What Is Financial Statement Analysis?
Financial statement analysis is the process of reviewing a company’s financial statements in order to make judgements. External stakeholders use it to evaluate an organization’s overall health as well as its operating results and market value. For internal stakeholders, it acts as a monitoring tool for the management of money.
Understanding Financial Statement Analysis
Important financial information on every facet of a business’s operations is documented in the financial statements of a corporation. They may therefore be assessed based on their past, present, and anticipated performance.
In the United States, generally accepted accounting standards (GAAP) serve as the foundation for financial reporting. The balance sheet, the income statement, and the cash flow statement are the three primary financial statements that must be produced and maintained by a business in accordance with these principles. Public companies must follow GAAP, which requires accrual accounting. Private companies have greater flexibility in their financial statement preparation and have the option to use either accrual or cash accounting.
Accrual accounting is required by GAAP, which public corporations must adhere to. Private businesses can choose between accrual and cash accounting, giving them more freedom in how they prepare their financial statements.
Several methods are frequently applied in financial statement analysis. The three most crucial methods are ratio analysis, vertical analysis, and horizontal analysis. By comparing the values of line items over two or more years, a horizontal analysis analyses data in a horizontal direction. An examination of the vertical impacts that line items have on other areas of the company and their proportions is known as vertical analysis. Ratio analysis creates statistical associations by using significant ratio measures.
Types of Financial Statements
Companies manage the operations of their firm and give transparency to their stakeholders by using the balance sheet, income statement, and cash flow statement. The three assertions are related to one another and produce various interpretations of a company’s operations and performance.
The book value of a corporation is displayed on the balance sheet. It is comprised of three categories: a company’s assets, liabilities, and shareholder equity. Short-term assets like cash and accounts receivable, liabilities like the company’s expense plans and the debt it is repaying, and shareholder equity, which includes details on equity capital investments and retained earnings from periodic net income, can all have a significant impact on a company’s operational efficiency. To show shareholder equity, the balance sheet’s assets and liabilities must be equal. This sum is known as a company’s book value, and it serves as an important performance indicator that varies in line with a company’s financial activities.
The income statement compares the revenue that a firm generates with the costs associated with its operations to produce a bottom line, or the net profit or loss. The income statement is divided into three sections to aid in the analysis of business efficiency at various stages. To calculate gross profit, start with income and the direct costs that go along with it. The next step is operational profit, which is calculated after deducting indirect expenditures like marketing, general, and depreciation. Finally, the net income is determined after interest and taxes have been subtracted.
Calculating the gross profit margin, operational profit margin, and net profit margin, which each divide profit by sales, is a common step in the basic examination of the income statement. Profit margin aids in illuminating business costs at different points of the operations.
Cash Flow Statement
The cash flows from operating, investing, and financing operations of the business are summarised in the cash flow statement. The top line item for operational operations is net income, which is carried over to the cash flow statement. Investment operations encompass the cash flows related to firm-wide investments, as suggested by their name. Cash flow from debt financing and equity financing are both included in the financing activities section. The bottom line displays how much cash is on hand for a business.
Free Cash Flow and Other Valuation Statements
Free cash flow statements and other valuation statements are also used by businesses and analysts to assess a company’s value. By discounting the free cash flow that a firm is anticipated to produce over time, free cash flow statements arrive at a net present value. As they move closer to potentially going public, private enterprises may retain a value statement.
Companies regularly update their financial accounts, which are then utilised internally for management of the company. The same corporate finance approaches are often used by internal and external stakeholders to manage firm operations and assess overall financial success.
Analysts generally employ numerous years of data to enable horizontal analysis when performing thorough financial statement examination. Each financial statement is also subjected to a vertical analysis in order to comprehend the impact of the various categories on the bottom line. Last but not least, ratio analysis may be used to separate out some performance measures from each statement and combine data points from several claims.
A list of some of the most popular ratio metrics is provided below:
- Asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity are all included in the balance sheet.
- Gross profit margin, operational profit margin, net profit margin, tax ratio effectiveness, and interest coverage are all included in the income statement.
- Earnings before interest, taxes, depreciation, and amortisation (EBITDA) are included in cash flow. These figures might be shown on a per-share basis.
- Complete: This comprises DuPont analysis, return on assets (ROA), and return on equity (ROE).
What are the advantages of financial statement analysis?
