Financial Statement Analysis An Introduction

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Financial Statement Analysis: An Introduction

September 14, 2015 | by Anastasia 3 0

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Home Magazine Financial Statement Analysis: An Introduction
Financial Statement Analysis is a method of reviewing and analyzing a companys accounting reports
(financial statements) in order to gauge its past, present or projected future performance. This process of
reviewing the financial statements allows for better economic decision making.
Globally, publicly listed companies are required by law to file their financial statements with the relevant
authorities. For example, publicly listed firms in America are required to submit their financial statements
to the Securities and Exchange Commission (SEC). Firms are also obligated to provide their financial
statements in the annual report that they share with their stakeholders. As financial statements are
prepared in order to meet requirements, the second step in the process is to analyze them effectively so
that future profitability and cash flows can be forecasted.
Therefore, the main purpose of financial statement analysis is to utilize information about the past
performance of the company in order to predict how it will fare in the future. Another important purpose of
the analysis of financial statements is to identify potential problem areas and troubleshoot those.
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Shutterstock.com | samui
Here, we will look at 1) the users of financial statement analysis, 2) the methods of financial
statement analysis, 3) key accounting reports (the balance sheet, income statement, and statement
of cash flows) and how they are analyzed, 4) other financial statement information, and 5) problems
with financial statement analysis.
USERS OF FINANCIAL
STATEMENT ANALYSIS
There are different users of financial statement analysis. These can be classified into internal and external
users. Internal users refer to the management of the company who analyzes financial statements in order
to make decisions related to the operations of the company. On the other hand, external users do not
necessarily belong to the company but still hold some sort of financial interest. These include owners,
investors, creditors, government, employees, customers, and the general public. These users are
elaborated on below:
1. Management
The managers of the company use their financial statement analysis to make intelligent decisions about
their performance. For instance, they may gauge cost per distribution channel, or how much cash they
have left, from their accounting reports and make decisions from these analysis results.
2. Owners
2. Owners
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Small business owners need financial information from their operations to determine whether the
business is profitable. It helps in making decisions like whether to continue operating the business,
whether to improve business strategies or whether to give up on the business altogether.
3. Investors
People who have purchased stock or shares in a company need financial information to analyze the way
the company is performing. They use financial statement analysis to determine what to do with their
investments in the company. So depending on how the company is doing, they will either hold onto their
stock, sell it or buy more.
4. Creditors
Creditors are interested in knowing if a company will be able to honor its payments as they become due.
They use cash flow analysis of the companys accounting records to measure the companys liquidity, or
its ability to make short-term payments.
5. Government
Governing and regulating bodies of the state look at financial statement analysis to determine how the
economy is performing in general so they can plan their financial and industrial policies. Tax authorities
also analyze a companys statements to calculate the tax burden that the company has to pay.
6. Employees
Employees need to know if their employment is secure and if there is a possibility of a pay raise. They
want to be abreast of their companys profitability and stability. Employees may also be interested in
knowing the companys financial position to see whether there may be plans for expansion and hence,
career prospects for them.
7. Customers
Customers need to know about the ability of the company to service its clients into the future. The need
to know about the companys stability of operations is heightened if the customer (i.e. a distributor or
procurer of specialized products) is dependent wholly on the company for its supplies.
8. General Public
Anyone in the general public, like students, analysts and researchers, may be interested in using a
companys financial statement analysis. They may wish to evaluate the effects of the firm on the
environment, or the economy or even the local community. For instance, if the company is running
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corporate social responsibility programs for improving the community, the public may want to be aware of
the future operations of the company.
METHODS OF FINANCIAL
STATEMENT ANALYSIS
There are two main methods of analyzing financial statements: horizontal or trend analysis, and vertical
analysis. These are explained below along with the advantages and disadvantages of each method.
Horizontal Analysis
Horizontal analysis is the comparison of financial information of a company with historical financial
information of the same company over a number of reporting periods. It could also be based on the ratios
derived from the financial information over the same time span. The main purpose is to see if the numbers
are high or low in comparison to past records, which may be used to investigate any causes for concern.
For example, certain expenditures that are high currently, but were well under budget in previous years
may cause the management to investigate the cause for the rise in costs; it may be due to switching
suppliers or using better quality raw material.
This method of analysis is simply grouping together all information, sorting them by time period: weeks,
months or years. The numbers in each period can also be shown as a percentage of the numbers
expressed in the baseline (earliest/starting) year. The amount given to the baseline year is usually 100%.
This analysis is also called dynamic analysis or trend analysis.
Advantages and Disadvantages of Horizontal Analysis
When the analysis is conducted for all financial statements at the same time, the complete impact of
operational activities can be seen on the companys financial condition during the period under review.
This is a clear advantage of using horizontal analysis as the company can review its performance in
comparison to the previous periods and gauge how its doing based on past results.
A disadvantage of horizontal analysis is that the aggregated information expressed in the financial
statements may have changed over time and therefore will cause variances to creep up when account
balances are compared across periods.
Horizontal analysis can also be used to misrepresent results. It can be manipulated to show comparisons
across periods which would make the results appear stellar for the company. For instance, if the profits
for this month are only compared with those of last month, they may appear outstanding but that may not
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be the case if compared with the same month the previous year. Using consistent comparison periods
can address this problem.
Vertical Analysis
Vertical analysis is conducted on financial statements for a single time period only. Each item in the
statement is shown as a base figure of another item in the statement, for a given time period, usually for
year. Typically, this analysis means that every item on an income and loss statement is expressed as a
percentage of gross sales, while every item on a balance sheet is expressed as a percentage of total
assets held by the firm.
Vertical analysis is also called static analysis because it is carried out for a single time period.
Advantages and Disadvantages of Vertical Analysis
Vertical analysis only requires financial statements for a single reporting period. It is useful for inter-firm or
inter-departmental comparisons of performance as one can see relative proportions of account balances,
no matter the size of the business or department.
Because basic vertical analysis is constricted by using a single time period, it has the disadvantage of
losing out on comparison across different time periods to gauge performance. This can be addressed by
using it in conjunction with timeline analysis, which shows what changes have occurred in the financial
accounts over time, such as a comparative analysis over a three-year period. For instance, if the cost of
sales comes out to be only 30 percent of sales each year in the past, but this year the percentage comes
out to be 45 percent, it would be a cause for concern.
KEY FINANCIAL
STATEMENTS & HOW
THEY ARE ANALYZED
The main types of financial statements are the balance sheet, the income statement and the statement of
cash flows. These accounting reports are analyzed in order to aid economic decision-making of a firm
and also to predict profitability and cash flows.
I. The Balance Sheet

