Many of us are multilingual, with English being the most common language spoken. Similarly, the business world also has a language of its own – finance. Every year it releases a host of financial statements to showcase where it stands to its stakeholders.
Every country has its financial reporting standards, and Singapore is no different. The legal requirements make it a vital part of every business. It, therefore, becomes important for the stakeholders, both internal and external, to have a base to fall back upon while making any decisions pertaining to an entity.
Embarking on a financial statement analysis gives them the requisite structure to ensure that they make informed decisions about the company.
This article walks you through the basics of financial statement analysis.
What is financial reporting?
Financial reporting refers to a set of standard practices as prescribed by the Accounting Standards Council Singapore. It is responsible for setting up accounting standards in the country. Financial reporting uses financial statements to showcase the financial health of the company for a specific time frame.
Financial reporting is a way to showcase the revenue, expenses, profit, capital, and cash flow of an entity in a standard form. It includes –
Also known as the Profit & Loss statement, the income statement is a financial representation of the profits or losses incurred by the entity in a specific period. It includes revenue and the expenses for the period, the balance of which represents profit or loss for the period.
A balance sheet summarizes all the assets and liabilities of the business on a specific date. It also presents the capital position of the company.
Cash flow statement
The cash flow statement presents the cash inflows and outflows of the company for the given period. It bifurcates cash flow into three categories – operations, investing, and financing. The sum of figures from these categories is known as Net Cash Flow.
Importance of financial reporting
Financial reporting is vital for the following reasons –
Helps in financial decision making
If there were no set measures for financial reporting, it would be difficult for people to understand the financial performance of the company.
Whenever the management wants to analyze and make a crucial business decision, it is imperative for them to understand its potential impact on finances.
Identifying roadblocks, being proactive, and finding financial trends with the help of financial statements would enable the leaders to make more informed decisions that are financially viable.
Stakeholders, whether internal or external, look for transparency before they make decisions pertaining to the company. A set pattern of financial statements makes it conducive for them to understand the financial integrity of the organization and the feasibility of the decisions they make.
When a company in Singapore has a collected and concise view of its financials, it becomes easier to ensure compliance with the laws and regulations prescribed by ACRA and other regulatory bodies in the country. It also helps them figure out shortcomings and rectify them at the earliest.
Debt management is a crucial aspect of every company’s success. Financial reporting helps management to gain meaningful insights into the current debt position of the organization. It also helps them figure out the optimum use of borrowed money in the future.
With financial reporting, you get clear visibility into the financial performance of the company. It enables the management to figure out the income tax dues of the entity accurately and helps eliminate financial complications while filing tax obligations every period.
Financial reporting is an accurate way of gauging past and present trends. It helps stakeholders figure out potential shortcomings of the company and empowers them to chart a way to eliminate them. It is also a key enabler in showcasing earning abilities and potential trends that the entity can ride on to earn big in the future.
Develop predictive strategies
Financial statement analysis is a key enabler for businesses as it gives them access to accurate financial data. It helps the management leverage the data by using predictive analytics to remove any gaps in the organization’s overall management and reporting.
In addition, its usage has also enabled organizations to widen their user base. By churning out vital KPIs and mixing them with relevant customer data, entities have been able to chart a viable course to reach their end goals.
Helps augment efficiency
Today, financial reporting is optimized for different screen sizes and operating systems. Given the shift to the WFH (work from home) scenario, it has become imperative for data to work seamlessly across devices in the same way.
It enables the workforce to utilize it to improve communication and bring in innovation. It has helped improve stakeholder efficiency and better protection against issues and errors.
What is financial statement analysis?
By now, we have understood that financial reporting is a way to communicate the company’s performance to the world.
So analyzing them helps the onlooker figure out so many things about the company. It may not be as enriching for insiders as it is for outsiders, but they can still gauge multiple aspects of how the company is being managed.
As for outsiders, the financial statement analysis is the way to understand the overall health of an organization. It helps them evaluate the financial performance and the business value provided to the world.
Who uses financial statement analysis?
Every stakeholder has the right to understand how the company is performing. The best way to do it is via a financial statement analysis. So here are the users of financial statement analysis –
- Management – They manage the company. The financial results are the key indicators of the performance of the organization based on the results that they have taken on its behalf.
- Shareholders – They are the part owners of the company. They study the financial statements to understand the ability of the company to utilize their money more effectively and drive in more revenue, thereby giving them higher returns (dividend or capital appreciation, or both).
