Difference Between Analysis and Interpretation of Financial Statements

Financial statements include the income statement, balance sheet, statement of cash flows, and a statement of changes in equity. The information in these statements is analysed and interpreted in order to facilitate decision making. The key difference between analysis and interpretation of financial statements is that analysis is the process of reviewing and analysing a company’s financial statements to make better economic decisions whereas Interpretation of financial statements refers to understanding what the financial statements indicate. Interpretation of financial statements is conducted through ratio analysis.

CONTENTS
1. Overview and Key Difference
2. What is Analysis of Financial Statements
3. What is Interpretation of Financial Statements
4. Side by Side Comparison – Analysis vs Interpretation of Financial Statements
5. Summary

What is Analysis of Financial Statements?

Analysis of financial statements is the process of reviewing and investigating company’s financial statements to make better economic decisions. Here, the information on financial statements of a company is compared with that of previous years or with other similar companies.

Comparison with Previous Years

It is vital for a business to grow continuously. To be able to identify whether this has happened and how it has happened, the information of previous accounting period should be compared with the current period. Many companies provide the results of the last financial year in a column next to the current year’s results for the ease of comparison. Financial statements of public companies are easy to compare since their preparation follows a standard format.

By looking at the above, users of the statement can clearly see that the gross profit has increased from 2015 to 2016.

Comparison with Other Companies

This is referred to as ‘benchmarking’. Comparing financial information with companies in the same industry gives rise to many benefits. These similar companies are often competitors, thus how they have performed relative to the company can be analysed using benchmarking. The results of this exercise are more effective when companies of similar size and similar product are compared.

E.g. Coca-Cola and Pepsi, Boeing and Airbus

What is Interpretation of Financial Statements?

Interpretation of financial statements refers to understanding what the financial statements indicate. This is very important to take necessary future actions to ensure that the financial health of the company remains at desired levels. Interpretation of financial ratios is done through ratio analysis.

Usually ratio analysis is conducted at the end of the financial accounting period. The amounts in year-end financial statements are used to calculate ratios. Year-end financial statement provides information regarding the results that were achieved during the year and the current status of the company by providing the amounts of assets, liabilities and equity it holds. While useful, these are mainly prepared for the presentation and regulatory purposes and have little value in understanding what this information means and how they can be utilized in making decisions for the future. These limitations are addressed through Ratio Analysis. Continuing from the above example,

E.g. By how much the gross profit has increased from 2015 can be calculated using the Gross margin ratio (Sales/Gross profit). The Gross margin for 2015 is 24% and has increased to 28% in 2016.

It provides an interpretation of the ratios calculated and depending on whether the result is positive or negative, management can decide what actions to be taken for the betterment of the future.

E.g. The Debt to equity ratio is a reflection of the financing structure of the company and reflects the amount of debt as a portion of equity. This should be maintained at a certain level; if the ratio is too high, it indicates that the company is primarily financed through debt, which is highly risky. On the other hand equity financing is costly than debt financing as interest paid on debt is tax deductible. Thus, depending on the ratio, management can decide what the future financing structure should be.

There are 4 main categories of ratios and a number of ratios are calculated for each category. Some of the most common ratios are as follows.

Since ratio analysis helps comparison of results in relative terms, the size of the company does not pose as an issue in analysis. However, the calculation of ratios is based on past information and sometimes shareholders are more concerned about receiving forecasts about the future.

What is the difference between Analysis and Interpretation of Financial Statements?

Summary – Analysis vs Interpretation of Financial Statements

The key difference between analysis and interpretation of financial statements depends on where the financial information is used to compare results with past periods (analysis) or whether to use them for future decision making by understanding what is indicated by the results (interpretation). Both analysis and interpretation of financial statements are time-consuming. While useful, the main drawback of these two exercises is that they are too focused on past results that cannot be changed. Most stakeholders are more concerned with future performance, thus may not see significant value in analysing and interpreting financial statements.

References
1. “Financial Statement Analysis.” Investopedia. N.p., 14 Nov. 2015. Web. 19 Apr. 2017.
2. Peavler, Rosemary. “How Do You Do Financial Statement Analysis?” The Balance. N.p., n.d. Web. 19 Apr. 2017.
3. “Financial Ratios and Analysis | Explanation | AccountingCoach.” AccountingCoach.com. N.p., n.d. Web. 19 Apr. 2017.