Every good company must have an expert in finance who can analyze financial statements carefully and effectively. Finance is delicate, so a person who holds full control of the financial statements must be responsible, and the person must work as detailed and as thoroughly as possible.
A financial professional must master these three areas:
- Structure of the financial statements: A professional in finance must know how to organize financial statements in a neat and easily understandable way.
- Characteristics of the industry in which the business operates: Each company holds unique characteristics depending on which industry the company operates in. A finance professional must be aware of such characteristics while understanding the industry environment affecting the company.
- Strategy for the company to distinguish itself from its competitors: Competition in the industry always gets tougher. Every company must have unique points that can put it ahead of competition.
A company must entrust a financial professional to hold the power to analyze the company finances. As such, the person has to master how to analyze financial statements effectively. If you are one of them, then follow these six steps to help you build an effective financial statement analysis:
Identify the Industry Economic Characteristics
The first thing that you have to master is determining the value chains analysis for the industry. This chain refers to all activities involved in the creation, manufacturing, and distribution of a product. It can also be for a service. This step usually utilizes the Porter’s Five Forces technique or other techniques such as analysis of economic attributes.
After mastering this first step, you can then continue to the next step. Master this step to do a comprehensive industry analysis without any mistake.
Identify Company Strategies
After you understand the economic characteristics of your industry, it is time to identify the strategies that can be used by your company. Observe and understand the nature of the products and services being offered by the company. They should include uniqueness of product, level of profit margins for each product, creation of brand loyalty, and control of costs carried out by the company.
Not only that, important factors such as supply chain integration, geographical diversification and industry should also be considered. Every company obviously has its own strategy for various areas; one of them is the financial strategy. You should try to understand the financial strategy of the company so you will not make any mistake when analyzing its finances.
Assess the Quality of the Company’s Financial Statements
It is time for you to review the key financial statements. You must review them in the context of relevant accounting standards, especially when checking the balance sheet accounts. In balance sheet accounts, various issues such as recognition, classification, and valuation can be the key to an accurate evaluation.
So, the question is whether the balance sheet is a complete representation of all the company’s economic positions. Finally, you must evaluate the income statement by accurately and properly evaluating the earnings quality as a complete representation of the company’s economic performance. Evaluation of cash flow statements will help you understand the impact of the company’s liquidity position. This can be analyzed from the investment, operations, and financial activities of the company within the financial period.
Basically, where funds originate from, where the funds are used, or how the liquidity is affected should all be included in the financials for the period.
Analyse Current Profitability and Risk
In addition to assessing the quality of the company’s financial statements, analyzing profitability as well as the risks that may occur can add value in evaluating a company and its financial statements. If you can do this, you will be seen as more professional in the eyes of the company. One of the most common tools for analyzing is the key financial ratios that have to do with asset management, liquidity, profitability, debt management and coverage, and risk/ market assessment.
There are two big questions that you must answer regarding profitability. First, how profitable are the company’s operations relative to its assets. Regardless of that, how the company can finance those assets, and how profitable a company is from the perspective of its equity shareholders.
You have to understand these questions and solve them according to your thinking and points of view. It is important to learn how to disaggregate return measures into main impact factors. It is also important for you to be able to analyze the financial statements ratio in a comparative way.
Prepare Assumptions for the Financial Statements
It is often challenging, but financial professionals must be able to make reasonable assumptions about the future of the company or the industry he is working in. Financial professionals must also know how these assumptions will affect company’s cash flows and funding.
You can take the form of pro-forma financial statements, using common techniques such as the percent of sales approach. With this, your financial strategy will be neatly organized according to the goals and impacts.
Value the company
While there are many ways to do valuation, do not miss the most common assessment method using the discounted cash flow methodology. You can calculate this based on the dividend and then project it, or you can also use other techniques like the free cash flows to shareholders or on enterprise basis.
Another approach is to use relative valuation, or accounting-based measures like economic value added.
After you carry out the company and financial statements analysis, then you need to answer the following question, “Are the numbers in the financial statements accurate and accountable?”
Why should we question this? There are many cases of accounting irregularities currently being reported to the authorities, such as aggressive accounting, earnings management, or even fraudulent reporting in the financial statements.
Many people end up with legal complications because of unclear accountability in their business’ financial reporting. As such, every business person has to understand all types of financial manipulations and how to detect them.
There are many accounting or financial softwares that can automate calculations and complex financial reporting to be simpler and more practical.
So, those are the steps that can be taken to have an effective financial statement analysis. You can also hire an accounting manager or outsource your financial management to get a more reliable and transparent financial reporting.