subject to seasonal fluctuations, within the year itself, according to the index calculated for the season of greatest or least activity. It is important to indicate that having too much liquidity in an entity or company is not appropriate.

Acidity ratio or acid test: Also known as immediate payment, it is similar to the previous one with the difference that in this the inventories are deducted for its calculation. Only the assets with the highest degree of cash conversion are taken.

Current Assets - Inventory

ACID TEST =

Current Liabilities

Pe r í od or collection: Also known as days sales outstanding (DSO) or billing cycle; It is used to evaluate accounts receivable. It indicates the average period that the company must wait to receive the cash payment after making a sale on credit.

It is calculated like this:

Days of the period

AVERAGE COLLECTION PERIOD =

Accounts receivable rotation

Pe ri od or pay: Usually called as average payment period, measures the average period elapsing from receipt of goods, raw materials and materials to the agreed date for payment. It is calculated as follows:

Days of the period

AVERAGE PAYMENT PERIOD =

Accounts payable rotation

R to zon total solvency: This ratio is commonly studied to measure the ability of the company to meet all of the debt of these commitments as they fall due.

Total active

TOTAL SOLVENCY REASON =

Totally passive

R to zon indebtedness: measures the proportion of external resources, including full funding of the company. The lower the better the creditors. Because the lower it is, the greater its support against losses in the event of liquidation. On the other hand, shareholders can benefit from leverage because it increases profits, although it indicates greater risk for them.

Totally passive

REASON FOR DEBT =

Total active

P or r c e n t a j and debt short: This ratio represents the proportion of short - term debt in total debt of the company. This is because the short-term indebtedness is more unstable and it must be constantly renewed, and preferably every year, it also presents a greater degree of uncertainty.

Short Debt

SHORT DEBT PERCENTAGE =

Total debt

Limitations of the reasons:

They always need a benchmark, by themselves they say nothing, hence the need for an intercompany or intracompany comparison. Many large companies operate different divisions in totally different industries and in such cases it is difficult to develop a meaningful set of Averages. Most companies want to be better than average, so reaching average performance is not necessarily satisfactory. Relying on industry leaders is preferable. Applying accounting practices of a different nature may distort the accuracy of comparisons. Inventory valuation and depreciation methods can affect financial statements and thus distort the accuracy of comparisons.

Du Pont Chart Method

It is a method where financial ratio analyzes are summarized. It consists of starting from a reason that is considered generalized or important, and breaking it down into as many reasons as possible that are related to each other and have an effect on the results of that reason. This chart is designed to show the relationships between return on investment, asset turnover, profit margin, and leverage.

The use of the pyramid or tree of reasons, as it is also often called, constitutes the application of a technique that facilitates the process of orderly interpretation of information, even facilitates the process of its presentation, avoiding confusion due to the presence of several numbers..

To apply this technique of presentation and interpretation of financial ratios, we begin by analyzing the behavior of financial profitability, the way in which the factors that condition it have influenced its variation. Then, the company's return on investment is followed, making its respective breakdown to determine the reasons that influence the effectiveness (turnover of all assets) and efficiency (the return on sales).

Horizontal Analysis Method

This method is also known as the dynamic analysis method, it is used by studying two or more financial statements of the same company on different dates, current data with calculations or information made in previous years. It includes procedures for increases and decreases or variations, it consists of comparing the similar concepts of the financial statements of separate dates obtaining differences between the compared figures. It also consists of comparing the indices or percentages of the financial statements of two or more periods.

The trend analysis, as it is also usually called, is carried out by taking a period as a reference and following a previously marked chronology. The greater the time series compared, the more clarity the analyst acquires to assess the situation. Although today's company may be very different from the company in 5 years.

Vertical Analysis Method

It is applied to analyze a financial statement corresponding to a certain date and reveals the composition of one item in another. This analysis answers questions such as: how is each sales weight, or each total financing weight, composed?

This analysis is carried out by calculating the integral percentages, that is, separating the contents of the financial statements into their integral parts, determining the proportion that each of the elements keeps with respect to the total.

Graphic Method

The graphical method is the presentation of information selected from the financial statements and represented graphically. When the information is shown through this method, the analyst or the person interested in the study has the facility of better visual and immediate perception.

Graphics, such as diagrams and statistics, allow material appreciation of the state of business without the fatigue of a great mental concentration, which sometimes does not have clear elements that lead to sound decisions.

Graphic media can be tables, relative or total number tables, charts or diagrams formed with designs or figures that provide great visibility.

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