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Wikimedia Commons
The balance sheet shows the current financial position of the firm, at a given single point in time. It is also
called the statement of financial position. The structure of the balance sheet is laid out such that on one
side assets of the firm are listed, while on the other side liabilities and shareholders equity is shown. The
two sides of the balance sheet must balance as follows:
Assets = Liabilities + Shareholders Equity
The main items on the balance sheet are explained below:
Current Assets
Current assets held by the firm refer to cash and cash equivalents. These cash equivalents are assets that
can be easily converted into cash within one year. Current assets include marketable securities, inventory
and accounts receivable.
Long-term Assets
Long-term assets are also called non-current assets and include fixed assets like plant, equipment and
machinery, and property, etc.
A firm records depreciation of its fixed, long-term assets every year. It is not an actual expense of cash
paid, but is only a reduction in the book value of the asset. The book value is calculated by subtracting
the accumulated depreciation of prior years from the price of the assets.
Total Assets = Current Assets + Book Value of Long-Term Assets
Current Liabilities
Current liabilities of the firm are obligations that are due in less than one year. These include accounts
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payable, deferred expenses and also notes payable.
Long-term Liabilities
Long-term liabilities of the firm are financial payments or obligations due after one year. These include
loans that the firm has to repay in more than a year, and also capital leases which the firm has to pay for
in exchange for using a fixed asset.
Shareholders Equity
Shareholders equity is also known as the book value of equity or net worth of the firm. It is the difference
between total assets owned by a firm and total liabilities outstanding. It is different from the market value
of equity (stock market capitalization) which is calculated as follows: number of shares outstanding
multiplied by the current share price.
Balance Sheet Analysis

