Techniques of Financial Statement Analysis

Finance is crucial to every corporation and functions as the industry’s language. Financial analysis is a terminology that refers to assessing the qualities of any company or business activity.

Tools for financial statement analysis can help evaluate a company’s performance and performance patterns. An analyst transforms data and information into financial metrics to aid decision-making. Analysts try to answer queries like: How well has the business done compared to its rivals and historical performance? What future performance can we expect from the company? What is the worth of this firm or the assets it issues based on predictions for future implementation?

Financial condition is analyzed through financial statement analysis to aid in decision-making. It enables external stakeholders to assess the company’s financial performance and market worth.

Types of Financial Statements

For a thorough understanding of financial analysis, let’s first understand the financial statement meaning. Financial statements are documents that describe a company’s operations and financial performance. The income statement, balance sheet, and cash flow statement are the three types of financial statements that any company has to analyze.

1. Balance sheet

The balance sheet displays a company’s book value towards the end of a financial year. Assets, liabilities (debt), and shareholder’s equity comprise its three components. Subtracting debt from assets is the simplest procedure for calculating book value or shareholder’s equity. The book value is a crucial performance indicator that changes according to the company’s financial activity, either increasing or decreasing.

A balance sheet helps in analyzing the liquidity position, leverage situation, and efficiency of the company on how well it manages its assets and liabilities. It is a fine print to analyze what amount a company owns as assets and what amount it owes as liabilities.

2. Income Statement

It displays a thorough account of a business’s revenue generation. It also goes by the name “profit and loss statement” and gives decision-makers a clear picture of whether the company is profitable.

The income statement has three primary components: revenues (amount earned by sales of goods and services), expenses (cost incurred), and net profit (final profit or loss). By analyzing the profit and revenue numbers over the years, you can directly gauge the financial health of a company.

3. Cash Flow Statement

It gives information on the amount of cash or cash equivalent that moves through the corporation through various inflows and outflows, including funds from financing, ongoing operational operations, and outside investment sources. It is a report card for how well a company manages its cash flow.

A crucial document for assessing a company’s financial performance is the cash flow statement, which works in conjunction with the balance sheet and income statement.

One more famous term in this statement is “free cash flow.” FCF is the leftover cash available with the company after covering operating costs and buying assets. This is a sign of cash left with the company to repay loans, dividend payments, and re-investment for growth purposes.

Methods of Financial Statement Analysis

A few different types of financial statement analysis can be performed, but they all aim to give insights into a company’s financial health and performance.

There are six widely used methods for analyzing financial statements: horizontal and vertical analysis, cost-volume-profit analysis, ratio analysis, trend analysis, and common-size analysis. Each approach enables the creation of a more thorough and complex financial profile.

1. Horizontal Analysis

The result of a horizontal analysis is often shown as a percentage increase in the same line item within the base year. It compares previous data (such as line items and ratios). Here, the performances of two or more periods are compared to comprehend the organization’s development through time. To get a broad sense of trends, each item in a ledger is contrasted to the prior time frame.

For instance, some components may cost the corporation more if the value of finished items increases by 10% over a year without being reflected in sales.

Financial professionals can estimate future forecasts and readily identify growth patterns and trends. Comparing growth rates across sector competitors is made simpler by this sort of study, which also provides insight into an organization’s operational outcomes and determines if it is doing so profitably and efficiently.

2. Vertical Analysis

A connection between different ledger line items is made via vertical analysis. With the help of vertical analysis, the performance of overall income and spending is outlined for analysts.

Here each line item is a percentage of every other item on the statement. For example, each line item on an income statement is expressed as a percentage of gross sales, whereas every line item on a balance sheet is shown as a percentage of total assets. Analysts can now analyze total performance in the context of revenues and costs.

3. Cost-volume Profit Analysis

Businesses may better comprehend the connection between sales, expenses, and profit with this analysis method. To aid the company’s top management in better planning and profit projection, it evaluates fixed and variable costs and defines the link between variable costs and sales.

Companies apply this method to gauge the breakeven point or profit they can start making by selling a specified number of units. It shows how the change in fixed cost, variable cost, and sales volume can determine the operating profit.

4. Trend Analysis

It involves looking at a company’s financial statements over time to see how it has been performing. This can be done on a macro level by looking at industry trends, or on a micro level, by looking at a company’s historical data.
Based on the assumption that what has happened in the past will happen again soon, it enables businesses to better anticipate and plan for rising trends and downward reversals within certain market sectors. Trend analysis is a helpful strategy since investors will make money if they follow directions (upward, downward, and sideways) rather than going against them.

5. Ratio Analysis 

It involves taking key financial metrics and comparing them to each other or industry averages to see how a company is performing in key areas.

Once the ratio has been determined, it may be compared to the previous period to see if the company’s performance aligns with predetermined goals. It enables management to identify any departure from expectations and implement remedial actions.

There are different ratios to analyze different parameters of a company such as current ratio (liquidity), debt-to-equity ratio (leverage), profit margin ratio (profitability), inventory turnover ratio (efficiency), and PE ratio (valuation).

6. Common-size Analysis 

It involves looking at a company’s financial statements and comparing all of the items on the statement to a base year. This is done to see how a company’s financials have changed over time and to identify trends.

In the balance sheet, the total assets are taken as common or base value and in the income statement, the base value is taken as revenues. This method helps with competitor analysis by understanding their capital structure and how much they are spending in line with the revenues.

Conclusion

Financial statement analysis can be performed by anyone with access to a company’s financial statements. However, it is most commonly done by financial analysts, investors, and creditors.

Financial statement analysis is essential for adhering to corporate rules and regulations, but the information also has many uses for the organization. Business owners may recognize their economic weaknesses and strengths, stay current on their bills, and ascertain their profit margins by studying financial statements.

You may examine a company’s finances with these financial statement analysis techniques, but you shouldn’t rely just on the facts. Make sure you research before purchasing stocks from a company.

Author: All Content is verified by SMC Global Securities.