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Financial Statements represent a formal record of the financial activities of an entity.

These are written reports that

quantify the financial strength, performance and liquidity of a company. Financial Statements reflect the financial effects of business
transactions and events on the entity.
Financial ratios are mathematical comparisons of financial statement accounts or categories. These relationships between
the financial statement accounts help investors, creditors, and internal company management understand how well a business is
performing and areas of needing improvement.
Financial ratios are the most common and widespread tools used to analyze a business' financial standing. Ratios are easy to
understand and simple to compute. They can also be used to compare different companies in different industries. Since a ratio is
simply a mathematically comparison based on proportions, big and small companies can be use ratios to compare their financial
information. In a sense, financial ratios don't take into consideration the size of a company or the industry. Ratios are just a raw
computation of financial position and performance.
Ratios allow us to compare companies across industries, big and small, to identify their strengths and weaknesses. Financial
ratios are often divided up into six main categories: liquidity, solvency, efficiency, profitability, market prospect, investment
leverage, and coverage.
Four Types of Financial Statements

Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an entity at a given
date. It is comprised of the following three elements:
Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
Equity: What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are
used to pay off its outstanding liabilities. Equity therefore represents the difference between the assets and liabilities.
View detailed explanation and Example of Statement of Financial Position

Income Statement, also known as the Profit and Loss Statement, reports the company's financial performance in terms of
net profit or loss over a specified period. Income Statement is composed of the following two elements:
Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc)
Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental charges, etc)
Net profit or loss is arrived by deducting expenses from income.

View detailed explanation and Example of Income Statement
Cash Flow Statement, presents the movement in cash and bank balances over a period. The movement in cash flows is
classified into the following segments:
Operating Activities: Represents the cash flow from primary activities of a business.
Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories (e.g. purchase of
a factory plant)
Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt together with the
payments of interest and dividends.

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the movement in owners'
equity over a period. The movement in owners' equity is derived from the following components:
Net Profit or loss during the period as reported in the income statement
Share capital issued or repaid during the period
Dividend payments
Gains or losses recognized directly in equity (e.g. revaluation surpluses)
Effects of a change in accounting policy or correction of accounting error

Comparative ratio analysis is a method companies use to assess financial performance. Though the ratios use accounting
information, they can provide a deeper meaning to the companys profitability, asset use, leverage, and other business activities.
Benchmarking is typically the most common purpose for this type of analysis. For example, a company often tracks its financial
leverage over several months or years to determine if it is more or less in current periods. Managers may also be subject to
performance reviews based on financial ratios that explain their departments' efficiency with the companys assets.
A company typically starts an analysis by separating ratios into groups, such as profitability, liquidity, financial leverage, and asset
turnover. The ratios test different parts of the business based on related accounting data. Information provided from each group
includes the ability to meet short-term debt obligations, use of assets to generate profits, use of debt in the business, and profit
earned from a single product or multiple product lines. Accountants typically prepare the ratios as they are neutral parties in the
analysis. From here, owners and executives take the data for comparative and review purposes.
A method used in the analysis of financial statements to identify new trends when data or ratios for a specific item
from multiple time frames are presented along side of each other for a straight across comparison. The same method came be used
to compare the outcomes of alternative solutions or processes applied in similar circumstances.

