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Financial Statement Analysis is a method of reviewing and analyzing a company’s 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.

© 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
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 company’s accounting records to measure the
company’s 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 company’s 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 company’s profitability and stability. Employees may also be
interested in knowing the company’s 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 company’s 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
company’s 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 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 company’s 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 it’s 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 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

© 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 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 firm’s 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 firm’s assets, not including any cash or cash equivalents, while unencumbered by the
debt the firm carries.
II. The Income Statement

© 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:

Earnings per Share = Net Income / Shares Outstanding


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 firm’s 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 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 company’s
image and address any unpleasant events that may have occurred, to show the customers that
they truly care about 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 company’s 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 company’s
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 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.
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11:20 amApril 14, 2017Austin

Quite educative
+2Reply

1:13 pmOctober 1, 2017Bernard Gichuhi

Splendid. You have done a good job Anastasia. Keep up the good work..
+2Reply
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