Lesson 6 - Financial Statements: Tools for Decision Making

Introduction
Financial statements are indispensable tools in making financial decisions. They shed light on the
performance of the company (income statement) and the financial condition of the company (balance
sheet). The cash flow statement shows where the cash came from and where it was spent. The
statement of changes in owner’s equity shows investments by owners (additional sale or issuance of
stock), withdrawals by owners (dividends declared by the board of directors), and any profit earned or
loss incurred by the company. As such, financial statements help not only managers and internal users
of the statements but also the external users of the financial statements as well.

Financial statement analysis highlights the connection, relation and importance of accounting to
financial management in particular and to finance in general. It is, however, important to bear in mind
that financial analysis is not an end in itself but rather an effort to understand and judge the
characteristics and performance of a highly interrelated system of financial relationships.

The Analytical Process

Financial analysis deals with the understanding of the relationship between financial concepts and daily
decision-making. Selecting the appropriate tool to use in financial analysis is of utmost importance in the
analytical process. Helfert (1994) stated, “Financial analysis is both an analytical and a judgmental
process which helps answer questions that have been carefully posed in a managerial context.” An
analytical process should always focus on structuring the issue in its context and manipulating the
proper data. The end purpose of financial analysis is to help people make sound decisions and
judgments. The result is always dependent upon the reliability of the information or data gathered and
the points of view of people who need the analysis and not necessarily the one making the analysis. It
will also depend on the objective of the analysis. Financial statement analysis is aimed at finding
answers to relevant and significant questions. Both quantitative and qualitative analyses are important
in making important financial decisions. Generally, a range of possible outcomes is better than specific
or precise amounts. The amount of effort in doing an analysis should match the significance or
importance of the desired outcome and the costs versus the benefits involved. If too much is spent in
doing the analysis and the amount saved or the benefit obtained from the analysis is lower than the cost
so spent, the analysis is not worthwhile. Suggested points for review and reconsideration before any
financial analysis task is started were given by Helfert as follows:
1. What is the exact nature and scope of the issue to be analyzed? Has the problem and its relative
importance in the overall business context been clearly spelled out, including the relevant
alternatives to be considered?
2. Which specific factors, relationships and trends are likely to be helpful in analyzing the issue?
What is the order of their importance? In what sequence should they be addressed?
3. Are the possible ways to obtain a quick “ballpark” estimate of the likely result to help decide on
(a) what critical data and steps might be and (b) how much effort should be spent on refining
these?
 4. How precise an answer is necessary in relation to the importance of the problem itself? Would
additional refinement be worth the effort?
5. How reliable are the available data? How is this uncertainty likely to affect the range of results?
What confirmation might be possible, and what degree of effort?
6. What limitations are inherent in the tools to be applied? How are these likely to affect the range
of results? Are the tools chosen truly appropriate to the problem?
7. How important are qualitative judgements in the context of the problem? What is the order of
their significance? Which analytical steps might be obviated by such considerations?

Asking and answering the foregoing questions will pave the way for a more focused approach in decision
making. It is the most rational approach to problem solving in financial/economic analysis.

Effective financial analysis is more than mere manipulation of financial data. The analytical process and
its results should clearly achieve the desired objectives – financial, economic or otherwise. The success
of a business firm and its long-term viability depends, to a large extent, on the sound decisions made by
management. This is due to the fact that almost all decisions have financial/economic implications. The
effective allocation, sourcing, and utilization of funds are all dependent on effective decision-making.

The economic trade-offs between benefits and costs are always involved in any financial or economic
decision. Not all trade-offs are simple. Some, or most, are complex especially when they involve large
amounts of funding. Our current business world is so complex, especially with the advent of
globalization. However, no matter how complex our business world is, all businesses have a common
goal – profit maximization to increase owner’s wealth and company value. As such, all managers have
the task of successful resource deployment that should result in a net improvement in the economic or
financial position of the company and, ultimately, that of the owners. Such additional value is generally
reflected in the price of the company’s stock, especially if the company’s stocks are publicly traded, i.e.,
sold in the exchanges (officially and formally organized market) or the over-the-counter market
(unofficially organized stock dealers and brokers). The stock price is dependent on the company’s
performance.

Trade-offs must be effectively and efficiently managed on a consistent basis to achieve long-run
profitability. This is where the role of effective and well-designed financial analysis comes to the fore.
Such effective and efficient financial analysis leads to effective decision-making by management leading
to successful company performance. Effective and efficient financial analysis also helps other decision
makers and users of the financial statements.

Basic Decision Areas

Operating Decision
Operating decisions deals with day-to-day activities of the firm. This includes decisions that are relevant
to pricing, selecting markets, choosing appropriate production and technology, outsourcing payroll,
outsourcing maintenance, and janitorial services, among others. It also includes decisions relative to a
firm’s operating leverage. Operating leverage involves the determination of the profitable level and the
proportion of fixed costs of operation versus the amount and nature of variable costs (changes with
volume) incurred in manufacturing, trading and service operations.

The financial analyst uses operating ratio as well as determines variances between budget and actual
performance. Break-even analysis is used to determine the volume of business a company needs to
reach where the income equals expenses. It means the company needs to go over this point to earn a
profit. This analysis enables the manager to set target sales figures that will guide the sales personnel in
their sales efforts to earn the desired profit.

