Financial statement analysis is the process of understanding an organization’s financial state by examining its financial records. The data can be used to make critical investment and lending decisions. Financial statement analysis requires someone to take raw information from financial statements and translate it into usable information for future decisions. Three types of analysis are utilized: horizontal analysis, vertical analysis, and ratio analysis. Various companies and investors benefit from financial statement analysis since it clarifies a company’s financial profile. By using various financial documents, it is easier to evaluate a company’s overall performance.
What is Financial Statement Analysis?
Financial statement analysis involves analyzing a company’s financial records for the best business decisions. External stakeholders use it to understand an organization’s health and gauge economic performance and business value. Meanwhile, internal constituents use it as a monitoring tool for managing finances. All companies must create a balance sheet, income statement, and cash flow statement, which is a starting point for financial statement analysis. Financial statement analysis allows investors and creditors to study financial documents and determine if a business is healthy enough to invest in or receive a loan offer. Factors such as trends, proportion analysis, and ratios are also considered for financial statement analysis.
What is the Purpose of Financial Statement Analysis?
The purpose of financial statement analysis is to gauge the strength and performance of a company through data on financial statements. Every company possesses a financial statement that serves as an official record of losses, profits, expenses, and revenue over a certain period. Financial statement analysis is crucial for decision-making since it plays a huge role in depicting a company’s health and if it has any financial defects. Moreover, companies can compare their performance over multiple periods through financial statement analysis. This will help companies in determining their financial state.
Who Makes Use of Financial Statement Analysis?
Several people use financial statement analysis. The main groups are creditors, investors, management, and regulatory authorities.
- Creditors: Creditors are individuals who have lent funds to companies with an interest in their ability to repay the debt. They focus on various cash flow measures.
- Investors: Investors (current and prospective) study financial statements to determine if a company can continue issuing dividends, generate cash flow, or continue growing at its historical rate.
- Management: Meanwhile, company controllers prepare ongoing analyses of companies’ financial results for management. This particularly relates to several operational metrics not seen by outside entities (cost per delivery, cost per distribution channel).
- Regulatory Authorities: For regulatory authorities, if a company is publicly held, its financial statements are viewed by the Securities and Exchange Commission (if the company files in the United States). They will decide whether a company’s statements conform to the countless accounting standards and rules of the SEC.
What is the Basis of Financial Statement Analysis?
Investors use financial statements to understand past decisions and make informed choices about investing in a company. When they review financial details, they can see how a company’s financial information has evolved and compared to competitors in the same industry. Managers, creditors, and regulators also examine financial statements. Financial statements provide a basis for financial data to evaluate a company’s financial position. The three primary financial statements used for financial analysis are the balance sheet, income statement, and cash flow statement.
- Balance sheets detail a company’s assets and liabilities. The information lets you see if a company has high debt levels relative to its assets. When you look at previous balance sheets, you may spot trends, like increasing reliance on debt or debt elimination. Other information on balance sheets is the statement of shareholder equity (which explains the value of outstanding shares). The statement of shareholder equity notes changes in the number of shares, buybacks, and other activities.
- Income statements (profit and loss statements) show how much revenue companies bring in and where the money goes. Expenses are divided into categories such as operating expenses and the cost of goods sold, which helps investors know where a business spends money. The bottom line of income statements lists net profits. Net profits are the amount left over after paying all expenses. Investors can gauge whether a company operates at a loss.
- Cash flow statements list the payments into and out of a company. Cash flow is crucial since running out of liquid cash can make companies insolvent. Cash flow differs from profits shown on an income statement. Income statements may include “expenses” unrelated to cash flows, such as depreciation or amortization. So, profits may not offer enough precision about a company’s cash position. Therefore, it is important to evaluate a company’s cash inflows and outflows separately from the figures on income statements.
What Benefits Does Financial Statement Analysis Provide?
Financial statement analysis allows you to evaluate a company’s performance through its balance sheet, income statement, or statement of cash flows. Due to the horizontal, vertical, or ratio analysis techniques, investors gain a more accurate picture of a company’s financial state. One benefit is the ability to detect patterns. Financial statements illustrate how much companies earn per year in sales. Sales may fluctuate, but financial planners should notice a pattern over years of sales figures. For instance, a company may have a pattern of increased sales when a new product is released. But, the sales may drop a year after being on the market. This is a good thing since it shows potential and sales patterns, so executives know when to expect a drop in sales.
Another benefit is the option to budget an outline. Using financial statements for future planning and decision-making allows someone to see the company’s budgets. The budgets show how much wiggle room a company has to acquire, launch products, develop marketing campaigns, or expand the current office size. When someone knows how much money is available for planning and decision-making, that ensures that the company does not overspend. Maintaining adequate funds and not overextending resources is a crucial part of remaining financially healthy.
