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 assess financial performance and commercial value. Internal constituents use it as a monitoring tool to manage finances.
Analysis of financial statements
Analysis of financial statements
A company’s financial statements record important financial data on all aspects of a business’s activities. As such, they can be assessed on the basis of past, current and projected performance.
In general, financial statements focus on generally accepted accounting principles (GAAP) in the United States. These principles require a business to create and maintain three main financial statements: the balance sheet, the income statement, and the statement of cash flows. Treasury. Public companies have higher standards for reporting financial statements. Public companies must follow GAAP standards which require accrual accounting. Private companies have more flexibility in preparing their financial statements and also have the option of using accrual or cash accounting.
Several techniques are commonly used in the analysis of financial statements. Three of the most important techniques include horizontal analysis, vertical analysis and report analysis. Horizontal analysis compares data horizontally, analyzing the values of line items over two years or more. Vertical analysis examines the vertical effects of line items on other parts of the business, as well as the proportions of the business. Ratio analysis uses important ratio metrics to calculate statistical relationships.
As mentioned, there are three main financial statements that each business creates and monitors: the balance sheet, the income statement, and the cash flow statement. Companies use these financial statements to manage their business operations and also to ensure transparency of reports to their stakeholders. The three statements are interconnected and create different views of a company’s activities and performance.
The balance sheet is a report on the financial value of a company in terms of book value. It is divided into three parts to include the assets, liabilities and equity of a business. Short-term assets such as cash and accounts receivable can speak volumes about the operational efficiency of a business. Liabilities include its spending arrangements and the loan capital it repays. Equity includes details of equity investments and retained earnings of periodic net income. The balance sheet must be balanced with assets less liabilities corresponding to equity. The resulting equity is considered to be the carrying amount of a business. This value is an important performance measure that increases or decreases with the financial activities of a company.
The income statement breaks down the income of a business against the expenses incurred in its activities to provide a net result, a net result. The income statement is divided into three parts which help analyze the efficiency of the business at three different points. It begins with revenues and the direct costs associated with revenues to identify gross profit. It then goes to operating profit which subtracts indirect expenses such as marketing costs, overheads and depreciation. Finally, it ends with a net profit which deducts interest and taxes.
Basic analysis of the income statement generally involves the calculation of the gross profit margin, the operating profit margin and the net profit margin, which each divide profit by income. The profit margin helps to show where the company’s costs are low or high at different points of operations.
The cash flow table provides an overview of the company’s cash flows from operating activities, investing activities and financing activities. The net result is reported in the cash flow table where it is included as a main item for operational activities. Like its title, investing activities include cash flows from company-wide investments. The financing activities section includes cash flows from debt and equity financing. The bottom line shows how much money a business has at its disposal.
Free cash flow and other valuation statements
Businesses and analysts also use free cash flow and other valuation reports to analyze the value of a business. Free cash flow statements arrive at a net present value by discounting the free cash flow that a company is expected to generate over time. Private companies can keep a valuation statement as they move towards a possible IPO.
Key points to remember
- Financial statement analysis is used by internal and external stakeholders to assess the performance and value of the business.
- Financial accounting calls on all companies to create a balance sheet, an income statement and a statement of cash flows that form the basis for analysis of the financial statements.
- Horizontal, vertical and ratio analysis are three techniques used by analysts to analyze financial statements.
Financial statements are maintained daily by companies and used internally for business management. In general, internal and external stakeholders use the same corporate financing methodologies to maintain business activities and assess overall financial performance.
When performing a complete analysis of financial statements, analysts typically use several years of data to facilitate horizontal analysis. Each financial statement is also analyzed with a vertical analysis to understand how the different categories of the statement influence the results. Finally, ratio analysis can be used to isolate certain performance measures in each instruction and also collectively collect the instruction data points.
Below is a breakdown of some of the most common ratio metrics:
Balance sheet: asset turnover, rapid ratio, receivables turnover, days on sales, debt on assets and debt on equity
Income statement: gross profit margin, operating profit margin, net profit margin, efficiency of the tax ratio and interest coverage
Cash flow: cash and profit before interest, taxes, depreciation and amortization (EBITDA). These measurements can be displayed by action.
Complete: return on assets (ROA) and return on equity (ROE). DuPont analysis also.