Drawing valid conclusions about the financial health of an entity is the primary objective of financial statement analysis. Properly evaluating a business helps decision-makers achieve corporate goals. Forensic accountants use financial statement analysis as an essential part of their investigations with the purpose of determining unusual transactions and identifying red flags that warrant further investigative techniques.
Financial statement analysis takes into consideration financial and non-financial data. It includes:
o Review of an organization policies, procedures, and processes
o Examination of the latest auditor’s report
o Review of letters from governmental entities such as the IRS
o Analysis of footnotes and additional information accompanying the financial statements
o Analyzing various relationships among components of the financial statements.
Financial analysis provides a clear understanding of the organization SWOT (Strengths, Weaknesses, Opportunities, and Threats) since it should be performed in conjunction with other valuation techniques and in comparison with other organizations within the same industry in which the entity operates.
When analyzing ratios, the main purpose is to infer conclusions about the solvency, operational efficiency, and profitability of a firm.
Evaluation of Solvency - It covers both short and long-term solvency.
Short-term solvency is the ability of a firm to meet its current obligations as they mature. Short-term creditors such as banks and vendors are interested in the following ratios:
a) Working capital, which is obtained by subtracting current liabilities from current assets (Current Assets minus current liabilities) to determine the liquid portion of resources or enterprise capital. The greater the amount of working capital, the greater the assurance that short-term obligations will be paid when due.
b) Current ratio is obtained by dividing current assets by current liabilities (current assets/current liabilities). Demonstrates the ability of an enterprise to meet current obligations from current assets.
c) The Acid test or Quick Ratio eliminates inventory and prepaid expenses, which are current assets that are not quickly converted into cash). It provides a picture of immediate solvency of an enterprise.
For example, Company ZXW, at December 25, 2008 had cash of $100,000, a current ratio of 1.5:1 and a quick ratio of .5:1. On December 31, 2008 all cash was issued to reduce accounts payable. This decision would cause current ratio to increase and quick ratio to decrease. The reason is that when the current ratio is greater than 1:1, any decrease in current liabilities will case an increase in the current ratio. When the quick ratio is less than 1:1, any decrease in quick assets will cause a decrease in the quick ratio.
The balance sheet is the financial statement that should be primarily used to assess a company’s liquidity and financial flexibility but it requires an analysis of the statement of cash flows to properly draw conclusions on an entity’s ability to meet current obligations.
Long -Term Solvency demonstrates the ability to meet interest payments, preferred dividends, and other fixed charges. Financial institutions look into this ratio as a required condition for the repayment of principal. The main ratios for analyzing long-term solvency are:
a) Debt to Equity, established by dividing total liabilities by owners’ equity (Total Liabilities/Owners’ Equity). It measures relative amounts of resources provided by creditors and owners.
b) Times Interest Earned is determined by dividing income before income taxes and interest charges into interest charges (Income Before Income Taxes and Interest Charges/ Interest Charges. This ratio measures the company’s ability to pay interest.
c) Times Preferred Dividends Earned is the result of dividing net income by annual preferred dividend requirement (Net Income/Annual Preferred Dividend Requirement). Measures the adequacy of current earnings for the payment of preferred dividends.
In addition to evaluation of solvency it is important to consider operational efficiency and profitability and investment analysis ratios. The operational efficiency is the ability of an organization to generate income and its ability to use assets effectively and efficiently.
Usually to portray an objective financial snapshot of an organization financial affairs different kinds of financial ratios and financial statements should be analyzed. Forensic accountants see beyond the numbers and identifying components of solvency is a path to in depth forensic investigations to uncover hidden assets and other financial crimes.