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Three tools you can use to detect red flags in your financial statements!

by , 06 October 2015
Managing your business requires financial statements to make informed, intelligent decisions that will affect its success or failure.

Your investors need financial statements to analyse investment potential and banks require financial statements to decide whether or not to loan you money.

So you need to make sure your financial statements are financially and ethically sound.

Read on for the three tools you need to analyse your financial statements and detect red flags.

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To analyse your financial statements use these three tools:

1.       Vertical analysis;
2.       Horizontal analysis; and
3.       Ratio analysis.

The following is an example of financial statements for both vertical and horizontal analysis:

Vertical Analysis:

This shows you the relationships between components of one financial statement, measured as percentages.
On your statement of comprehensive income each asset is shown and a percentage of total assets. You show each liability item as a percentage of total liabilities and equity. And show each line as a percentage of net sales.
So by looking at every item, as a percentage, this tells you exactly where each rand of your revenues is going.
So it's easy to spot which items are eating up your month profit.
In the above example, we observe that accounts payable is 29% of total liabilities. Historically, we may find that this account averages slightly over 25%. In year two, accounts payable rose to 51%. Although the change in the account total may be explain through a relationship with a rise in sales, this rise might be a starting point in a fraud inspection.

Horizontal analysis:

With this method you can compare numbers from one period to the next. So you need to use financial statements from at least two different periods. Each line item has an entry in a current period column and a prior period column. You compare those two entries to show the rand difference and percentage change between the two periods.
In the previous example, cash declined by R30 000 from year one to year two, a 67% drop. Further analysis reveals that the 80% increase in sales has a much greater increase in cost of goods sold, which rose to 140%.
This is an unusual increase and displays a declining financial condition. If management employed fraudulent accounting in the period, it might mean that revenues were understated for some reason.

Ratio analysis:

This allows you to measure the relationship between two different financial statement amounts. The relationship and comparison are key to an analysis. You first need to work out the first year's ratio, the second year's ratio. 
The ratios give your perspective on the financial stability, liquidity etc. Its better when assets exceed liabilities. But if assets equal liabilities, be concerned because this reflects problems with your cash flow.
Many professionals, including bankers, investors, business owners, and investment analysts, use this method to better understand a company's financial health. Ratio analysis allows for internal evaluations using financial statement data. The relationship and comparison are the keys to the analysis. For further insight, financial statement ratios are used in comparisons to an entity's industry averages.

P.S. Need to draw up correct financial statements for your business? Here's the one complete guide you need to compile 100% legally compliant income statements and balance sheets

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