What is a Financial Statement Analysis?

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Definition:

Financial statement analysis uses information from financial statements to evaluate a company’s performance and help investors make data-backed decisions.

🤔 Understanding financial statement analysis

Financial statement analysis is a study of a company’s financial statements to gain the necessary knowledge to make decisions. Balance sheets, income statements, and cash flow statements are key reports used in financial statement analysis. Internal stakeholders use financial statement analysis to track performance according to company goals. External stakeholders use financial statement analysis to gain insights into a company's financial performance and estimate its value. Two typical types of financial statement analysis are ratio analysis and common-size analysis. Ratio analysis uses mathematical calculations with items from a company’s financial statements to express relationships. Common-size analysis shows accounts as percentages using other accounts as a base for one or several periods. Ratio and common-size analysis signal trends in a company’s performance.

Example

Let’s imagine that you’re looking to invest in a publicly-traded U.S. tech company. To help you choose a company with a good track record of profitability, you can perform a type of financial statement analysis referred to as ratio analysis. To evaluate a tech company’s profitability, you could use a profitability ratio known as the return on assets or ROA (ROA = Net Income/Average Total Assets). Through the ROA, you can determine the tech company that provided the highest ratio over a period. All things being equal, the company with the highest ROA would be the right choice for your investment.

Takeaway

Using financial statement analysis is like comparing two movies…

When rating two films, you can just say one is better or worse than the other. However, most people will want an explanation behind your rating. If you were to have a set of criteria for comparing the two movies, you’d have better support for your rating. Likewise, financial statement analysis provides a framework to compare the performance of two companies.

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What is a financial statement analysis?

Financial statement analysis evaluates a company’s performance by seeking trends in its financial statements. Examples of financial statements (financial reports over a period) used in financial statement analysis are:

  • Balance sheet: A summary of all of the company's assets, liabilities, and shareholders’ equity as of a certain date.
  • Income statement: An overview of the revenue and expenses of a company during a defined period, providing you a company’s net income (revenue - expenses, also referred to as bottom line).
  • Cash flow statement: A breakdown of a company’s cash inflows and outflows into investing, financing, and operating activities during a stated time period. A cash flow statement is also referred to as a statement of cash flows.

How do you find trends in financial statement analysis?

In financial statement analysis, you seek trends in financial performance through two techniques: ratio analysis and common-size analysis.

Ratio Analysis

A type of financial statement analysis that uses financial ratios (mathematical calculations using data from financial statements) to seek signals in company performance.

There are many types of financial ratios. Examples of financial ratios include:

  • Liquidity ratios: Financial ratios measuring a company’s ability to pay its debts due within a year.
  • Profitability ratios: Financial ratios measuring a company’s ability to generate revenue.
  • Efficiency ratios: Financial ratios measuring a company’s ability to complete day-to-day operations.

Common size analysis

Another type of financial statement analysis that sets a base for an account (e.g., cash, accounts receivable, and accounts payable) and expresses other accounts as a percentage of that account.

Vertical analysis is a common size analysis that focuses on a single period, while a horizontal analysis uses two or more periods.

Example of ratio analysis

Let’s assume a company needs to buy a piece of production equipment and finds a vendor offering credit due within six months. To decide whether or not to approve the loan to the company, the lender can perform ratio analysis to determine the company’s liquidity — The ability to pay loans due within a year.

An example of liquidity ratios is the current ratio (Current Ratio = Current Assets/Current Liabilities). The lender can use the current ratio to evaluate the company’s ability to pay its debts due within a year (current liabilities) with resources that turn into cash within a year (current assets).

Example of common-size analysis

Using the same scenario above, the lender could also use cash as a base and calculate current assets and current liabilities as percentages of cash. If the lender uses a single period, this analysis is a horizontal common-size analysis.

Through this horizontal analysis, a lender can have a better idea of the percentage of cash that the company has to meet its short-term debts.

Why are financial statements analyzed?

Individuals often prefer to analyze financial statements because these reports generally have to meet commonly accepted guidelines for financial reporting.

In the United States, a company typically prepares its financial statements according to the generally accepted accounting principles (GAAP). In Europe and other countries, financial statements often follow the guidelines from the International Financing Reporting Standards (IFRS).

Since public financial statements generally must meet reporting standards, financial statements provide a source of data with consistent formatting. By sticking to a set of well-defined rules, financial statements are useful for financial analysis.