Financial ratio analysis is one of the most popular financial analysis techniques for companies and particularly small
companies. Ratio analysis provides business owners with information on trends within their own company, often called trend
or time-series analysis, and trends within their industry, called industry or cross-sectional analysis.
Financial ratio analysis is useless without comparisons. In doing industry analysis, most business use benchmark companies.
Benchmark companies are those considered most accurate and most important and are those used for comparison
regarding industry average ratios. Companies even benchmark different divisions of their company against the same division of
other benchmark companies.
There are other financial analysis techniques to determine the financial health of their company besides ratio analysis, with one
example being common size financial statement analysis. These techniques fill in the gaps left by the limitations of ratio analysis
discussed below.
1. Benchmark to Industry Leaders' Ratios, Not Industry Averages
This may be contrary to everything you have ever learned. But, think about it. Do you want high performance for your company? Or
do you want average performance? I think all business owners know the answer to that one. We all want high performance. So
benchmark your firm's financial ratios to those of high performing firms in your industry and you will shoot for a higher goal.
As for a limitation of ratio analysis, the only limitation is if you use average ratios instead of the ratios of high performance firms in
2. Companies' Balance Sheets are Distorted by Inflation
Ever wonder why you always hear that balance sheets only show historical data? This is why. A balance sheet is a statement of a
firm's financial condition at a point in time. So, looking back on a balance sheet, you see historical data. Inflation may have occurred
since that data was gathered and the figures may be distorted.
Reported values on balance sheets are often different from "real" values. Inflation affects inventory values and depreciation, profits
are affected. If you try to compare balance sheet information from two different time periods and inflation has played a role, then
there may be distortion in your ratios.
3. Ratio Analysis Just Gives you Numbers, not Causation Factors.
You can calculate all the ratios you can find from now until doomsday. Unless you try to find the cause of the numbers you come up
with, you are playing a useless game. Ratios are meaningless without comparison against trend data or industry data. Ratios are also
meaningless unless you take the limitations listed in this article into account.
4. Different Divisions May Need Comparison to Different Industry Averages
Very large companies may be composed of different divisions manufacturing different products or offering different services. To
make ratio analysis mean something, different industry averages may need to be used for each different division. The ratio analysis,
used in this way, will certainly be more accurate than if you tried to do a ratio analysis for this type of large company.
5. Companies Choose Different Accounting Practices
Different companies may use different methods to value their inventory. If companies are compared that use different inventory
valuation methods, the comparisons won't be accurate. Another issue is depreciation. Different companies use different
depreciation methods. The use of different depreciation methods affects companies' financial statements differently and won't lead
to valid comparisons.
6. Companies can use Window Dressing to Manipulate Their Financial Statements
Ratio analysis is based entirely on the data found in business firms' financial statements. If the financial statements for a company
are not quite as good as they should be and a company would like better numbers to show up in an annual report, the company may
use window dressing to manipulate the data in the financial statements. Bear in mind - this is completely against the concept
of financial and business ethics and flies in the face of corporate governance.
What exactly is window dressing? The company will perform some sort of transaction at the end of its fiscal year that will impact its
financial statements and make them look better but is then taken care of as soon as the new fiscal year starts. That is the simplest
form of window dressing.
You can see that if ratio analysis is used with knowledge and intelligence and not in a mechanical and unthinking manner (like just
cranking out the numbers), it can be a very valuable tool for financial analysis for the business owner. Its limitations have to be keep
in mind but they should be more or less intuitive to a savvy business owner.
Advantages and Limitations of Ratio Analysis
Financial ratio analysis is a useful tool for users of financial statement. It has following advantages:
It simplifies the financial statements.
It helps in comparing companies of different size with each other.
It helps in trend analysis which involves comparing a single company over a period.
It highlights important information in simple form quickly. A user can judge a company by just looking at few numbers instead of
Limitations
Different companies operate in different industries each having different environmental conditions such as regulation, market
structure, etc. Such factors are so significant that a comparison of two companies from different industries might be misleading.
Financial accounting information is affected by estimates and assumptions. Accounting standards allow different accounting policies,
which impairs comparability and hence ratio analysis is less useful in such situations.
Ratio analysis explains relationships between past information while users are more concerned about current and future
information.
Financial Management is the process of managing the financial resources, including accounting and financial reporting, budgeting,
collecting accounts receivable, risk management, and insurance for a business.

In an organisation, the process of financial management is associated with financial planning and financial control. Financial planning seeks
to quantify various financial resources available and plan the size and timing of expenditures. Financial control refers to cash flow
monitoring. Inflow is the amount of money coming into a particular entity, while outflow is a record of the expenditure being made by the
entity. Managing this movement of funds in relation to the budget is essential for the sustainability of the business.

From an organisation standpoint, the process of managing finances is to achieve the various goals set by the organisation at a given point of
time. Businesses also seek to generate substantial amounts of profits, following a particular set of financial processes.

While a well-organised bookkeeping system is vital, it is even more critical on what the organisation does with it to establish its methods for
financial management and control. With a good financial management system, the business owners will not only know how the business is
doing financially, but why. The business owners will then be able to use it to make decisions to improve the operation of its business.

There are 6 critical areas that are involved in the operating activities of the organisation which forms part of a good financial management
process. The ability to master and manage these 6 areas will greatly shape the financial vertical of the organisation:

Financial Planning - Identify what financial resources are needed to obtain and develop the resources to achieve the goals. Typically,
financial planning results in very relevant and realistic budgets.

Financial Accounting - It clarifies records and interprets in monetary terms transactions and events of a financial nature. Financial
accounting will involve maintaining records of transactions (book-keeping), preparing balance sheets and profit and loss accounts,
preparing value added statements, managing cash, handling depreciation and inflation accounting. The accounts prepared by the
organisation will be audited to ensure that they present a 'true and fair view' of its financial performance and position.

Budget Management - A budget depicts what the organisation expects to spend (expenses) and earn (revenue) over a time period. Amounts
are categorised according to the type of business activities, or accounts (for example, telephone costs, sales of catalogs, etc.). Budgets are
useful for planning the finances and then tracking if the organisation is operating according to plan. They are also useful for projecting how
much money is required for a major initiative, for example, buying a facility, hiring a new employee, etc. There are yearly operating
budgets, project budgets, cash budgets, etc.

Managing Cash Flow - The overall purpose of managing the organisations cash flow is to ensure that there is sufficient cash to pay current
bills. Businesses can manage cash flow by examining a cash flow statement and cash flow projection. Cash flow statement includes total
cash received minus total cash spent. It primarily looks at the actual cash transactions. It is a challenging task to be able to track and
manage the cash flow of the organisation.

Managing Checking Account - The check register is a primary means to record and track cash. It is important to know how to manage the bank
account of a business regardless of the organisations years of operation.

Credit and Collections - One of the biggest challenges in managing cash flow may be decisions about granting credit to customers or clients, and
how to collect payment from them.

Budget Deviation Analysis - Budget deviation analysis regularly compares what is expected, or planned, to earn and spend with what is actually
spent and earned. The budget deviation analysis can help greatly when detecting how well the organisation is tracking its plans, how much
to accurately budget in the future, where there may be upcoming problems in spending, etc. A budget deviation analysis report might
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