During the financial crisis in 2008, the world witnessed the bankruptcies of leading firms such as Lehman Brothers or Washington Mutual. These collapses caused the losses of many shareholders and stock investors and raised the importance of financial analysis in investment. This project looks at the necessity of financial statement analysis in investment decision making with an emphasis on how to use it to reveal potential risks.

Introduction

One of the most important long-term decisions for any business is investment with the aim of making gains in the future. Investment decisions are concerned with the use of funds including buying, holding or selling and each decision could be vital to a firm. A careless decision may result in a long-term loss or even worse, bankruptcy. Therefore, an in-depth understanding and analysis is necessary for a high quality investment decision process. This is also even more critical to investors who invest in stock of company or shareholders. Financial statement analysis is critical in making effective stock investment decisions. By study the balance sheet, income statement, cash flow statement and statement of owners’ equity separately and combined, an analyst might have a good sense of a company’s overall financial picture; therefore, the investment decisions are likely to be reasonable and profitable.

I. Understanding of financial statements analysis

In order to understand the analysis of financial statements, it is necessary to define financial statements.

According to Fabozzi (2003), financial statements are summaries of the operating, financing and investment activities of a business. These reports provide information to both investors and creditors in making credit, investment, and other business decisions. In other words, financial statements might be used as a tool to predict a company’s future earnings.

There are four basic financial statements including: the balance sheet, the income statement, the statement of cash flows and the statement of shareholder’s equity.

Firstly, the balance sheet is a summary of the assets, liabilities and equity of a business at a particular time. Assets include the resources of an enterprise that are used to generate profits. Therefore, if a company owns assets, the company can expect them to produce cash inflows in the future. Take for example, cars of a taxi company will be used in order to serve customers and gain income to the company. Liabilities are obligations of the business, or in other words, the commitments to creditors in the form of future cash outflows. Another factor is Equity, which reflects ownership. This means equity represents the part of a firm’s value that is not owed to creditors and therefore is left over for the owners. Thus, equity is the difference between assets and liabilities.

Another part of financial statements is income statement, which is a summary of the revenues and expenses of a business over a period of time. Therefore, it shows both the results of the firm’s operating and financing decisions during that time, and people can also call this as the profit and loss statement.

Thirdly, statement of cash flows is a summary over a period of time of a firm’s cash flows. This statement lists separately its operating cash flows, investing cash flows, and financing cash flows.

The last main part of financial statements is the statement of shareholders’ equity. This provides additional information about equity including the amounts and changes in equity accounts; thus, it is considered as a link between the balance sheet and the income statement.

Apart from the four main parts, the financial statements include notes in order to give additional information to readers. The first notes summaries the company’s accounting policies such as methods of inventory accounting, methods of depreciation and foreign currency translation. Depending on each company, then there may be additional notes providing, for example, information on mergers or acquisitions.

Financial statement analysis is a process that examines past and current financial date for the purpose of evaluating performance and estimating future risks and potential.

II. What influences the making of Investment decision?

In order to understand how financial report analysis affects investment decisions, it is important to understand the main contributing factors of making an investment decision.

According to Cahill (2003), the investment decision making bases on assessing the sector’s prospects, assessing the company’s prospects and evaluating the value of company. A sector’s prospects, which are dependent upon the supply/ demand, pricing and cost trends within the industry, provide information to analyze a company’s prospects in more details. Meanwhile, the analysis of the prospects for the company is based on four drivers including management and strategy, performance and returns, financial positions and outlook for earnings. The combination of these factors determines the value put on a company’s share. After analyzing the numbers and the four factors, it is important to evaluate those numbers with some approaches such as price/earning.

As it can be seen clearly, financial statements are essential source of information in analyzing company’s prospects and in evaluating company’s value. Therefore, it is safe to assume that financial statements analysis is important in the making of investment decision.

III. The influences of financial statements analysis on investment decision

1. Financial ratio analysis and its effect

Financial ratio is one of the most important tools of financial analysis. In financial ratio analysis, the relevant information that will be processed is primarily from the financial statement data. A ratio is a mathematical relation between two quantities, in this case is from financial statements. Generally, by using financial ratios, investors can evaluate five aspects of operating performance and financial conditions including return on investment, liquidity, profitability, activity and financial leverage.

With return on investment ratios, analysts compare measures of benefits, such as net income or earning before interest and taxes, with measures of investment in order to evaluate how well the firm uses its sources in its operations. Thus, analysts could consider increasing their investment into the firm if its ratio of net income to total assets is larger than other firms in the same sector. Moreover, not only compare current figures, investors might compare a firm’s current ratio with its ratio in the past so that they could have a view of how well the firm operate in the recent period of time. On the other hand, investors can assess the company’s liquidity, which is the ability to meet the short-term obligations using current assets, by several ways including current ratio, quick ratio or net working capital to sales ratio. Take for example, a ratio of current assets to current liabilities will provide information about the comparison between assets that can be readily turn in to cash and obligations that are due in the near future. In other words, by calculating this ratio, people might know the ability of a company to satisfy obligation due in the near future; therefore, they could have an valuable information about the safety of investing in that company. As it can be seen clearly, the higher a firm’s liquidity is, the more secure the investment is.

