Analysis of Financial Statements

What is Analysis of Financial Statements?

The analysis of financial statements is a procedure of studying a company's financial reports for decision-making purposes.

This technique is used by many stakeholders, including credit and equity investors, the government, the general public, and internal decision-makers. Stakeholders also have various interests, and they prefer to use various strategies to achieve their requirements.

In addition, equity investors use financial analysis to determine and predict an organization's long-term profit potential and the sustainability and growth of dividend payments.

Creditors also use these statements to ensure that the interest and principal on the company's debt securities (such as bonds) can and will be paid on time. External stakeholders use it to assess an organization's general status and financial performance.

Internal stakeholders use analysis as a personal financial management monitoring tool. These stakeholders can evaluate and measure the value and risk of their investments, to which they can then make decisions regarding their current positions.

A financial statement is also a technique for assessing and displaying an organization's risks, performance, financial health, and prospects using specialized approaches.

In this article, we will cover the three types of financial statement analysis, how each form of financial analysis can be applied, and the main techniques analysts can use to analyze any statements.

How to analyze financial statements?

A company's financial statements track crucial financial data on all aspects of its operations. As a result, they may be assessed based on their past, current, and future performance.

Financial reports are subject to generally accepted accounting principles (GAAP) as a requirement by the SEC. There are three main types that a corporation must prepare under these standards:

• Income statement
• Balance Sheet
• Cash flow statement

Additional statements that are common for public companies to publish are:

• Notes to accounts
• Statement of changes in equity

There are many techniques and equations that can be used to analyze these statements, such as fundamental analysis, the DuPont analysis, horizontal and vertical analysis, and the use of financial ratios.

In addition, the following are five of the most prevalent techniques used in financial statement analysis:

1. Horizontal analysis: analyzes data over two or more years by comparing the values of line items.
2. Vertical analysis: examines the vertical impacts of line items on other sections of the business as well as the proportions of the company.
3. Ratio analysis: creates statistical links using important ratio measures.
4. Fundamental analysis: determining the worth of an asset and analyzing the factors that may impact its price in the future.
5. DuPont analysis: a strategy to resolve many drivers of return on equity (ROE)

The different types of financial statements are:

Balance Sheet 

A balance sheet shows a corporation's assets, liabilities, and shareholder equity at a certain point in time. It serves as the foundation for calculating investor returns and assessing a company's financial structure.

It also shows what a company owns and owes and how much money shareholders have invested. Balance sheets can be combined with other essential financial accounts to conduct basic analysis or calculate financial ratios.

Assets or liabilities that do not display on a company's balance sheet are referred to as off-balance sheet (OBS) items. They are, nonetheless, assets and liabilities of the organization, even though they are not recorded on the balance sheet.

• Balance sheets should be compared to previous periods.
• Off-balance sheet items are usually ones the company does not own or are not a direct obligation of the company.
• Investors can use ratios from a balance sheet to get an overview of a company's financial health.
• Because various sectors have varied ways of financing, balance sheets should be compared to those of other enterprises in the same industry.
• Users can use the balance sheet to determine whether a company has a positive net worth.
• Also, to determine whether it has enough cash and short-term assets to cover its obligations and whether it is highly indebted compared to its peers.

This statement of a company's financial worth is expressed as book value, and it is divided into three sections:

1. Assets

Usually, assets can be used to manufacture commodities, fund operations, and drive expansion. Physical assets could be machinery, property, raw materials, and inventories. Intangible assets are patents, royalties, and other intellectual property.

Companies account for their assets and categorize them based on criteria representing their liquidity, how easily they can be converted to cash, whether they are physical or non-physical assets, and how they are utilized to produce value.

Assets are classified into two categories: 

• Current assets can be converted to cash in one year or less, and non-current or long-term assets cannot.
• Assets like cash and accounts receivable can reveal much about a company's operational efficiency.

Assets = Liabilities + Shareholders’ Equity

2. Liabilities

Any money owed to a third party by a corporation, ranging from bills owed to suppliers to interest on bonds given to creditors to rent, utilities, and salaries, are considered liabilities.

For example, short-term liabilities include payroll expenses and accounts payable, which include money owed to vendors, monthly utilities, and other expenses. Wages payable consider the total amount of accrued income that employees have not received.  

Current liabilities have a one-year due date and are presented in order of maturity. On the other hand, long-term liabilities are payable after one year at any time. It also includes the company's expense arrangements and the debt capital it is repaying.

Tax relief is offered in advance of an accounting expense/unpaid liabilities, or revenue is accrued but not taxed until it is received, resulting in deferred tax liabilities—the amount of taxes that have accrued but will not be paid for another year.

3. Shareholders' equity

Shareholders' equity is the amount returned to shareholders if a company's total assets were liquidated and all of its debts repaid. Analysts typically use this financial statistic to assess a company's financial health.

It contains data on equity capital investments and retained earnings from periodic net income. It is also known as net assets since it equals a company's total assets less its liabilities or debt owed to non-shareholders.

Income Statement

An income statement presents the income and expenses of a firm. It compares a company's revenue to its operating expenditures to reach a bottom line, such as net profit or loss.

It also displays if a firm is profitable or losing money over a certain period to explain the efficacy of the business's plans at the start of a financial quarter. This report with the balance sheet and cash flow statement helps understand your company's financial health.

In addition, it supports business owners in determining if they can profit by growing sales, lowering expenditures, or doing both. Business owners can also use income statements to determine if their strategies have paid off.

An income statement is the main component of a company's performance reports that must be filed with the Securities and Exchange Commission (SEC).

This report has three sections, each of which helps in the analysis of business efficiency at three separate levels, as shown below:

• First, calculate gross profit, and the formula is:

Gross Profit = Revenue – Cost of Goods Sold

• Then, the operating profit subtracts indirect expenses like marketing costs, general costs, and depreciation.
• Finally, the net income is calculated after subtracting interest and taxes.

The computation of gross profit margin, operating profit margin, and net profit margin, which each divides profit by revenue, is a common part of basic income statement analysis.

Cash Flow Statement

The cash flow statement (CFS) outlines the inflow and outflow of cash and cash equivalents (CCE) into and out of business.

I. CFS shows how the company's cash flows from the main three operations: operating, investment, and financing.

a. Operating Activities (OCF): This shows how much money a firm makes from its products or services, such as salary, wage, rent, income tax, and interest payments.

b. Investing Activities (ICF): This category includes asset purchases or sales, loans paid to suppliers or received from customers, and any payments associated with mergers and acquisitions (M&A).

c. Financing Activities (CFF): The sources of cash from investors and banks and how cash is delivered to shareholders.

• Include any dividends, stock repurchase payments, and principal debt repayment (loans) paid by the industry corporation.

II. This statement estimates a company's ability to manage its cash position or how successfully it generates cash to meet debt commitments and support operational expenses. 

III. The direct and indirect methods are the two approaches for calculating cash flow.

As seen below, the cash follows statement has various outlines that describe its activities:

The top-line item for operating activities is net income, which is carried over to the cash flow statement. Moving to the next line, which is investing activities, comprises cash flows associated with firm-wide investments.

Then, the cash flow from debt and equity financing is included in the financing activities section. Ultimately, the bottom line reveals how much cash a business has on hand.

Edited by Colt DiGiovanni | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Account Balance
• Debt
• Interest Rate
• Market Capitalization
• Stock Exchange