Investors and analysts use several methods while judging if a company is financially sound and worthy of investment. Analyzing financial statements is one of them.
Financial statements are written records that describe a company’s operations and financial performance. They help stakeholders to get an understanding of the company’s performance in the long run.
In this article, we shall take a look at what is financial statement analysis, what are the types of financial statements and the techniques and methods of financial statement analysis.
What is Financial Statement Analysis?
Financial statement analysis is the process of analyzing a company’s financial statements to understand the overall financial health of an organization and to evaluate financial performance and business value. The findings are then used for decision making by internal as well as external stakeholders.
Types of Financial Statements
Companies primarily maintain three financial statements:
Balance Sheet
The balance sheet reveals a company’s financial position in terms of book value at the end of a specific year. It consists of three components, i.e., assets, liabilities and shareholders equity.
The total of the assets must be equal to the total of liabilities and shareholders equity. The book value of a company is equal to its total assets minus its total liabilities. It serves as an important financial metric that increases or decreases with the financial activities of a company.
Income Statement
The income statement indicates the financial performance of a company in terms of profit or loss, at the end of a specific period. It indicates a company’s gross profit/loss, operating profit/loss and net profit/loss. These are three different points to analyze a business’ efficiency.
The statement begins with revenue and the direct costs associated with it, to identify gross profit/loss. It then moves to operating profit/loss, which is arrived at after subtracting indirect expenses like marketing costs, general costs, and depreciation. Net profit is arrived at after deducting interest and taxes.
A company’s gross profit margin, operating profit margin, and net profit margin, indicate where company costs are low or high at different points of the operations.
Cash Flow Statement
A company’s cash flow statement provides an overview of the company’s cash flow from operating, investing, and financing activities. It gives information about the amount of cash or cash equivalents and shows how a company is managing its cash flow. It works in conjunction with the balance sheet and income statement.
Methods of financial statement analysis
Analysts and investors use several techniques to develop a fair understanding of a company’s financial performance and financial position. Here are some of the most commonly practiced methods of financial analysis:
Horizontal Analysis
The horizontal analysis of financial statements involves the comparison of two or more periods to understand a company’s progress. Each component of a ledger is compared with the previous period to comprehend the organization’s development through time.
In other words, the result of a horizontal analysis is often shown as a percentage increase in the same line item within the base year, to get a broad sense of trends.
For example, the cost of finished goods might have increased by 25%, but the same is not reflected in the sales. Thus there may be some other components that are costing the company more.
Vertical Analysis
Vertical analysis helps to establish a connection between different ledger line items. It helps us gauge the overall income and spending.
In this type of analysis, each line item is a percentage of every other item on the statement. For example, net income is expressed as a percentage of gross sales, whereas every line item on a balance sheet is shown as a percentage of total assets. Analysts can now analyze total performance in the context of revenues and costs.
Ratio Analysis
Ratio Analysis involves comparing key financial metrics against each other or with industry averages to see how a company is performing in key areas.
Once the ratio has been calculated it can be compared with the historical data or with industrial data to find out if a company’s performance is as per set expectations. It helps the management highlight deviations and take corrective measures.
Key categories of ratios include:
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Liquidity Ratios:
- Current Ratio
- Quick Ratio (Acid-Test Ratio)
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Profitability Ratios:
- Gross Profit Margin
- Net Profit Margin
- Return on Assets (ROA)
- Return on Equity (ROE)
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Efficiency Ratios:
- Inventory Turnover
- Accounts Receivable Turnover
- Asset Turnover
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Debt or Leverage Ratios:
- Debt to Equity Ratio
- Interest Coverage Ratio
- Debt Ratio
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Market Ratios:
- Price-to-Earnings (P/E) Ratio
- Price-to-Sales (P/S) Ratio
- Dividend Yield
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Coverage Ratios:
- Times Interest Earned (TIE) Ratio
- Fixed Charge Coverage Ratio
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Market Performance Ratios:
- Earnings Per Share (EPS)
- Book Value per Share
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Solvency Ratios:
- Debt Service Coverage Ratio (DSCR)
- Solvency Ratio
Trend Analysis
This method involves looking at a company’s financial statements over time to analyze its performance over a period of time. It can be done on a macro level by looking at industry trends, or on a micro level, by looking at a company’s historical data.
Trend analysis is based on the assumption that what has happened in the past will happen again soon. It enables businesses to better anticipate and plan for rising trends and downward reversals within certain market sectors.
In closing
A company’s balance sheet, income statement and cash flow statements are the financial statements that are used to analyze its business.
The most commonly used techniques and methods of financial statement analysis include horizontal analysis, vertical analysis, ratio analysis and trend analysis. These techniques provide a unique perspective on a company’s financial performance. They can be used to make informed decisions about investing, lending or partnering with the company.
Also Read: Economic Indicators That Have An Impact On Your Portfolio
FAQs
Financial statement analysis is the process of analyzing a company’s financial statements like its balance sheet, Income statement and cash flow statement to get inputs for decision-making and to assess a business’ value.
The income statement, the balance sheet, and the cash flow statement are the three types of financial statements. The income statement provides details about a company’s income and expenditure to arrive at profit or loss at the end of a specified period. The balance sheet provides a snapshot of a company’s financial position as of a specific date. While the cash flow statement shows the inflows and outflows of cash during a specific period.
Analysts use several techniques to develop a fair understanding of a company’s financial performance and financial position. The most commonly practiced methods of financial analysis are horizontal analysis, vertical analysis, ratio analysis and trend analysis.
Horizontal analysis is a method of financial statement analysis that compares a company’s progress over a period of time. Each component of a ledger is compared with the previous period to gather a general understanding of trends.
Vertical analysis is a method of financial statement analysis that compares the relationship between line items within a single financial statement. This involves expressing each line item as a percentage of a base item, such as total revenue or total assets.
Ratio and trend analysis is a method of financial statement analysis that involves calculating ratios that provide insight into a company’s financial performance. Ratios can be used to evaluate liquidity, profitability, efficiency, and solvency. Whereas, trend analysis involves analyzing financial data over a period of time to identify patterns and trends.
