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 as well as 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 analysts use when analyzing financial statements.
Financial Statement Analysis
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 U.S. 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 also 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 include 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 line items have on other parts of the business and also 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 also 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, and shareholders' 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’s 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’s 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 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 such as 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 firmwide 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 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 also 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. 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 operating trends.