The basic purpose of accounting is to provide useful information about an economic entity and to facilitate the decision-making of its different users (shareholders, creditors, investors, clients, administrators, and government). Consequently, as 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 into 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 standards, accounting criteria, forms of presentation, etc. This information subsystem is known by the name of financial accounting because it expresses in quantitative and monetary terms the transactions carried out by an entity as well as certain economic events that affect it, to provide useful and secure information to users. outsiders for decision-making.
The final product of the accounting process is financial information, an essential element for the various users to make decisions. The information for financial analysis that these users require is primarily focused on:
- Evaluation of the financial situation.
- Profitability evaluation.
- Liquidity assessment.
The adjusted trial balance provides the information necessary to prepare basic financial statements.
Accounting considers that every business must present four basic reports. In this way, there is the income statement that reports on the profitability of the operation, it is a statement of financial position or balance sheet, whose purpose is to present a list of resources (assets) of the company as well as the sources of financing (liabilities and capital) of said resources, the statement of changes in stockholders’ equity, whose objective is to show the changes in the investment of the owners of the company, and the statement of changes in the financial situation, whose objective is to give information about the liquidity of the business, that is, to present a list of the sources of cash and disbursements thereof, 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 prepared, an additional step is still necessary: the financial analysis of the same. Indeed, analyzing the information contained in financial statements is an excellent basis for making appropriate decisions in the business world.
There are various techniques to carry out financial analysis, all of which 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 analysis of reasons includes two aspects: the calculation and the interpretation to try to know the performance of the company.
Items of cash 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.
For users of the financial report, it is very important to know the company’s non-financial data, since this allows them to broaden the user’s vision and understand analytically and logically the behavior of the financial data that is 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, to have a more solid basis for decision-making.
Financial indicators are used to weigh and evaluate the results of the company’s operations, these indicators are the relationship of one figure with another within or between the financial statements of a company that allows weighting and evaluating the results of the company’s operations.
Different financial reasons allow for satisfying the needs of users. 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 the short-term liquidity ratios, to assess the payment capacity of its client.
- A creditor may be interested in the profitability ratios, which reflect the ability to generate profits since in this way the debtor will have available resources to settle their 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 equity.
- Liquidity indicators :
- circulating reason.
- Liquidity test.
- Asset utilization indicators :
- Rotation of accounts receivable.
- Average collection period.
- Inventory rotation.
- Total asset turnover.
- Passive Usage Indicators :
- The ratio of total liabilities to total assets.
The first group of financial indicators, referring to profitability, tries to evaluate the number of profits obtained concerning the investment that originated them, either considering in its calculation the total assets or the stockholders’ equity.
The second group, which refers to the liquidity of a company, has the objective of analyzing whether the business has sufficient capacity to meet the obligations contracted by and for its operations. Obligations are 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 all of its accounts from its customers. Concerning assets, the ratio of use expresses how productive the assets have been in terms of generating sales.
The group that refers to the use of liabilities consists of evaluating the general indebtedness situation concerning its assets and the capacity to cover its contracted debts.
This financial indicator measures the percentage of sales that manage to convert into profit available to 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 the administration to obtain the maximum yield on the investment, which is integrated with the total assets. This indicator can also be obtained by combining the profit margin on sales and total asset turnover.
Return on investment = Net income / Total assets
Return on investment = Net income / Net sales X Net sales / Total assets
Return on Equity
This indicator measures the return on net investment, that is, stockholders’ equity. Through it, the net profit that an organization has generated during a period is related and compared with the investment that corresponds to the shareholders. Return on 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 equity = Net income / Equity
This indicator tries to reflect the relationship that exists between the financial resources available to a company in the short term to meet the payment obligations contracted in the same period, which makes it possible to determine 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 current 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 items whose conversion into cash is immediate; that is why inventories are not considered, since they require more time and effort to be converted into cash. For this reason, this is a similar indicator but more demanding than the indicator of current assets. In the current assets section, there may be other losses that are not as easy to convert into cash or that do not represent a flow as in the case of prepayments. These items can also be considered for the financial analysis of liquidity 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 Turnover
It is indisputable that accounts receivable are related to the sales made by a company since they are conditioned based on the credit period granted to customers. The greater the number of times that credit sales represent accounts receivable, that is, turnovers, the better, since this indicates that collection is efficient or that there are better customers. 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 of the net sales of the period is used. As with the acid test, for comparison purposes, the same financial analysis criteria must be maintained.
Accounts receivable turnover = Sales / Accounts receivable = n times
Average collection period
This indicator suggests how long it takes customers on average to pay their bills.
Average Collection Period = Accounts Receivable / Average Daily Sales = Average Days
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
Total asset turnover
This indicator reflects the relationship of total assets to sales since it shows the number of times that the company uses them to generate income for the items it produces.
Total asset turnover = Sales / Total assets = n times
Indicators related to the use of liabilities
The 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.
The ratio of total liabilities to total assets = Total liabilities / Total assets = amount owed for each dollar of assets
These indicators or financial ratios, mentioned above, are used to evaluate the financial situation of any company. Similarly, as previously mentioned, based on the financial information provided by the companies that belong to the same industry or economic sector, the average values of the financial indicators by type of industry or sector are calculated, to use them as a reference. to evaluate the financial performance of a company compared to others of the same type. In this way, it can be determined which aspects of the entity are consistent with the average or above or below the industry average. The information can also be used 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 extraordinarily useful instruments, they are not exempt from limitations, which is why their application requires great care. The indicators are made from accounting data, which are sometimes exposed to different interpretations and even manipulations.
The financial manager must also be careful in judging whether a certain financial indicator is good or bad, and also in making a complete judgment about a company from a set of such indicators.
The adherence to the average financial indicators of the industry does not establish with certainty that the company functions normally and that it has a good administration. The financial analysis of indicators is a useful part of the research process, however, taken in isolation, they are not sufficient answers to make judgments about the performance of companies.
Vertical analysis in financial analysis
Vertical analysis is an extremely useful financial analysis tool because it allows you to compare a specific item concerning the total to which it belongs. In the case of the statement of financial position, the total assets for each year are 100% as well as the total liabilities and capital. From there, all the items of assets and liabilities and capital, respectively, are calculated by the percentage they represent concerning the total they belong by dividing the amount of the item between 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, the percentage is calculated for all other items by dividing their amount by the total sales in the period.
Horizontal analysis in financial analysis
Horizontal analysis is extremely important when it comes to detecting behavior trends over time of the items that are part of the financial statements. Unlike the vertical analysis, in the horizontal analysis, a year base is taken as a reference to which 100% is assigned and from it, the increases or decreases suffered by each of the items in the income statement and the income statement are calculated. the financial situation over time.
This same procedure can be applied to the statement of financial position to determine trends concerning a base year.
In conclusion, financial analysis is the method developed by which financial statements are used and the information is evaluated in such a way that the current state of a company can be determined. Through the study of financial statements, it seeks 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 evaluate the present, but it also gives the possibility of making future decisions related to the administration of a company and maximizing its utility. Such decisions may include investment plans, borrowing, operations, etc.