Additionally, financial statements from publicly-traded companies are readily available. In the United States, publicly-traded companies must follow GAAP guidelines and publicly disclose their financial statements. However, private companies have more flexibility in the preparation and disclosure of financial statements.

How do you analyze a financial statement?

A financial statement analysis often involves six steps:

  • Define the objective for the analysis: Examples of goals are the evaluation of an equity investment in a company or the application for a business loan.
  • Collect the necessary data: Besides a company’s financial statements, you may need additional reports, such as quarterly or annual filings with the Securities and Exchange Commission (SEC), the regulatory body of security markets in the United States. Process the collected data: You can use financial analysis techniques, including ratio analysis and common-size analysis (vertical analysis and horizontal analysis).
  • Interpret the processed data: After performing your calculations, you can use the processed data to seek meaning such as relevant trends based on your analysis’s objective.
  • Communicate findings and recommendations: Using the information provided, you present a recommendation (e.g., “make the investment”, “don’t approve the loan”) and provide the supporting information.
  • Repeat process, if needed: Depending on several factors (like the number of decision-makers, new information, or evolving situation), you may need one or more rounds of this process for a successful financial statement analysis.

What are the types of financial statements?

The primary types of financial statements are:

  • Balance sheet: A snapshot of a company’s financial position over a period. A balance sheet consolidates all company accounts into assets, liabilities, and shareholder’s equity.
  • Income statement: A summary of a company’s profit over a period. An income statement lists revenue and expenses as line items to calculate the net income (revenue - expenses).
  • Cash flow statement: A statement of cash flows lists a company’s cash inflows and outflows over a period. A cash flow statement classifies cash inflows and outflows into cash flows from financing, investing, and operating activities.
  • Statement of owner’s equity: A summary of the changes to the shareholder’s equity account. If the company owners were to retain earnings over the period, a statement of retained earnings would be a necessary item for the statement of owner’s equity.

What are the methods of financial statement analysis?

The main methods of financial statements analysis are ratio analysis and common-size analysis.

Ratio analysis

Over time, analysts have found relationships between the accounts in a company’s financial statement. For instance, the amount of dollars in total liabilities per every dollar of shareholder’s equity signals a company’s solvency — A company’s ability to pay its long-term debts.

A creditor can use solvency ratios in a financial statement analysis to evaluate a company’s ability to pay back a loan due in five years. The creditor can also use financial ratios to assess the quality of the company’s assets to be used as collateral for the loan.

Common size analysis

By calculating accounts as a percentage of another account (common-size analysis), you can also understand the relationship between accounts in a financial statement.

For example, you could express a cash flow statement as a common-size cash flow statement by calculating all line items as percentages of total cash flows. A common size cash flow statement would allow you to understand what percent of total cash flows goes into operating, investing, and financing activities.

A common size analysis using a single period is a vertical analysis, while one using several periods is a horizontal analysis. An operations manager can use common-size analysis to track their department’s ability to meet spending goals.

What tools are used for financial analysis?

Spreadsheet software (like Excel, Numbers, or Google Spreadsheets) is often an essential tool for financial analysis. Ratio analysis and common-size analysis require the calculation of several operations. Spreadsheet applications allow you to automate calculations, handle large amounts of financial information, edit your work efficiently, and share it quickly with others.

Graph software and regression software are also essential tools for financial analysis.

  • Graphs can be useful to visually represent a finding from your financial statement analysis.
  • Regressions can play a role in making predictions about accounts. Regression analysis is a type of quantitative analysis that uses mathematical models to make predictions.
  • Most spreadsheet software includes some kind of graph and regression tools.

How do you create a financial analysis report?

The guiding principles for developing a financial analysis report are the report’s objective and applicable laws and regulations.

Objective: The report’s objective serves as a guideline into the formality and length of the report.

  • For example, a lender deciding whether or not to approve an average of 20 loans per day may look for a one-paragraph report highlighting three critical financial ratios.
  • Alternatively, a financial analyst making a recommendation to allocate a $1M investment to an investment portfolio manager may need a very lengthy and comprehensive report.

Laws and regulations: Some financial analysis reports are subject to applicable laws and regulations that may require strict adherence to a specific format.

There are several types of financial analysis templates available depending on what type of analysis you’re trying to perform. Many of them can be found online for free.

What is the importance of financial reporting and analysis?

Financial reporting and analysis are essential for decision making that’s backed by financial information.

The purpose of financial reporting and analysis is to provide a recommendation, such as approving a loan or allocating funds to an investment.

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