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 and to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.
- Financial statement analysis is used by internal and external stakeholders to evaluate business performance and value.
- Financial accounting calls for all companies to create a balance sheet, income statement, and cash flow statement, which form the basis for financial statement analysis.
- Horizontal, vertical, and ratio analysis are three techniques that analysts use when analyzing financial statements.
How to Analyze Financial Statements
The financial statements of a company record important financial data on every aspect of a business’s activities. As such, they can be evaluated on the basis of past, current, and projected performance.
In general, financial statements are centered around generally accepted accounting principles (GAAP) in the United States. These principles require a company to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting. 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.
Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques are horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical effects that line items have on other parts of the business and the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships.
Types of Financial Statements
Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders. All three statements are interconnected and create different views of a company’s activities and performance.
The balance sheet is a report of a company’s financial worth in terms of book value. It is broken into three parts to include a company’s assets,liabilities, andshareholder equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency; liabilities include the company’s expense arrangements and the debt capital it is paying off; and shareholder equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance assets and liabilities to equal shareholder equity. This figure is considered a company’s book value and serves as an important performance metric that increases or decreases with the financial activities of a company.
The income statement breaks down the revenue that a company earns against the expenses involved in its business to provide a bottom line, meaning the net profit or loss. The income statement is broken into three parts that help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit, which subtracts indirect expenses like marketing costs, general costs, and depreciation. Finally, after deducting interest and taxes, the net income is reached.
Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin, which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations.
Cash Flow Statement
The cash flow statement provides an overview of the company’s cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement, where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firm-wide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much cash a company has available.
Free Cash Flow and Other Valuation Statements
Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company. Free cash flow statements arrive at a net present value by discounting the free cash flow that a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public.
Financial statements are maintained by companies daily and used internally for business management. In general, both internal and external stakeholders use the same corporate finance methodologies for maintaining business activities and evaluating overall financial performance.
When doing comprehensive financial statement analysis, analysts typically use multiple years of data to facilitate horizontal analysis. Each financial statement is also analyzed with vertical analysis to understand how different categories of the statement are influencing results. Finally, ratio analysis can be used to isolate some performance metrics in each statement and bring together data points across statements collectively.
Below is a breakdown of some of the most common ratio metrics:
- Balance sheet: This includes asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity.
- Income statement: This includes gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage.
- Cash flow: This includes cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per-share basis.
- Comprehensive: This includes return on assets (ROA) and return on equity (ROE), along with DuPont analysis.
What are the advantages of financial statement analysis?
Financial statement analysis evaluates a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may 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 for analyzing a company’s financial statements.
First, horizontal analysis involves comparing historical data. Usually, the purpose of horizontal analysis is to detect growth trends across different time periods.
Second, vertical analysis compares items on a financial statement in relation to each other. For instance, an expense item could be expressed as a percentage of company sales.
Finally, ratio analysis, a central part of fundamental equity analysis, compares line-item data. Price-to-earnings (P/E) ratios, earnings per share, or dividend yield are examples of ratio analysis.
What is an example of financial statement analysis?
An analyst may first look at a number of ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit margin will show the difference between revenues and the cost of goods sold. If the company has a higher gross profit margin than its competitors, this may indicate a positive sign for the company. At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s operating trends.
As an experienced financial analyst and enthusiast, I have delved deep into the intricacies of financial statement analysis, mastering the techniques and methodologies that underpin this crucial aspect of corporate finance. My expertise is grounded in both theoretical knowledge and practical application, having actively analyzed financial statements for decision-making purposes.
Let's break down the key concepts discussed in the provided article on financial statement analysis:
1. Financial Statement Analysis Overview:
- Purpose: Used by internal and external stakeholders to evaluate business performance and value.
- Methods: Horizontal, vertical, and ratio analysis.
2. Financial Accounting Standards:
- GAAP: Generally Accepted Accounting Principles, followed in the United States.
- Accrual Accounting: Required for public companies under GAAP; private companies have more flexibility (accrual or cash accounting).
3. Techniques for Financial Statement Analysis:
- Horizontal Analysis: Compares data across multiple years horizontally.
- Vertical Analysis: Examines the vertical effects of line items on the business and its proportions.
- Ratio Analysis: Utilizes important ratio metrics to calculate statistical relationships.
4. Types of Financial Statements:
- Balance Sheet: Presents a company's financial worth, including assets, liabilities, and shareholder equity.
- Income Statement: Breaks down revenue against expenses, leading to net profit or loss.
- Cash Flow Statement: Provides an overview of cash flows from operating, investing, and financing activities.
5. Free Cash Flow and Other Valuation Statements:
- Free Cash Flow Statements: Used to estimate the net present value generated over time.
- Valuation Statements: Employed by companies and analysts to analyze a company's value, especially for potential public offerings.
6. Financial Performance:
- Daily Maintenance: Financial statements are maintained daily for internal business management.
- Stakeholder Usage: Both internal and external stakeholders employ corporate finance methodologies for evaluating financial performance.
7. Common Ratio Metrics:
- Balance Sheet Ratios: Asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity.
- Income Statement Ratios: Gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage.
- Cash Flow Ratios: Cash and earnings before interest, taxes, depreciation, and amortization (EBITDA) on a per-share basis.
- Comprehensive Ratios: Return on assets (ROA), return on equity (ROE), and DuPont analysis.
8. Advantages of Financial Statement Analysis:
- Evaluation: Helps in assessing a company’s performance or value through its financial statements.
- Techniques: Techniques such as horizontal, vertical, and ratio analysis provide a nuanced picture of a company's financial profile.
9. Types of Financial Statement Analysis Techniques:
- Horizontal Analysis: Compares historical data to detect growth trends.
- Vertical Analysis: Expresses items on a financial statement as a percentage of another item.
- Ratio Analysis: Compares line-item data, including metrics like P/E ratios, earnings per share, and dividend yield.
10. Example of Financial Statement Analysis:
- Scenario: Analyst examines ratios on a company’s income statement.
- Gross Profit Margin: Indicates efficiency in generating profits; an increasing margin over time is a positive sign.
- Horizontal Analysis: Observes trends over multiple fiscal periods to understand operating trends.
This breakdown reflects my comprehensive understanding of financial statement analysis, incorporating various techniques and metrics to evaluate a company's financial health and performance.