What are the Different Types of Financial Statement Analysis?
The two main methods for financial statement analysis are horizontal and vertical analysis. Horizontal analysis compares financial information over multiple periods, while vertical analysis lists each line item on a statement as a percentage of another item. Essentially, line items on income statements are shown as a percentage of gross sales, while line items on balance sheets are depicted as percentages of total assets. The horizontal analysis examines the results of multiple periods, while the vertical analysis reviews the proportion of accounts to each other within a single period.
Another method for analyzing financial statements consists of several types of ratios. Ratios calculate the relative size of one number concerning another. After calculating ratios, you can compare them to the same ratio computed for a certain period. For a typical financial statement analysis, most ratios are within expectations. A small number will highlight potential problems that reviewers will spot.
The different types of financial statement analysis are listed below.
- Liquidity Ratios: Liquidity ratios are the most important since they measure how long a company can remain in business. They estimate how a debtor can pay off existing debt without raising external capital. The margin of safety is calculated using the current ratio, quick ratio, and operating cash flow ratio. A higher liquidity ratio proves a company is more liquid and can cover outstanding debts.
- Activity Ratios: Activity ratios indicate how efficiently a company can leverage the assets on its balance sheet to gain revenue and cash. Often referred to as “efficiency ratios,” activity ratios help analysts determine how companies manage inventory management. Inventory management is crucial to a business’s operational fluidity and fiscal health. Activity ratios can be used to compare two firms in the same sector or to monitor a single company’s fiscal health.
- Leverage Ratios: Leverage ratios examine how much capital comes from debt (loans) or gauge a company’s ability to meet its financial obligations. Leverage ratios are important since companies rely on a mix of equity and debt to finance operations. Knowing the amount of debt a company holds is beneficial in determining whether debts will be paid timely. Some common leverage ratios are the debt-to-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio.
- Profitability Ratios: Profitability ratios assess a business’s ability to generate earnings relating to its revenue, operating costs, balance sheet assets, or shareholders’ equity over time. You can compare profitability with efficiency ratios, which ponder how well companies use assets to generate income internally. Higher ratio results are favorable, but these ratios offer more information than similar companies’ results, the company’s historical performance, or the industry average.
How do you Begin a Financial Statement Analysis?
One of the main tasks for analysts is examining financial statements. It is beneficial for companies to review their financial performance at least once a month, and it helps keep the business in good shape. Some companies only look at their books every few months, which does not allow enough time to spot errors. The more you study your finances, the more opportunities for growth you can find. However, some people may not know where to begin with a financial statement analysis.
To begin a financial statement analysis, here are steps you can follow:
- Compare Your Records:
If you review your business documents regularly, this is a good start. But, to enhance your financial review, you must compare your actuals (how your business performed) to your forecast. Compare your plan to what happens in a monthly meeting with your key staff. Have your forecast on file along with accounting software reports so you can analyze the two and determine if you are on track.
- Single Out Exceeding Projections or Where Improvement is Needed:
When forecasting, you are making educated guesses. So, your actual financial performance will change in a given month. You will usually be off track or performing worse than expected, on track and close to expectations, or outperforming forecasts and exceeding expectations. By comparing previous records with the recent month of your business, you have a better idea of where your company stands. Also, you will see where the company is excelling, what you should reel in, and which areas need more work.
- Review Your Income Statement:
Income statements list your income and expenses. When you compare this document to your forecast, you can see if your sales are meeting your goals and if you are keeping expenses in line with your budget. If you are unsure what information is on an income statement or how to read it, various resources are available to help you understand it. It is a crucial part of the financial analysis process.
- Analyze Your Cash Flow Statement:
Cash flow statements show how cash moves into and out of business. When you compare this statement to your cash flow forecast, you will see whether you can grow your bank balance the way you envisioned or why you may be off track.
- Review Your Balance Sheet:
Balance sheets provide an overview of a company’s financial position. You can view how much money you are owed, how much you owe others, and what assets your business has. Balance sheets help you understand if you are collecting money from customers at the proper rate and taking on more debt than necessary.
How does Financial Statement Analysis Help Business Growth?
Financial statement analysis is crucial for complying with business laws and regulations. But, it also meets the needs of various parties and stakeholders. Business growth relies on the timely and accurate study of financial statements. Financial statement analysis can help businesses grow by providing information that will help financial planners, accountants, and others make important decisions on plans, expansions, and product launches that can help the company advance and remain open. Individuals with advanced analytical, problem-solving, and technical skills are ideal for handling these documents. It is crucial to determine a company’s ability to pay its debts.
