Role of financial statement in investment decision making

Financial Statement Analysis for Investment Decision-making

Every negligent financial choice can lead to bankruptcy or, even worse, a long-term loss. Now, this is what investors cannot afford to do.

Hence, for a high-quality investment choice process, a thorough understanding and analysis are required. This is much more important for investors who purchase business or shareholder stock. 

Now, effective stock investment decisions require careful consideration of financial statement analysis. Therefore, the analyst in charge must have a thorough understanding of a company's total financial picture and statement of owners' equity to bring trustworthiness to the financial statement. 

That's why it is essential to learn the significance of financial statement analysis for investment decisions. Read on to learn more -

Investment Financial Analysis

Since the analysis should be concerned with investments, learning about the structure of investment financial analysis is necessary.

Here, an analyst who is not employed by the company performs an analysis for all the areas of investment. For this, the analysts have a choice between a top-down and bottom-up investment strategy. 

Now, a top-down strategy starts by looking at macroeconomic opportunities, such as high-performing industries, and then digs deeper to identify the top businesses inside those industries. 

On the other hand, a bottom-up strategy focuses on a particular business and does a ratio analysis similar to those used in corporate financial analysis, looking at previous performance and anticipated future performance as investment indications.

Further, the analysis is performed in three categories -

1.Fundamental Analysis

For determining a company's value, the fundamental analysis examines the ratios derived from the financial statements, such as its profits per share (EPS). Here, your ultimate objective is to present a figure that an investor can use to determine whether an asset is undervalued or overvalued. Based on this, they may or may not proceed towards investment initiatives.

2.Technical Analysis

Technical analysis uses statistical trends gathered from trading activity, such as moving averages (MA). This approach assumes that the price of a security reflects all publicly available information. Instead, it focuses on the statistical analysis of price movements. 

Moreover, technical analysis focuses on the market sentiment, which is influenced by price trends, instead of analysing a security's fundamental attributes only.

3.Horizontal vs. Vertical Analysis

For the analysis of financial statements, two approaches are preferred - horizontal and vertical analysis.

The horizontal analysis goes through several years of comparable financial data, expanded across a large horizon with a particular year considered as the baseline.

After this, each account for each subsequent year is compared to this baseline, creating a percentage that easily identifies which accounts are growing (hopefully revenue) and which accounts are shrinking (hopefully expenses).

On the contrary, vertical analysis chooses a benchmark to observe how every other component on a financial statement compares to that margin. 

Most often, the filter is set for 'net sales'. 

This way, a company can then compare things like the cost of goods sold, gross profit, operating profit, or net income as a percentage of this benchmark. 

How is a Financial Analysis Carried Out?

The first thing that needs to be highlighted is that the areas - corporate finance and investment finance environments are both suitable for conducting financial analysis. 

The priority here is to go over the income statement, balance sheet, and cash flow statement for either of the areas.

However, the most popular method preferred by financial analysts is the process of calculating ratios from the data in the financial statements for comparison against those of other companies or against the company's own historical performance. 

Moreover, extrapolating a company's historical performance, such as net earnings or profit margin, into a projection of the company's future performance is a crucial component of corporate finance research.

How Does Financial Analysis Influences Making Investment Decisions?

Below are the factors of financial analysis that influence making investment decisions -

1.Process of analysis of financial ratios

The necessary data to be analysed in a financial ratio analysis comes mostly from financial statement data. 

Now, the general fact is - a ratio is a mathematical relationship between two amounts. In this case, the two quantities are taken from financial accounts. 

Investors can generally assess five areas of operating performance and financial conditions by utilising financial ratios, including return on investment, liquidity, profitability, activity, and financial leverage.

Analysts use return on investment ratios to assess how effectively a company uses its resources in its operations by contrasting measures of benefits with metrics of investment, such as net income or earnings before interest and taxes. 

This way, analysts can decide to increase their investment in the company if the ratio of net income to total assets is higher than that of other companies operating in the same industry. 

Again, investors shall also compare a company's current ratio to its past to get an idea of the past performances of the company. 

Not only that, investors can evaluate a company's liquidity, or its capacity to pay short-term commitments out of current assets, by looking at the current ratio, quick ratio, or net working capital to sales ratio. 

2.Analysis of the Earning

Before making a decision, investors need to predict the market value of a company's securities, i.e. to foresee a company's future cash flows. 

This is challenging, so instead, investors look at the past and present correlation between stock price and some basic variables. That's why earnings are required as a component used to estimate the value of securities.

Now, earnings vary depending on the situation, so it is normal to apply various ways based on the actual situation. The operating earnings of the company, or the earnings before interest and taxes, are likely to be the emphasis if an investor is assessing the performance of a company's operations.

Here, the EPS (earnings per share), which stands for displaying the amount a company makes on each share over the course of an accounting period, is commonly employed. So, when making investment decisions, EPS is also a key factor. 

Moreover, a company with a high EPS appears to be profitable and is worth investing in.

3.Cash Flow Analysis

Cash flow is a crucial component of valuation and aids analysts in determining a company's current worth based on the present value of its anticipated future cash flow. 

Furthermore, by comprehending cash flow, an investor may judge if a company can continue paying dividends and follow its current capital spending plan without needing outside funding.

Today, a company can be transparent about sharing its cash flows on the statement in two straight ways -

• First, the company can directly disclose all the inflows and outflows of the cash.  
• Secondly, the company can adjust net income to account for depreciation and other non-cash items. 

From this, an analyst can gain insight into the company's operations by examining the relationships between cash flow from operations, cash flow from investment activities etc.

For instance, a new, rapidly expanding company is likely to depend on external financing and hence have a negative cash flow from operations and a positive cash flow from financing activities.