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What is 'Financial Statement Analysis'

Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes and to understand the overall health of an organization. Financial statements record financial data, which must be evaluated through financial statement analysis to become more useful to investors, shareholders, managers, and other interested parties.

BREAKING DOWN 'Financial Statement Analysis'

Financial statement analysis is an evaluative method of determining the past, current, and projected performance of a company. Several techniques are commonly used as part of financial statement analysis including horizontal analysis, which compares two or more years of financial data in both dollar and percentage form; vertical analysis, in which each category of accounts on the balance sheet is shown as a percentage of the total account; and ratio analysis, which calculates statistical relationships between data.

[Financial statements are the most important and easily understood documents for long-term investors to analyze for new investment opportunities. In addition to showing revenue growth and profitability, financial statements show debt coverage ratios, free cash flow generation, and other important information. Investopedia's Fundamental Analysis Course (a five-hour course with on-demand video, exercises, and interactive content) demonstrates how to read financial statements, interpret financial ratios, and make informed investment decisions.]

Financial Statements

Financial statement analysis allows analysts to identify trends by comparing ratios across multiple periods and statement types. These statements allow analysts to measure liquidity, profitability, company-wide efficiency, and cash flow. There are three main types of financial statements: the balance sheet, income statement and cash flow statement. The balance sheet is a snapshot of the company's assets, liabilities, and shareholders' equity at a specific period. Analysts use the balance sheet to analyze trends in assets and debts. The income statement begins with sales and ends with net income. It also provides analysts with the gross profit, operating profit, and net profit. Each of these is divided by sales to determine gross profit margin, operating profit margin, and net profit margin, respectively. The cash flow statement provides an overview of the company's cash flows from operating activities, investing activities, and financing activities.

Financial Statement Analysis

Each financial statement provides multiple years of data. Used together, analysts track performance measures across financial statements using several different methods for financial statement analysis, including vertical, horizontal, and ratio analyses. An example of vertical analysis is when each line item on the financial statement is listed as a percentage of another. Horizontal analysis compares line items in each financial statement against previous time periods. In ratio analysis, line items from one financial statement are compared with line items from another. For example, many analysts like to know how many times a company can pay off debt with current earnings. Analysts do this by dividing debt, which comes from the balance sheet, by net income, which comes from the income statement. Likewise, return on assets (ROA) and the return on equity (ROE) compare company net income found on the income statement with assets and stockholders' equity found on the balance sheet.

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