The balance sheet is analyzed to obtain some key ratios that help explain the health of the firm at a given
point in time. These metrics are as follows:
Debt-Equity Ratio = Total Debt / Total Equity
The debt-equity ratio is also called a leverage ratio. It is calculated to assess the leverage, or gearing, of a
firm to show how much it relies on debt to finance its activities. This ratio has pertinent implications for
the financial health of the firm and the risk and return of its shares.
Market-to-Book Ratio = Market Value of Equity / Book Value of Equity
The market-to-book ratio is used to reflect any changes in a firms characteristics. The variations in this
ratio also show any value added by the management and its growth prospects.
Enterprise Value = Market Value of Equity + Debt Cash
The enterprise value of a firm shows the underlying value of the business. It reflects the true value of the
firms assets, not including any cash or cash equivalents, while unencumbered by the debt the firm
carries.
II. The Income Statement
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Wikimedia Commons | Microsoft
The purpose of an income statement is to report the revenues and expenditures of a firm over a specific
period of time. It was previously also called a profit and loss account. The general structure of the income
statement with major components is as follows:
Sales revenue
Cost of goods sold (COGS)
= Gross profit
Selling, general and administrative costs (SG&A)
Research and development (R&D)
= Earnings before interest, taxes, depreciation and amortization (EBITDA)
Depreciation and amortization
= Earnings before interest and taxes (EBIT)
Interest expense
= Earnings before taxes (EBT)
Taxes
= Net income
The net income on the income statement, if positive, shows that the company has made a profit. If the net
income is negative, it means the company incurred a loss.
Earnings per share can be derived from knowing the total number of shares outstanding of the company:
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Earnings per Share = Net Income / Shares Outstanding
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Income statement Analysis
Some useful metrics based on the information provided in the income statement and the balance sheet
are as follows:
Profitability Ratios:
1. Net profit margin: This ratio calculates the amount of profit that the company has earned after taxes
and all expenses have been deducted from net sales.
Net profit Margin =Net Income / Net Sales
2. Return on Equity: This ratio is used to calculate company profit as a percentage of total equity.
Return on Equity = Net Income / Book Value of Equity
Valuation Ratios:
Price to earnings ratios (P/E ratio)
The P/E ratio is used to evaluate whether the value of a stock is proportional to the level of earnings it can
generate for its stockholders. It assesses whether the stock is overvalued or undervalued.
(P/E) Ratio = Market Capitalization / Net Income = Share Price / Earnings per Share
III. The Statement of Cash Flows

The statement of cash flows shows explicitly the sources of the firms cash and where the cash is utilized.
It is essentially a statement whereby the net income is adjusted for non-cash expenses and any changes
to the net working capital. It also reflects changes in cash coming from, or being used by, investing and
financing activities of the firm. The structure and main components of the cash flow statement are as
follows:
Cash from operating activities = Net income + Depreciation Changes in net working capital
Cash from financing activities = New debt + New shares Dividends Shares repurchased
Cash from investment activities = Capital expenditure Proceeds from sales of long-term assets
All three of the above determine the bottom line: changes in cash flows.
Cash Flows Statement Analysis

In order to measure how much cash is available to the company for investments without outside financing
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or money diverting from operations, it is useful to conduct a simple cash flow statement analysis. The free
cash flow, as the name suggests, allows a company to be able to pay dividends, repay its debts, buy
back its stock and also make new investments to facilitate future growth. The excess cash produced by
the company, free cash flow, is calculated as follows:
Net Income
+ Amortization/Depreciation
Changes in Working Capital
Capital Expenditures
= Free Cash Flow
Some analysts also study the cash flow from operating activities to see if the company is earning quality
income. In order for the company to be doing extremely well, the cash from operating activities must be
consistently greater than the net income earned by the company.
OTHER FINANCIAL
STATEMENT
INFORMATION
Apart from the key financial statements, complete financial reporting statements also include the
following:
Business and Operating Review

The business and operating review is also called management discussion and analysis. It serves as a
preface to all the complete reporting statements in which the management talks about recent events,
discloses essential information regarding expansion and future plans, and discusses significant
developments in the business industry.
The business and operating review is a good place for the company to share any good news with the
general public. They have room to elaborate on plans that would help enhance the companys image and
address any unpleasant events that may have occurred, to show the customers that they truly care about
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talking openly to their customers.
Statement of Change in Shareholders Equity

The statement of change in shareholders equity is also known as equity analysis. It provides information
about all the changes in the companys equity value over a certain time period. It reconciles the opening
balances of the equity accounts with the closing balances. There are two types of changes expressed in
the statement of change in shareholders equity:
1) Changes arising from any transactions conducted with shareholders of the company. For example,
issuing new shares, paying dividends, purchasing treasury stock, and issuing bonus shares, etc.
2) Changes that are a result of alterations in the comprehensive income of the company. These
changes might include revaluation of fixed assets, net income for the period and fair value of for-
sale investments, etc.
Notes to the Financial Statements

