A company’s financial statements are the most effective way to communicate financial information to owners, investors, and the government. So, financial statement analysis helps company management and external stakeholders evaluate the company’s overall health and potential future performance.
This guide will explain what financial statement analysis is, how to conduct it, and its significance.
What is Financial Statement Analysis?
Financial statement analysis is a process that focuses on reviewing and analyzing a company’s financial statements for decision-making. It involves using analytical procedures to evaluate a businesses’ financial performance, risks, financial health, and future potential.
Financial statement analysis uses data from financial documents and converts it into useful information for its stakeholders. For example, investors use it to value a company, while lenders evaluate its creditworthiness. Furthermore, financial statement analysis enables company management to analyze the efficiency of its operating activities to guide important business decisions. As a result of its various applications, different types of financial statement analysis range from very general to very specialized.
Common Types of Financial Statements
Financial statements are documents that describe the financial health of a company. Publication of these reports is typically quarterly or annually. Companies create various financial statements depending on the needs, wants, or requirements of their audience.
The 3 most widely used statements in financial statement analysis are the balance sheet, income statement, and cash flow statement. Each statement is unique and offers detailed financial information. However, all three statements are interconnected, and together they give a comprehensive overview of the company’s operating activities and financial performance.
The balance sheet is a representation of a company’s present financial health. It indicates what it owns and what it owes. Hence, it shows the total assets and how they are financed through debt (liabilities) or shareholders’ equity. As a result, it gives a quick overview of a corporation’s financial position at a particular point in time. Thus, other common names are a company’s statement of financial position or statement of net worth. Remember, the balance sheet has to balance out: assets are shown on one side (typically left), and liabilities plus shareholders’ equity on the other (typically right).
ASSETS = Liabilities + Shareholders’ Equity
There are two categories for assets and liabilities, current and non-current assets and liabilities.
Current assets, also called short-term assets, are relatively easily convertible into cash and include cash, accounts receivable, and inventory. As a result, they tell a lot about the company’s operational efficiency and liquidity. On the other hand, non-current assets cannot be easily converted into cash and include property, plant, equipment (PP&E), and non-tangible assets such as goodwill.
Equally important are liabilities. They include the outstanding payroll payments, money owed to vendors, bonds and taxes, rent and utility payments, and debts. Finally, you can calculate shareholders’ equity (or a company’s net worth) by taking the sum of all assets and deducting the value of all liabilities. The main components of shareholders’ equity are outstanding shares and retained earnings.
An income statement is a financial report that gives an overview of a company’s revenue (sales) and expenses during a specified period. It shows how revenue minus expenses result in a company’s net income or net profit. Hence, its other name; profit and loss statement.
NET INCOME = ( Total Revenue + Gains ) – ( Total Expenses + Losses )
Income statements communicate top-line revenue and account for the cost of goods sold (COGS), selling, general & administrative expenses (SG&A), interest on debt, taxes, and other expense items. Furthermore, it provides stakeholders such as investors and analysts with various detailed metrics and useful information. For example, it shows a company’s net profit, and when compared with its net profits from previous years, it indicates if net profit has been consistently growing. In addition, ratios such as earnings per share (EPS) are also part of the income statement and are important metrics in an investor’s toolbox.
Statement of Cash Flows
These reports provide useful data concerning the cash and cash equivalents coming in and going out of the company over a period of time. The statement of cash flows is a detailed reconciliation of how a company generates and uses cash. Activities on cash flow statements are broken down into three primary categories: operating, investing, and financing.
Investors, regulators, and creditors use cash flow statements to determine how well the company manages its short-term and long-term finances. Generally, cash flow statements provide a clear view of a company’s short-term ability to pay its debts. Therefore, the statement of cash flows reflects a company’s liquidity, solvency, and short-term viability.
Most companies also generate other financial statements besides the balance sheet, income statement, and cash flow statements. What types of statements depend on a company’s needs. For example, the Statement of Retained Earnings reflects a corporation’s retained earnings change over the reporting period. This statement includes dividends paid, profits and losses from operations, shares issued during the specified period, and other items credited to retained earnings.
Another example is the Statement of Shareholders’ Equity. This statement generally shows changes in the value of stock and the number of shares issued. It also reports whether the company has bought back shares previously held by shareholders.