Moreover, professional investors even extend their analysis skill by adding profitability ratios, which help them gauge how well a firm is managing its expenses. With detailed information in financial statements, investor can select and use different profitability ratio in each case. For example, suppose an analyst wants to evaluate how well production facilities are managed, it is reasonable to focus on the comparison between gross profit, which is a measure of income that is direct result of production management, and sales. This ratio shows the portion of each dollar of sales that remains after deducting production expenses; hence, the analyst might evaluate the firm’s ability to manage expenses. In general, it would be unwise to invest in a company that cannot control its expenditures appropriately (Akintoye, 2009).

Apart from above ratios, activity ratios can be used to evaluate the benefits produced by specific assets; thus, they would be useful in specific circumstances. For instance, a ratio of cost of goods sold to inventory provide information about how quickly a firm has used inventory to generate the goods and services that are sold. Another kind of ratios is financial leverage ratio, which is used to assess how much financial risk the firm has taken on. These ratios are essential to evaluate the safety of investment decision to that company.

Although financial ratio analysis help analysts in evaluating a firm’s operations, risk and potential returns so that they can decide to invest in the firm’s securities or not, this analysis cannot tell the whole story and must be used with care due to some limitations such as interpretation of the ratios or accounting data.

2. Earning analysis

In order to give out a right investment decision, investors have to forecast the market value of firm’s securities, or in other words, forecast a company’s cash flows in the future. However, this is difficult and as an alternative, investors examine the historical and current relation between stock price and some fundamental factors. In many cases, the factor is used to estimate the value of securities is earnings.

Earnings are varying in different circumstances; therefore, it is common to use different approaches depend on real case. For example, if an investor is evaluating the performance of a company’s operations, the focus is likely on the operating earnings of the company – the earnings before interest and taxes.

Generally, earning analysis is usually referred to the amount of earning per share of stock. In this case, the EPS (earnings per share), which shows how much on each share is earned by the firm in a given accounting period, is widely used. A firm with high EPS seems to be a profitable firm and is worth to invest in; thus, EPS can play a significant role in investment decision making.

However, earnings can be adjusted by the firm itself and in fact, there are pressures that force the firm to adjust its earnings such as meeting analyst forecast or meeting shareholders’ expectation. In particular, earnings can be manipulated using a number of devices including the selection of inventory method and the selection of depreciation method. The pressure to report constantly increasing earnings may also result in wrong earning report. For example, Leslie Fay showed increasing earnings in 1990 and 1991, even though its business was not that excellent (Fabozzi, 2003). Therefore, similar to using financial ratios analysis, earning analysis should be done with most careful attitudes.

3. Cash Flow analysis

According to Fabozzi (2003), cash flow play an important role in valuation and help analyst calculate the current value of a company base on the present value of its expected future cash flow. Moreover, understanding cash flow allows an investor to assess the ability of a firm to maintain current dividends and its current capital expenditure policy without relying on external financing.

Currently, a firm reports its cash flows on the statement of cash flows using either the direct method, which is reporting all cash inflows and outflows, or the indirect method, which is adjustment the net income with depreciation and other noncash expenses. By looking at the relations among cash flow from operations, cash flow from investing activities and cash flow from financing activities, an analyst could have a overview of the firm’s activities. For example, a young fast growing company is likely to have a negative cash flows from operation and a positive cash flows from financing activities because the company rely on external financing. Examination of the sources of cash flows, especially over time, gives analysts a general idea of the company’s operations. For instance, P&G, which is a mature firm, has a consistent cash flow. Moreover, cash flow information may help the analyst identify companies that may encounter financial difficulties. A clear example of this case is W.T. Grant company during 1966-1974 with no definite clues of bankruptcy that were showed on profitability ratio, turnover ratio and liquidity ratios. However, a study of cash flows from operations clearly revealed that company operations were causing an increasing drain on cash (Fabozzi, 2003).

For above reasons, cash flow analysis is an essential part of making investment decision.

Conclusion

Financial analysis is the basis for investment and financing decisions and the basic data for this analysis is the financial statement data. This data can be used to analyze the relationships between different elements of a firm in order to provide an overview as well as an in-depth view of company’s operation and financial condition. Moreover, by looking at the calculated financial ratios, in the connection with economic data, investor can make judgments about past and future financial performance and conditions. Besides, earnings analysis and cash flow analysis may provide even more detailed information about the firm, and also help investor to see potential risk. Therefore, it is safe to assume that financial statement analysis play an irreplaceable role in making investment decisions.