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 stakeholders use it as a monitoring tool for managing the finances.
Analyzing 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 standards 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 affects 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.
As mentioned, there are three main financial statements that every company creates and monitors: the balance sheet, income statement, and cash flow statement. Companies use these financial statements to manage the operations of their business and also to provide reporting 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 its expense arrangements and the debt capital it is paying off. Shareholder’s equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance with assets minus liabilities equaling shareholder’s equity.
The resulting shareholder’s equity is considered a company’s book value. This value is 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, net income profit or loss. The income statement is broken into three parts which 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, it ends with net profit which deducts interest and taxes.
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.
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 – Asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity
- Income statement – Gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage
- Cash flow – Cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per share basis.
- Key performance indicators (KPIs) – KPIs are a measurable value that demonstrate how effectively a company is achieving key business objectives. KPIs are evaluated over a specified time period, and are compared against past performance metrics or acceptable norms.
Examples of KPIs include: Sales KPIs (e.g., number of new contracts; dollar value of new contracts); Financial KPIs (e.g., growth in revenue, gross profit margin; net profit margin); Customer KPIs (e.g., number of customers retained, percentage of market share); Marketing KPIs (e.g., monthly website traffic, number of qualified leads, and blog articles published).
What would some KPIs be for your business?