Common Types of Financial Statement Analysis
There are various types of financial statement analysis. Here are the most common ones:
Financial Ratio Analysis
Financial ratio analysis analyzes data from financial statements by calculating ratios used to evaluate a corporation’s overall financial condition. These ratios are popular tools for analysts, investors, and a corporation’s management team to gain useful insight into specific areas of a company’s financial health.
Financial ratio analysis is the most popular type of financial statement analysis and can be classified into multiple categories. Here are some of the most common ones:
Liquidity Ratios – Liquidity ratios show an enterprise’s ability to pay its short-term obligations and gauge a company’s short-term viability. In other words, it refers to a company’s ability to pay its short-term bills and debts and, if needed, its capability to sell assets quickly. The 2 most important liquidity ratios are the Current Ratio and the Quick Ratio.
Solvency Ratios – These ratios refer to a company’s ability to meet its long-term debts and obligations. Prospective lenders typically use solvency ratios to evaluate a company’s creditworthiness. However, solvency ratios vary from industry to industry and should only be compared with competitor ratios in the same industry. Commonly used solvency ratios are the Debt-to-Equity ratio (D/E ratio) and the Debt-to-Assets Ratio.
Profitability Ratios – These ratios measure and evaluate the ability of a corporation to generate a profit. Profitability ratios are important to managers to steer the corporation in the right direction. They are also important to investors to show them their return on investment.
There are 2 types of profitability ratios, margin ratios and return ratios. One very popular margin ratio is the Gross Profit Margin ratio which equals Gross Profit divided by Sales in which Gross Profit equals Sales minus the Cost of Goods Sold. Another popular margin ratio is the Net Profit Margin ratio which equals Total Revenue minus all expenses.
The most important return ratios are Return On Equity (ROE), Return On Assets (ROA), and Return On Invested Capital (ROIC).
Leverage Ratios – These ratios compare a company’s total debt to either its assets and/or its equity. Leverage ratios are basically a measure of risk. A widely-used leverage ratio is the Debt-to-Equity Ratio.
Turnover Ratios – Turnover ratios indicate how well a company utilizes its resources. Common turnover ratios are the Working Capital Turnover Ratio, Accounts Payable Turnover Ratio, Accounts Receivable Turnover Ratio, Asset Turnover Ratio, and Inventory Turnover Ratio.
Valuation Ratios – These ratios typically tell investors how much they are paying for the company regarding its earning power or the value of its assets. The Price-to-Earnings Ratio (P/E ratio), PEG ratio, and the Earning-per-Share ratio (EPS) are some of the most popular valuation ratios that quickly allow investors to gauge the investment worthiness of a business.
Horizontal analysis compares historical data such as financial ratios and financial statement line items over multiple reporting periods. It is also known as trend analysis and shows how different financial metrics have changed between multiple periods.
The results are either expressed as absolute values or as percentages of the base year. This type of financial statement analysis is a popular tool for management to compare a corporation’s current performance to its previous years. Typically, it involves a company’s balance sheet and income statement. It is a great way to show a company’s growth trend, what areas are doing well and what areas need improvement. Horizontal analysis is crucial not only to the management team but also to lenders and investors.
Horizontal analysis often involves preparing comparative financial statements. A comparative statement compares a particular financial statement, such as an income statement, with prior-year income statements. Typically, it compares the latest year’s financials with previous years’ financials. Thus, comparative statements give a quick overview that enables stakeholders to evaluate a company’s progress, identify trends, and even make it possible to compare the company with its competitors. As a result, comparative financial statements are better for analysis than single-period statements.
For example, the SEC requires public companies to publish comparative financial statements in their 10-K and 10-Q forms.
Horizontal analysis does have its limitations. For example, dependent on the base period selected, it can make a company’s performance look better than it really is. In other words, it can distort the results. So, when the base year selected is a year in which the profits were unusually low, it will show higher profit growth rates than what they really are if the base year selected would have been a year with an “average” profit.
Vertical analysis, also called common-size financial statement analysis, is less complicated than horizontal analysis. It is the proportional analysis of one financial statement. To conduct vertical analysis, you have to prepare common-size income statements or balance sheets. A common-size statement is a statement where each line item is a percentage of a base figure of another line item on that statement.
For example, every line item is expressed as a percentage of gross sales on an income statement. Another example would be when, on a balance sheet, every line item is shown as a percentage of total assets. For example, assume that a balance sheet shows total assets of $1,000,000 and a cash balance of $25,000. Then cash is 2.5% of total assets.