Investment Decision
Investment Decision refers to deciding what assets to acquire, be they current assets as marketable
securities or non-current assets as property, plant or equipment and long-term investments in stocks
and bonds. It includes decisions relative to projects to undertake or business to enter into. Current
available resources and new funding obtained can be utilized to fund:

1. Working Capital
Working capital equals current assets minus current liabilities. Current assets include cash,
receivables, short-term investments, and prepaid expenses. Current liabilities include interest
and salaries payable, accounts payable, short-term notes payable, and unearned revenues.
Operating expenses involve expenses for current operations like salaries, advertising, delivery,
rent, maintenance, communications, among others. These expenses place a burden on the
company’s current assets.

The investment in working capital already includes operating expenses and payment of current
liabilities because these are for current operations. This involves the preparation of the working
capital budget.

2. Property, Plant and Equipment

Property, Plant and Equipment are the non-current assets of the firm. They are the resources
that have relatively long lives and include land, building, equipment and machinery, and
furniture and fixtures.

The investment for Property, Plant and Equipment involves what is termed as capital budgeting.
A capital expenditure is one intended for long-term assets and projects.

3. Major Spending Programs

Major spending programs are programs such as research and development, product or service
development, promotional and advertising programs, or long-term investment alternatives for
excess funds so that cash can be converted into an earning asset. Funds available for the short
term are invested in marketable securities or short-term investments, while funds available over
the long term are invested in either stocks or bonds.
Evaluating alternatives and options open to a company is a critical function of management. Choosing
the best alternative is aimed at producing the maximum benefits to the firm. At times, disinvestment
becomes an option taken by a firm if critical analysis leads to the conclusion that such disinvestment
decision is for the best of the company. Disinvestment means decision such as withdrawal from a
market (e.g. the international market or a certain geographical market in the domestic scene) if
operations in the said market are unprofitable or unproductive. Discontinuing a certain product or
service is a disinvestment decision. Considerations as increasing sales price and/or reducing cost by
reducing size or certain ingredients or components making the product still saleable and as useful as the
original may lead to the conclusion that the market or the product is really unprofitable or unproductive.
It is after these considerations are made that the option to discontinue a certain market or product is
done.

Financing Decision
Financing Decision refers to decision that involves funding investments and operations over the long
run. It includes decisions that relate to the company’s capital structure, debt-equity mix, funding
sources, dividend policies, cost of capital, among others. Management has to decide whether borrowing
directly from a bank, issuing bonds, or issuing stock is the best and most fitted means of financing a
certain need.

Financial analysts use profitability ratios such as return on investment (ROI), return on assets (ROA),
price-earnings ratio, and value per share, which are all important to stockholders and potential investors
and long-term creditors.

Steps in Analyzing the Financial Statements

Analysis of the financial information contained in the financial statements helps in understanding the
concept of finance in business. Such analysis requires understanding the information given and drawing
of logical conclusion to arrive at a particular sound decision. The following steps are required in the
analysis of the financial statements:
1. Understanding the information provided in the financial statements.
2. Drawing logical conclusion based on the data presented.
3. Making the appropriate decision on the course of action to take.

Horizontal Analysis
Analysis of the financial statements can be done comparatively to show performance and financial
condition in prior years as compared to the current year. This is termed horizontal analysis. This reveals
if the profitability and the financial condition of the firm are improving or not. This comparison usually
reveals trend; the reason why it is sometimes referred to as trend analysis. Trend analysis involves
analysis of significant changes in absolute amounts and percentages, including an analysis of changes in
the ratios used in ratio analysis. Ratios in prior years are compared to ratios in the current year.
Generally, a combination of horizontal and vertical analysis is done for better results. Also, company
figures are compared with industry figures. There are several organizations that publish comparative
statistics for industry groups to assist financial analysts and decision makers.
Generally, the percentage changes are more important and useful than the absolute money values. Data
for series of years, rather than just the past and the current years, are more useful for arriving at a more
logical conclusion and better judgment. Significant trends can only be shown by comparative data over a
number of years. There is danger of misinterpretation if comparison is limited to just two, even three
years.

The analyst or decision maker must be careful in using data from long period in the past as these data
may no longer be comparable, relevant, or useful in present due to changes in industry, company
structure, or in relation to the current economic and financial environment.

Comparative Income Statement

Comparative income statement shows the changes that occur in the different elements of the income
statement in absolute money and percentage of increase/(decrease) to see if the performance of the
company is improving or not.
Comparative Balance Sheet

Vertical Analysis
Vertical Analysis refers to the type of analysis where one number is compared to another to identify
significant relationships. There are two types of vertical analysis: common-size statement and ratio
analysis.

Common-size Statements
Common-size statements refer to the traditional financial statements expressed in percent. Each
element of the financial statements is compared to these base figures (net sales for the income
statement and total assets for the balance sheet); that is the reason the statements are referred to as
common-size.
Common-size statements are the traditional financial statements transformed into percent instead of
the absolute money values so the reader would know the percentage of the base of each element in the
financial statements.

Common Size Income Statement

Common Size Balance Sheet