Financial statement analysis is the process of examining a company’s financial statements to make informed decisions. External stakeholders utilize it to understand the overall health of an organization and evaluate its financial performance and business value. Internal constituents use it as a tool for managing and monitoring finances.
Key Takeaways
- Key to Stakeholder Insights: Both internal and external stakeholders utilize financial statement analysis to assess business performance and value.
- Foundational Documents: Financial accounting mandates the creation of fundamental documents: a balance sheet, income statement, and cash flow statement, which serve as the basis for this analysis.
- Analyzing Techniques: Analysts commonly deploy three main techniques: horizontal analysis, vertical analysis, and ratio analysis.
Mastering Financial Statement Analysis
The financial statements of a company encapsulate essential financial data concerning the entirety of a business’s operations. These statements can be evaluated based on past, current, and projected performance.
Core Principles
Financial statements in the United States generally adhere to Generally Accepted Accounting Principles (GAAP). These principles require a company to prepare and maintain three primary financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies face more stringent standards for financial statement reporting, necessitating compliance with GAAP and the use of accrual accounting. Private companies have more flexibility and can opt for either accrual or cash accounting.
Analytical Techniques
Several methodologies are often employed in financial statement analysis. The three most significant techniques are horizontal analysis, vertical analysis, and ratio analysis:
- Horizontal Analysis: Involves comparing values of line items across multiple years to detect trends and growth patterns.
- Vertical Analysis: Examines the impact of line items on various components within the same financial period, revealing business proportions.
- Ratio Analysis: Utilizes key ratios to calculate and understand statistical relationships.
Dive into the Types of Financial Statements
Companies use three fundamental financial statements to run their business operations and provide transparency to stakeholders. These documents are interconnected and offer different perspectives on a company’s activities and performance.
1. Balance Sheet
The balance sheet offers a snapshot of a company’s financial worth according to book value. It consists of three parts: assets, liabilities, and shareholder equity. Short-term assets such as cash and accounts receivable highlight operational efficiency. Liabilities include expenses and debt repayment details, while shareholder equity consists of capital investments and retained earnings. Calculated as asset value minus liabilities, the balance sheet serves as an important performance metric reflecting the company’s book value.
2. Income Statement
The income statement breaks down a company’s revenue against expenses, leading to the net profit or loss figure, or the ‘bottom line.’ Divided into three parts, it assesses gross profit, operating profit, and net income. Gross profit sheds light on efficiency by subtracting direct costs from revenue, operating profit considers indirect expenses, while net income subtracts interest and taxes.
3. Cash Flow Statement
The cash flow statement summarizes the inflows and outflows of cash from operating, investing, and financing activities. It starts with net income from the income statement and delves into the operational, investment, and financing cash activities, concluding with the available cash figure.
Free Cash Flow Statements
For valuation, companies also create free cash flow statements which estimate the company’s value by discounting its projected free cash flow over time. These statements are crucial for in-depth financial assessments.
Analyzing Financial Performance
Financial statements are essential for daily management and are employed by both internal and external stakeholders using the same corporate finance methodologies to evaluate a company’s financial performance.
Analytical Approaches
Comprehensive financial statement analysis involves examining multiple years of data for horizontal analysis. Vertical analysis evaluates interrelationships within the same period, and ratio analysis isolates performance metrics for individual and collective evaluations.
Common Ratio Metrics
- Balance Sheet: Asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, debt to equity.
- Income Statement: Gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, interest coverage.
- Cash Flow: Cash availability, EBITDA calculations, per-share metrics.
- Comprehensive Metrics: Return on assets (ROA), return on equity (ROE), DuPont analysis.
Benefits of Financial Statement Analysis
The ultimate aim of financial statement analysis is to evaluate a company’s performance or value through the critical examination of the balance sheet, income statement, or statement of cash flows. By using methodologies such as horizontal, vertical, and ratio analysis, stakeholders gain a nuanced understanding of a company’s financial profile.
Methods of Financial Statement Analysis
Analysts primarily employ three techniques:
- Horizontal Analysis: Compares historical data to identify trends and growth over various periods.
- Vertical Analysis: Assesses how different items on a financial statement relate to each other, such as expenses to total sales.
- Ratio Analysis: Involves comparing specific data points like price-to-earnings ratios, earnings per share, and dividend yields.
Example of Financial Statement Analysis
An analyst might begin by examining several profitability ratios from a company’s income statement to determine efficiency and shareholder value generation. For instance, if a company boasts a higher gross profit margin than its competitors, this indicates a favorable position. The analyst may also notice an upward trend in the gross profit margin over nine fiscal periods, thus using horizontal analysis to highlight operating efficiency.
Related Terms: GAAP, accrual accounting, cash accounting, financial statements.
References
- Congressional Research Service. “Cash Versus Accrual Basis of Accounting: An Introduction”, Page 3 (Page 7 of PDF).
- Internal Revenue Service. “Publication 538 (01/2022), Accounting Periods and Methods: Methods You Can Use.”