Vertical analysis is also useful for trend analysis as it can indicate relative changes over multiple periods. For example, if the Cost of Goods Sold typically had been around 30% per year for the last 3, 4, and 5 years ago, but then increased to 40% 2 years ago, and to 45% 1 year ago, this could be very concerning. It would indicate that the Cost of Goods Sold is increasing significantly.
Trend analysis is another type of financial statement analysis. It is also called time-series analysis, and it compares financial ratios across multiple periods to analyze specific areas of the company’s performance. Financial ratio analysis is a type of trend analysis. A company can also compare its current year’s performance to previous years using other financial information.
Trend analysis is generally performed with the help of the company’s balance sheet and income statement. This type of financial analysis lets management determine whether the company has experienced positive or negative changes in areas like efficiency, liquidity, or profitability. As a result, the company can plan appropriate action to improve its position if necessary.
Industry analysis, also known as benchmarking and cross-sectional analysis, involves comparing a company’s financial ratios with the industry standards to see the comparative performance of the business.
Who Uses Financial Statement Analysis and Why?
Financial statement analysis is a powerful tool that various groups of people use for various reasons. Here are some of its primary users.
Management – A company’s management uses financial statement analysis to analyze the efficiency of its operating activities to guide important business decisions.
Creditors – Those who lend money are always interested in the company’s ability to pay back debt, its other financing activities, and its cash flow activities.
Investors – Financial statement analysis helps both current and prospective investors learn about the company’s financial health and potential growth to evaluate the attractiveness of the investment.
Shareholders – Shareholders provide the company with its working capital. They want to know how efficiently the company uses its resources, pays its dividends, grows dividend pay-outs, and increases its prospects.
Regulatory authorities – Public companies have to comply with laws, rules, regulations, and financial accounting standards from several regulatory authorities regarding how to prepare their financial statement. Regulatory authorities aim to make financial statement analysis more accurate for everyone involved.
Limitations of Financial Statement Analysis
Though financial statement analysis is a powerful tool, it has some limitations that you should be aware of to prevent any errors in interpreting the results. Besides the obvious limitations that interpretation is always subjective and that financial statement analysis is based on historical data and, therefore, does not guarantee future results, here are some other significant limitations.
Quality of underlying data
Financial statement analysis depends largely on a company’s published data and reports. This means the accuracy of analysis relies largely on the integrity and genuineness of the financial statements. It is important to note that financial statements are not always error-free, though they are subject to auditing. For many reasons, including intentional misrepresentation, they may not present the real picture of the company’s financial position.
Problem in comparability
When comparing something, it is crucial to compare apples to apples. However, sometimes a company makes changes in its accounts or in how they report something. This might result in a comparison that does not compare apples to apples anymore. For example, the company may have listed an expense under one category in a certain period and under a different category in another period. As a result, an investor who is used to finding the expense in one place might wrongly assume that the expense no longer exists. Although following standardized accounting practices and audits usually address these issues, sometimes reporting discrepancies will fall through the cracks.
Analysts also use financial statement analysis. They compare the financial ratios of different companies to determine how well a business matches up to its competition. However, every company aggregates financial information in different ways. For example, different accounting methods and different fiscal years often make comparisons between companies less accurate.
Furthermore, sometimes companies will intentionally use numbers that will make them look better. As a result, there is a risk of drawing incorrect conclusions due to this limitation, so be aware.
Like any other data, financial statements have a shelf life. In today’s world of the internet and digitalization, things change rapidly. This implies that when financial statement analysis is done, the results should be used promptly. Financial statement analysis that is based on some situations can get irrelevant after this situation changes. If the analyst or investor uses the results after losing relevance, wrong decisions are likely the result.
Ignores qualitative factors
Financial statement analysis only considers the company’s financial data in its financial statements. As a result, it ignores all qualitative factors such as consumer loyalty and employee satisfaction, which can significantly affect a company’s future performance. Hence, financial statement analysis only presents a part of the complete picture and should be combined with other types of analyses.
Financial statement analysis is one of the most effective techniques to evaluate a company’s financial condition. Therefore, company management uses it as an invaluable monitoring tool to manage its finances and improve its operations. Furthermore, financial statement analysis is also a useful tool for external stakeholders for evaluating the company’s overall health and future performance.
Many people rely on financial statement analysis for important investing, lending, and valuation decisions. Therefore, it is important to understand what it is and how it is being used.