In order to evaluate a company’s performance or value, financial statement analysis examines its balance sheet, income statement, and statement of cash flows. Investors may create a more complex picture of a company’s financial profile by utilising a variety of methodologies, such as horizontal, vertical, or ratio analysis.
What are the different types of financial statement analysis?
Three major strategies are most frequently used by analysts to examine financial statements of a corporation.
Comparing historical data is the first step in a horizontal analysis. Horizontal analysis is frequently used to identify growth trends throughout a range of time periods.
Second, vertical analysis evaluates how different financial statement components relate to one another. For instance, a cost item may be stated as a percentage of revenue generated by the business.
The final step in basic equity research is ratio analysis, which analyses line-item data. Examples of ratio analysis include price-to-earnings (P/E) ratios, earnings per share, or dividend yield.
How to conduct Financial Statement Analysis
What is process of Financial Statement Analysis?
There are three main steps in the financial statement analysis process:
- Reformulating Financial Statements As Reported: Reformulating reported financial statements entails restating financial statements so that they better serve the analytical goal and enable a more accurate and efficient interpretation of the company’s performance. In the event of an income statement reformulation, reported items are split into recurring and non-recurring components, and earnings are divided into core and supplemental earnings. When a balance sheet is reformulated, the components are divided into operating assets and liabilities and financial assets and liabilities. Remove financing activities from cash flow from operations, such as interest expense, in cash flow statements.
- Measurement error adjustments: Measurement error adjustments are made to reduce the noise in the input data and to improve the accuracy of the reported accounting figures. As an illustration, present the balance sheet instead of the income statement when showing R&D spending.
- Financial Ratio Analysis Using Reformed and Corrected Financial Statements: Calculating multiple ratios to get insight into a company’s performance is part of doing ratio analysis on the adjusted financial statements. Professionals often use one of two approaches: ratio analysis or vertical and horizontal analysis to examine a company’s financial statements.
Vertical and Horizontal Analysis
In order to analyse financial accounts, two similar but distinct methodologies are used: vertical analysis and horizontal analysis. Each one refers to how a financial statement is interpreted and the comparisons that an analyst might make as a result. To grasp a financial statement’s contents as a whole, both methods of analysis are essential.
Reading down one column of a financial statement is known as vertical analysis. Vertical analysis is used to ascertain how certain line items in a statement link to another item in the report, as opposed to horizontal analysis, which is used to find patterns across time. An income statement may, for instance, display each line item as a proportion of gross sales.
The horizontal analysis describes the practice of comparing current financial data to earlier reporting periods. This method of analysing a financial statement is also known as “trend analysis,” because it enables one to examine how various financial measures have evolved over time: Liabilities, for instance, and whether they changed from Q1 to Q2.
The technique of analysing a financial report’s data in relation to another piece of data in the same report is known as ratio analysis.
There are several types of ratios that might provide you information about the health of a firm. These fall mostly under the following categories:
Profitability Ratios: These ratios provide information about a company’s profitability. The gross profit ratio, return on equity, break-even point, return on equity, and return on net assets are a few crucial profitability measures.
Liquidity Ratios: Liquidity ratios provide information on a company’s level of liquidity, which is crucial for assessing a company’s viability. Cash coverage ratio, current ratio, and liquidity index are a few crucial liquidity parameters.
Leverage Ratios: Leverage ratios reveal the extent to which a business is reliant on debt to fund operations. Debt to equity, debt service coverage, and fixed charge coverage are a few crucial leverage ratios.
Activity Ratios: Activity ratios give information on how well a business is using its resources. Accounts payable turnover rate, accounts receivable turnover rate, inventory turnover rate, and working capital turnover rate are a few crucial activity ratios.
Once a ratio has been determined for the current period, you may compare it to earlier periods to see how the firm has changed over time. The ratio can also be compared to industry norms to determine if the business in issue is operating well or poorly.
What is an example of financial statement analysis?
To ascertain how well a firm produces profits and shareholder value, an analyst may first examine a variety of ratios on its income statement. For instance, the gross profit margin will display the discrepancy between sales and costs. It may be a good indicator for the business if the company has a larger gross profit margin than its rivals. Applying a horizontal analysis to the company’s operational statistics, the analyst may also see that the gross profit margin has been rising over the last nine fiscal quarters.