What is financial statement analysis?
Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization as well as to assess financial performance and business value. Internal constituents use it as a monitoring tool for financial management.
Key points to remember
- Financial statement analysis is used by internal and external stakeholders to assess business performance and value.
- Financial accounting requires all businesses to create a balance sheet, income statement, and cash flow statement that form the basis of financial statement analysis.
- Horizontal, vertical and ratio analysis are three techniques used by analysts to analyze financial statements.
Analysis of financial statements
How to analyze financial statements
A company’s financial statements record important financial data on all aspects of a company’s activities. As such, they can be assessed based on past, current and projected performance.
In general, the financial statements focus on generally accepted accounting principles (GAAP) in the United States. These principles require a business to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have more stringent standards for presentation of financial statements. Public companies must follow GAAP which requires accrual accounting. Private companies have greater flexibility in preparing their financial statements and also have the option of using accrual or cash accounting.
Several techniques are commonly used in the analysis of financial statements. Three of the most important techniques are horizontal analysis, vertical analysis and ratio analysis. Horizontal analysis compares data horizontally, analyzing the values of row items over two or more years. Vertical analysis examines the vertical effects of line items on other parts of the business as well as the proportions of the business. Ratio analysis uses important ratio measures to calculate statistical relationships.
Types of financial statements
Businesses use the balance sheet, income statement, and cash flow statement to manage their business operations and also to provide transparency to their stakeholders. The three statements are interconnected and create different views of a company’s activities and performance.
The balance sheet is a report of the financial value of a business in terms of book value. It is divided into three parts to include the assets, liabilities, and equity of a business. Short-term assets such as cash and accounts receivable can say a lot about the operational efficiency of a business, liabilities include provisions for business expenses and the loan capital it pays back, and equity includes details of equity investments and retained earnings of periodic net earnings. Income. The balance sheet must balance assets and liabilities up to equity. This number is considered the book value of a business and serves as an important measure of performance that increases or decreases with the financial activities of a business.
The income statement breaks down the income of a business against the expenses incurred in its activity to provide a bottom line, i.e. net profit or loss. The income statement is divided into three parts which help to analyze the efficiency of the business at three different points. It starts with the revenues and the direct costs associated with the revenues to identify the gross margin. It then goes to operating profit, which subtracts indirect expenses such as marketing, overhead, and depreciation. Finally, after deducting interest and taxes, net income is achieved.
Basic income statement analysis typically involves the calculation of gross profit margin, operating profit margin, and net profit margin, each of which divides profit by revenue. The profit margin helps to show where the costs of the business are low or high at different points of operations.
Statement of cash flows
The statement of cash flows provides an overview of the company’s cash flows from operating activities, investing activities and financing activities. The net result is reported in the cash flow statement where it is included as the first item of operating activities. Like its title, investing activities include cash flows from company-wide investments. The financing activities section includes cash flows from both debt and equity financing. The bottom line shows how much cash a business has at its disposal.
Free cash flow and other valuation statements
Businesses and analysts also use free cash flow statements and other valuation statements to analyze the value of a business. Free cash flow statements arrive at a net present value by discounting the free cash flow that a business is expected to generate over time. Private companies can keep a valuation statement as they progress towards a possible IPO.
Financial statements are kept daily by companies and used internally for business management. In general, internal and external stakeholders use the same corporate finance methodologies to maintain business operations and assess overall financial performance.
When performing a comprehensive financial statement analysis, analysts typically use several years of data to facilitate horizontal analysis. Each financial statement is also analyzed with a vertical analysis to understand how the different categories of the statement influence the results. Finally, ratio analysis can be used to isolate certain performance metrics within each statement and also aggregate data points between statements collectively.
Below is a breakdown of some of the more common ratio metrics:
Balance sheet: asset turnover, quick ratio, receivables turnover, days to sale, debt to assets and debt to equity
Income statement: gross profit margin, operating profit margin, net profit margin, tax ratio efficiency and interest coverage
Cash flow: Cash and earnings before interest, taxes, depreciation and amortization (EBITDA). These measurements can be displayed by action.
Full: Return on Assets (ROA) and Return on Equity (ROE). DuPont analysis as well.
What is financial statement analysis?
Financial statement analysis is the process of evaluating a company’s performance or value through a company’s balance sheet, income statement, or cash flow statement. By using a number of techniques such as horizontal, vertical or ratio analysis, investors can develop a more nuanced picture of a company’s financial profile.
What are the different types of financial statement analysis?
Most often, analysts will use three main techniques to analyze a company’s financial statements. First, horizontal analysis involves comparing historical data. Usually, the purpose of horizontal analysis is to detect growth trends over different time periods. Second, vertical analysis compares the elements of a financial statement against each other. For example, an expense item can be expressed as a percentage of the company’s sales. Finally, ratio analysis, a central part of fundamental equity analysis, compares the data of line items. Examples of ratio analysis are P / E ratios, earnings per share or dividend yield.
What is an example of financial statement analysis?
An analyst may first examine a number of ratios on a company’s income statement to determine how effectively it generates profit and shareholder value. For example, the gross profit margin will show the difference between revenue and cost of goods sold. If the business has a higher gross profit margin than its competitors, this may indicate a positive sign for the business. At the same time, the analyst can observe that the gross profit margin has increased over nine years, by applying horizontal analysis to the operational trends of the company.