Notes to the financial statements are basically additional information provided in a companys financial
statements. These notes provide details and information that are left out of the main reporting documents.
They are important for the sake of clarity on many points as they outline the accounting methodology
used for recording certain transactions. The notes to the financial statements are essentially footnotes
because if included in the main statements, they would obscure the important information, as they are
generally quite elaborate and detailed.
The following notes are usually used to impart important disclosures for explaining the numbers on the
financial statements:
1) Notes that show the basis for presentation
2) Notes that advise on significant accounting policies
3) Notes about valuing inventory
4) Notes about depreciating assets
5) Notes about intangible assets
6) Notes that disclose subsequent events
7) Notes about employee benefits
8) Notes that reveal contingency plans
PROBLEMS WITH
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FINANCIAL STATEMENT
ANALYSIS
Financial statement analysis is a brilliant tool to gauge the past performance of a company and predict
future performance, but there are several issues that one should be aware of before using the financial
statement analysis results blindly, as these issues can interfere with how the results are interpreted. Some
of the issues are:
Comparability between Companies

This is a big issue for analysts because they can seemingly compare financial statement analyses
between different companies on the basis of ratios used, but in reality it may not paint an accurate
picture. The financial ratios of two different companies may be compared to see how they match up
against each other, but each company may aggregate all their information different from each other in
order to draw up their accounting statements. This may lead to incorrect conclusions drawn about a
company in relation to other companies in the industry.
Comparability between Periods

The change in accounts where financial information is stored may skew the results of the financial
statement analysis, from one period to the next. For example, if a company records an expense in one
period as cost of goods sold, while in another period, it is recorded as a selling and distribution expense,
the analysis between those two periods would not be comparable.
Operational Information
Analysts do not take into account operational information of a company, as only financial information is
analyzed and reviewed. There may be several indicators in operational information of the company which
may be predictors of future performance, for example, the number of backlogged orders, any changes in
licenses or warranty claims submitted to the company or even changes in the culture and work
environment. Therefore, analysis of financial information may only relay half the story.
Image credit: Wikimedia Commons under public domain, Wikimedia Commons | Microsoft under public
domain,
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3 comments Sort: by Oldest
1 9:12 am April 7, 2016
Stuart Joseph Taylor

Nice review Anastasia. It would be great if you also share tutorial on how to create a robust
nancial statement analysis using ms excel
Reply
2 11:20 am April 14, 2017
Austin
Quite educative
Reply
3 12:45 pm July 7, 2017
Chandni Arora
Thank you. This article covers everything about nancial statement analysis. Very helpful.
Reply
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9/26/2017 Financial Statement Analysis: An Introduction

Financial Statement Analysis: An Introduction

Advantages and Disadvantages of Horizontal Analysis

Advantages and Disadvantages of Vertical Analysis

I. The Balance Sheet

Assets = Liabilities + Shareholders Equity

The main items on the balance sheet are explained below:

Total Assets = Current Assets + Book Value of Long-Term Assets

Balance Sheet Analysis

Debt-Equity Ratio = Total Debt / Total Equity

Market-to-Book Ratio = Market Value of Equity / Book Value of Equity

Enterprise Value = Market Value of Equity + Debt Cash

II. The Income Statement

Wikimedia Commons | Microsoft

Cost of goods sold (COGS)

Selling, general and administrative costs (SG&A)

Research and development (R&D)

= Earnings before interest, taxes, depreciation and amortization (EBITDA)

Depreciation and amortization

= Earnings before interest and taxes (EBIT)

= Earnings before taxes (EBT)

Net profit Margin =Net Income / Net Sales

Return on Equity = Net Income / Book Value of Equity

Price to earnings ratios (P/E ratio)

III. The Statement of Cash Flows

Cash Flows Statement Analysis

Changes in Working Capital

= Free Cash Flow

Business and Operating Review

Statement of Change in Shareholders Equity

Notes to the Financial Statements

1) Notes that show the basis for presentation

2) Notes that advise on significant accounting policies

3) Notes about valuing inventory

4) Notes about depreciating assets

5) Notes about intangible assets

6) Notes that disclose subsequent events

7) Notes about employee benefits

8) Notes that reveal contingency plans

Comparability between Companies

Comparability between Periods

Share your thoughts and experience

3 comments Sort: by Oldest

1 9:12 am April 7, 2016

Stuart Joseph Taylor

2 11:20 am April 14, 2017

3 12:45 pm July 7, 2017

CLEVERISM HOT JOBS

Junior Sous Chef

See all ...

Lara & Co.

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CP17: Podcast with Neil Patel from

What to Look for in a Great Product

# Business, Career, Human Resources, Job search

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