Techniques for interpreting financial statements
There are many methods or techniques for interpreting figures and we have used several already. Common methods include:
1 comparisons with past or budgeted performance or position;
2 ratios - presenting one figure relative to another;
3 materiality and relative amounts;
4 considering relationships - analytical review;
5 comparisons with external performance - benchmarking;
6 charts and graphs.
1. Comparisons with past or budgeted performance or position
One of the simplest interpretations and for many situations the most useful is to compare the latest period's figures with a previous period or budgeted figures. If those figures are for a stable, unchanging and predictable business, interpretation is straightforward. If the previous period or budget figures are acceptable in the sense of representing those that give rise to normal, if not optimum performance and the latest figures are the same (within the bounds of materiality, which is discussed in Chapter 5), presumably all is well.
2. Ratios - presenting one figure relative to another
The premise of this book is that financial strategy is focused on making a return or at least on improving the contributory actions of increasing margins, controlling or reducing operating costs, increasing sales volumes and investing no more than is needed for sustainable operation. The pyramid of ratios, as it can be termed, has long been used by accountants and executives as the suite of ratios which, if regularly produced and responded to, will ensure financial success for the entity - a stable, if not growing return on capital employed. Ratio analysis with worked examples is considered in more detail below.
3. Materiality and relative amounts
This is more about developing the technique of focusing on the significant amounts or the numbers in which a small change will have a disproportionate effect on the business.