- Regulatory authorities – if the general public has an interest in the company, the regulatory authorities use financial statement analysis to ensure that the organization complies with several rules and regulations as stated in the Companies Act and elsewhere.
- Creditors – It helps them analyze the cash position of the company and determine its ability to repay its dues.
- Potential investors – They use it to evaluate the prospects of investing in the company. It helps them understand and gauge whether the company’s outlook attracts them and makes for a lucrative investment.
Types of financial statement analysis
We already know the importance of a financial statement analysis from the stakeholders’ perspective. This part will discuss the types of financial statement analysis that you need to know.
The types of fundamental statement analysis relevant for a particular scenario depend on the information the stakeholder is looking to garner from it. Here are the most common types of financial statement analysis that you are likely to use –
Horizontal financial statement analysis is the comparison of multiple periods of financial information to understand the company’s performance. Here, the profit & loss statement and balance sheets of a period are compared with that of the previous such period/periods. It helps analysts to showcase the changes that have taken place in the company’s financials over time or compare it with any preceding period’s performance.
Here are three different ways to perform horizontal analysis –
Percentages are often easier to compare than absolute figures in SGD terms. You can divide the current period figure with the previous year’s figure and multiply it by 100.
The result will reflect the change in the current period in percentage terms. You can use any item present in the income statement, balance sheet, or cash flow to compare it with the benchmark and gauge its movement.
Unlike the percentage method where you compare specific items, the direct comparison compares the financial statements on a line-by-line basis. This analysis comes into play when you want to understand the absolute change in SGD terms of each item. We can further investigate any abnormal surge or dip to eliminate possible shortcomings.
The variance method allows you to analyze the company’s performance over a course of time. You can assign a benchmark year/quarter (any of the previous years/quarters) and allocate scores according to each year’s performance.
It will allow you to gauge the gradual movement for each line item and understand the percentage change between the periods.
Vertical analysis is simpler than horizontal financial statement analysis. Here, you take the figures of each item from the financial statements for a period (typically, a year).
You will need common-size income statements and a balance sheet for this purpose, i.e., you consider the sales figure in the concerned income statement as 100% and state other items as a percentage of sales.
As for the balance sheet, we consider the total assets or the total liabilities as 100%. Then adjust each line as a percentage of total assets.
It gives you the insight to understand what part of total asset that a particular asset takes up or the COGS (cost of goods sold), indirect expense percentage in total sales, and such other relevant figures. You can compare the results with the benchmark KPIs to understand the performance of the company.
Ratio analysis is very common for people looking to carry out financial statement analysis. Here, you use different ratios to determine the company’s performance from different aspects.
You can either gauge the ratio on a standalone basis or pit it against the same in the previous period. If the management is robust, we can expect most of these ratios to be within the expected range, whereas there can be some that will exceed or miss the mark.
It will help you bring attention to the potential problems that exist.
Here we list the general group of ratios that you are most likely to use –
These are the elemental ratios that help you understand the ability of the company to stay in business. These show how liquid the company’s cash position is, and how capable it is in paying its short-term liabilities.
- Current ratio – It shows the ratio of the current ratio compared to the current liability of the company. It is industry-specific, but anything between 1.5 and 3 is considered ideal.
- Quick ratio – Similar to the current ratio, but it removes prepaid expenses and inventories to present a stricter result.
- Cash coverage ratio – It determines the amount of cash and cash equivalent present with the company to pay off its current liabilities. Typically, the ratio must be above 1, but anything around 2 is considered favourable.
- Liquidity index – It presents the amount of time required to convert a company’s assets into cash.
These ratios indicate how well the company is utilizing its resources. These represent the quality of management and their ability to maneuver everything they have at their disposal.
- Fixed asset turnover ratio – It represents the efficiency of the management in generating net sales from its fixed assets. The ideal ratio varies from one industry to another.
- Sales to working capital ratio – It represents the business’ ability to generate sales for every SGD infused into the working capital of the business. Anything above 0 is considered ideal. If the ratio is too high, it probably represents underutilized capital.
- Inventory turnover ratio – it represents the number of times a company has sold and replaced its inventory during a given period. Even though the ideal number varies across industries, anything between 5 and 10 is considered favourable.
- Accounts receivable turnover ratio – It represents the efficiency of a company in collecting its dues. If the company’s account receivable turnover ratio is higher than the industry average, it means that it is good at handing in its receivables.
- Accounts payable turnover ratio – It represents the company’s ability to repay dues in a timely manner. If the industry average is 3, anything above it is considered favourable for the entity.
