Operating activities is the basis of every business and understanding operating activities of any business makes us understand how a business makes her income. The income statement is prepared based on accrual principle to report net income for a period along with the components: revenues, expenses, gains, and losses. This then means that we will get useful insight into the risk exposure and economic performance of a business if we can just analyse the operating activities of the business. A closer look into; how revenues are generated and reported, how expenses are recognized, what constitutes gains and losses is the approach am going to take in this article. Note however that this article is a continuation of financial statement analysis and analyzing investment activities. If you arrived here through search engine, do your self a favour to read the preceding articles before this for a clearer understanding
- Analyzing revenues
What you should basically lookout for here is the acceptability of items that are included here. What is the basis for recognizing revenue? Are the economic realities of an event taken into account before treating an item as revenue? Particularly lookout for ‘commission sales’ to see if certain facts are concealed in those figures as a lot has been hidden under commission sales in the past. This is one area where managers and business executives attempts to fool users of accounting information. They include the total sales made as against the commission they are entitled to.
- Analyzing expenses
Are items treated as expenses qualified to be treated that way? Policies of capitalization and amortization should be carefully reviewed. Amortization and capitalization are terms used to explain how businesses treat long term cost as part of current period’s cost. Cost behaviour analysis should be carried out on cost in order to establish the constituents of cost. This will give you ‘the analyst’ insight into the business risk that the business is likely to face. Business risks are those risks that a business will stop being profitable or stop meeting her set objective(s). If more of the expenses are current in nature, it then means that the business stand the chance of suffering more from the effect of business risk. Depreciation policies should also be closely looked at to ensure that reasonable estimates are used.
- Analyzing gains
Be satisfied that paper gains are not recorded in the current year’s profit. Analyzing the ‘statement of cash flows’ of the business will help in this regard. Gains from revaluation of assets should properly be labeled ‘unrealized profit’ or whatever term the prevailing legislations in your country allow.
- Analyzing losses
Steps to be taken here are similar to those taken on ‘analyzing gains’ above. Are there seasonal losses in the financial statements? If yes, what is the likely continual nature of the loss? A calculated answer to these questions will help you make an informed value-added decision.
If you had followed us through this series of financial statement analysis, you will agree with me that financial statement analysis is a process and not a destination and also a means to an end; not an end on its right. Knowledge from other relevant sources like some you see here and fundamental analysis should always be sought if you are to carryout any meaningful financial analysis and financial statement analysis.
To your success in understanding operating activities of businesses!!