Understanding Financial Statements: How to analyse and interpret

Financial statements are a summary of the financial records of an organisation that shows its financial performance over a given period and financial position as at a point in time. In my previous article (published on 25th April 2024), we looked at why companies publish their financial statements.

The purposes for which companies publish their financial statements as identified were to facilitate capital allocation, mitigate agency conflicts, enhance market efficiency, fulfil stakeholder expectations, signal company performance, and meet legal and regulatory requirements.

It was pointed out that these purposes could only be achieved if the users of financial statements understand what the statements are communicating. This article is therefore aimed at providing basics to analysing and interpreting financial statements.

Prerequisite to Analysis and Interpretation of Financial Statements

The primary requisites for undertaking financial statement analysis and interpretation are getting a basic understanding of the components of financial statements, the key elements of financial statements and fundamentals of ratios and proportions.

These requisites can easily be attained by at least a Junior High School (JHS) graduate with enough curiosity to understand financial statement analysis and interpretation. These fundamentals are elaborated in the paragraphs below.

The components of financial statements per the International Accounting Standards Board are Statement of Financial Position (also called the Balance Sheet), the Statement of Profit or Loss and Other Comprehensive Income, Statement of Changes in Equity, Statement of Cash flows, Notes to the accounts and comparative information.

The Statement of financial position shows the assets, liabilities and equity at a point in time (mostly at the end of a financial period). The Statement of profit or loss and other comprehensive income shows the income and expenditure for a period. The Statement of changes in equity shows the movements in ownership value. The Statement of cash flows shows how operating, investing and financing activities have impacted the inflow and outflow of cash and cash equivalents.

The Notes to the account present explanation on the principles and methods used in preparing the financial statements and provides additional details and context for the figures presented in the financial statements. The Comparative information is the financial information for prior period.

The key elements of financial statements are the broad categories of information presented by the financial statements. These are assets, liabilities, equity, revenue, expenses, gains and losses. Assets comprise of all the resources of the business expected to provide economic benefits. Liabilities represent obligations to persons who are not owners of the business.

Equity is the portion of the assets that remains after meeting the obligations to persons who are not owners of the business (i.e. Equity = Assets -Liabilities). Revenue is the income generated from the regular activities of the business. Expenses are the costs incurred in the process of earning revenue. Gains represent increase in equity which is not because of revenue generation. Losses represent decrease in equity which is not because of revenue generation.

Ratios and proportions are basic concepts used to compare quantities and express relationships between them. A ratio is a method of comparing two or more quantities by showing how many times one value contains or is contained within the other or others.

A proportion is the equation that expresses one ratio as the equivalent of another (i.e. it states that two ratios are equal). While ratios help in assessing financial statements for a particular period, proportions help in comparing ratios across different time periods and against industry standards and competitors.

Financial Statement Analysis and Interpretation

Financial statement analysis and interpretation can be classified into three main groups, which are common size(vertical) analysis, trend(horizontal) analysis and financial ratios analysis. Common-size analysis compares line items in a financial statement for a specific period to a particular line item of the same financial statement for the same period.

Trend analysis is comparing the financial statements of a period to one or more other periods financial statement. Financial ratios analysis compares different line items of the same financial statements to assess performance in relation to profitability, efficiency, liquidity, solvency and market.

Common size (Vertical Analysis)

This form of financial statement analysis involves comparing all the line items in the financial statement to a particular line item to determine how many times each line item is contained in it.

The line item mostly used in the statement of financial position is the total assets figure, that is, each line item is expressed as a percentage of or ratio to the total assets figure. In the statement of profit or loss and other comprehensive income, the element mostly used is total revenue (total sales) figure, that is, each line item is expressed as a percentage of or ratio to the total revenue figure.

Interpretation of Bank Statements Using Common Size Analysis

In interpreting a bank’s statement of profit or loss and other comprehensive income using the Common Size analysis.

A large percentage of interest income to total revenue (interest income plus non-interest income) indicates that the bank relies heavily on traditional lending activities for its income.

High interest expenses could signal high borrowing costs or that the bank is paying competitive rates on deposits, potentially impacting profitability.

A higher percentage of net interest income to total income (mostly referred to as net interest margin) suggests the bank is generating more income from its interest-earning assets relative to its interest-bearing liabilities, which is generally a positive sign for profitability.

A higher percentage of non-interest income (fees, commissions, and trading income, etc) indicates that the bank is diversifying its income sources beyond traditional lending.

A higher percentage of operating expenses to total income indicates inefficiency and poor operational cost control.

A high proportion of loan loss provisions to total income may indicate rising credit risks or deteriorating asset(loan) quality, which could impact profitability.

A higher percentage of profit before tax to total income indicates strong performance and good cost control.

A higher percentage of net profit (after tax) to total income (mostly referred to as net profit margin) means more of the bank’s income is reaching the bottom line after expenses, provisions, and taxes are taken and signifies efficiency in converting total income into profit.

In relation to interpreting a bank’s statement of financial position using the common size analysis.

A higher percentage of cash and cash equivalent to total assets indicates greater liquidity, showing how much of the bank’s assets can be quickly converted to cash. However, if a significant part is non-earning cash, it can affect the profitability of the bank.

A larger proportion of investment securities to total assets (financial instruments like bonds, government securities, or equities) often suggests a focus on stable, lower-risk income from investments.

A higher percentage of loans and advances to customers to total assets indicates a strong focus on lending, but it can also imply higher exposure to credit risk (the probability that borrowers will not payback).

A higher percentage of other assets (e.g. receivables, prepayments, income receivable, inventory, etc) to total assets can indicate less focus on core banking operations or significant investments in areas like technology.

A higher percentage of property, plant and equipment (PPE) to total assets shows potentially lower efficiency, decreased liquidity, slow adoption of digital banking, overvalued assets, or large physical presence due to expanding network of branches.

A high percentage of customer deposits (the primary source of funding to banks) to total assets indicates a strong customer trust and reliance on deposit funding, which is generally stable and is accompanied by low-cost.

A higher percentage of borrowings from other financial institutions to total assets reflects reliance on external funding, which may increase cost of funds because these are mostly very expensive.

A significant proportion of other liabilities (accrued expenses, deferred taxes, and other financial obligations) to total assets might indicate the bank has sizable short-term obligations beyond customer deposits.

A higher percentage of shareholder’s equity relative to total assets generally reflects stronger capital adequacy and lower leverage, which improves financial stability.

A higher percentage of retained earnings to total assets can indicate consistent profitability and sound management practices.

A higher proportion of reserves to total assets may reflect prudent risk management or regulatory compliance.

In conclusion, common size analysis offers a method to evaluate financial statements by expressing each line item as a percentage of a key figure, like total assets or total revenue. This approach enables a clearer understanding of how different components contribute to a company’s overall financial performance and position.

For instance, in the banking sector, it highlights income structure, cost efficiency, liquidity levels, and exposure to risks. By comparing these percentages across time periods or with competitors, users can assess operational strengths and weaknesses more effectively.

In the next article, we will delve into financial ratios and trend analysis, exploring how they complement common size analysis to provide a more comprehensive evaluation of a company’s financial standing. Stay tuned!

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