Profitability ratios measure the efficiency of the company in generating profits. It represents the wealth being generated by the company for its shareholders.
These fall into two major categories – return ratios and margin ratios. The former ones, i.e. return ratios, help determine the efficiency of the company in generating returns for its shareholders.
Margin ratios help understand the company’s ability to turn sales into profits.
- Return on assets (ROA) – It represents the ability of the company in using the deployed assets to generate profits. Anything between 5% and 20% is considered good, whereas anything above 20% is considered terrific.
- Returns on Equity (ROE) – It is the most significant ratio for the current and the potential shareholders of the company. ROE determines the company’s ability to earn a return on its equity investments. Anything between 15% and 20% is considered an ideal ROE.
- Return on capital employed (ROCE) – It represents the profitability of the company by deploying the available capital. It includes debt and equity capital. The ideal ROCE is industry-specific, but anything above twice the prevalent interest rates in the country is considered ideal.
Leverage ratios indicate the level of debt employed by the business against any other item in its financial statements. These indicate the ability to pay back the debt of the company.
- Debt-Equity ratio – It represents the company’s ability to leverage debt to earn higher returns for its shareholders. The debt-to-equity ratio falling between 1 and 1.5 is considered ideal in most scenarios.
- Fixed-charge coverage ratio – It represents how well the business can cover its fixed expenses. It is the ratio of the net book value of capitalized and WIP assets to the total secured debt on such assets. A value of 1.25 or higher is considered ideal for the fixed charge coverage ratio.
- Debt service coverage ratio – It represents the company’s ability to repay its debt using its operating income. A value of 2 or higher is considered ideal for the debt service coverage ratio.
Benefits of financial statement analysis
Financial statement analysis is an integral part of the decision-making with regard to an organization and the way it functions.
If you are within the organization, conducting it at least once is the norm. If you are a stakeholder or are pondering about investing in a company, you can do it periodically to decide if the association is worth it.
Here are the benefits that financial statement analysis offers –
It makes investment decisions easier
It is impossible for financial analysts to gauge the future performance of the company accurately, but they can use the financial statements to give a rough idea of where it is headed.
Even though the projections are devoid of any unforeseen event, it gives a basis for the internal managers to base their investment decisions.
If the financials are strong, it gives the people external to the entity more reasons to become a stakeholder.
Aids lending decisions
Any financial lender will look to lend to only those entities that are capable of repaying its dues. For that to happen, these businesses must have a strong upcoming cash flow for the next few years.
Analyzing the financial statements helps lenders draw an unbiased view of the company’s financial health. This gives them reasons to accept or deny the request to lend them funding.
The management and top executives rely on financial statement analysis to gauge the results of the efforts put in by them with regard to their corporate governance endeavours. It also helps them with the probable impact of any tweaks they make in their strategies.
Trends depend on a plethora of factors. So it is imperative for businesses to understand that the trends of two different entities will look very different from each other. For example, if you are a start-up, it is normal for you to have losses for the first few quarters.
What is not normal is you not meeting your expected projections. If that is the case, it is necessary to look for ways to ensure that they meet upcoming projections by revamping the requisite processes.
Eliminating the false sense of security
Numbers, when looked on from a distance, can often fail to depict the real picture. Financial analysts, however, can employ real-time observations and draw critical insights to help management be proactive and take precautionary measures before it is too late.
Issues with financial statement analysis
There is no doubt when we say that financial statement analysis is an integral part of corporate decision-making. However, it too suffers from several bottlenecks –
Inconsistency between periods
For companies using financial statement analysis across periods, there can often be a change in the treatment of items. For example, what we considered as fixed assets in the last period can be termed as a current asset or vice versa. It can often make comparisons inaccurate.
Inconsistency between companies
Two companies in Singapore can go about their finances in two different ways. So even though they are competitors, comparing their financial performance is not the most viable decision that an analyst can make.
It can lead to wayward insights that do not match with real-world happenings.
Presents an incomplete picture
Financial performance is not always in line with the operational performance of a company. So using it to base your future decisions may not be the best decision. It is imperative for you to consider the operational ratios too while taking any major decision pertaining to the entity or your relation with it.
Financial statement analysis deals with the numbers presented in the financial reports of an entity. It helps us interpret the performance of the business from several points of view and also helps draw forecasts to further aid your decisions.
Even though financial statement analysis is a must-have, it is not always the most effective for decision-making. You must combine it with additional steps, such as asking the right questions and merging the operational results to understand the performance of the entity accurately.