Financial Statement Analysis

By Investopedia

Basic Financial Statement Analysis

What is Financial Statement Analysis?
Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes and to understand the overall health of an organization. Financial
statements record financial data, which must be evaluated through financial statement
analysis to become more useful to investors, shareholders, managers, and other interested
parties.

Financial Statement Analysis

Financial statement analysis is an evaluative method of determining the past, current, and
projected performance of a company. Several techniques are commonly used as part of
financial statement analysis including horizontal analysis, which compares two or more years
of financial data in both dollar and percentage form; vertical analysis, in which each category
of accounts on the balance sheet is shown as a percentage of the total account; and ratio
analysis, which calculates statistical relationships between data.

Financial Statements
Financial statement analysis allows analysts to identify trends by comparing ratios across
multiple periods and statement types. These statements allow analysts to measure liquidity,
profitability, company-wide efficiency, and cash flow. There are three main types of financial
statements: the balance sheet, income statement and cash flow statement. The balance sheet is
a snapshot of the company's assets, liabilities, and shareholders' equity at a specific period.
Analysts use the balance sheet to analyze trends in assets and debts. The income statement
begins with sales and ends with net income. It also provides analysts with the gross profit,
operating profit, and net profit. Each of these is divided by sales to determine gross profit
margin, operating profit margin, and net profit margin, respectively. The cash flow statement
provides an overview of the company's cash flows from operating activities, investing
activities, and financing activities.

Financial Statement Analysis

Each financial statement provides multiple years of data. Used together, analysts track
performance measures across financial statements using several different methods for
financial statement analysis, including vertical, horizontal, and ratio analyses. An example of
vertical analysis is when each line item on the financial statement is listed as a percentage of
another. Horizontal analysis compares line items in each financial statement against previous
time periods. In ratio analysis, line items from one financial statement are compared with line
items from another. For example, many analysts like to know how many times a company
can pay off debt with current earnings. Analysts do this by dividing debt, which comes from
the balance sheet, by net income, which comes from the income statement. Likewise, return
on assets (ROA) and the return on equity (ROE) compare company net income found on the
income statement with assets and stockholders' equity found on the balance sheet.

What Are Financial Statements?

Financial statements are written records that convey the business activities and the financial
performance of a company. Financial statements include the balance sheet, income statement,
and cash flow statement. Financial statements are often audited by government agencies,
accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes.

Understanding Balance Sheets

The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a
snapshot in time. The date at the top of the balance sheet tells you when the snapshot was
taken, which is generally the end of the fiscal year.

The Formula for the Balance Sheet Is

Assets=(Liabilities+Owner’s Equity)

How to Calculate and Identify the Balance Sheet

The balance sheet totals will be calculated already, but here's how you identify them.

1. Locate total assets on the balance sheet for the period.

2. Total all liabilities, which should be a separate listing on the balance sheet.
3. Locate total shareholder's equity and add the number to total liabilities.
4. Total assets should equal the total of liabilities and total equity.

What Do Financial Statements Tell You

Investors and financial analysts rely on financial data to analyze the performance of a
company and make predictions about its future direction of the company's stock price. One of
the most important resources of reliable and audited financial data is the annual report, which
contains the firm's financial statements.

The financial statements are used by investors, market analysts, and creditors to evaluate a
company's financial health and earnings potential. The three major financial statement reports
are the balance sheet, income statement, and statement of cash flows.

What Does the Balance Sheet Tell You?

The balance sheet identifies how assets are funded, either with liabilities, such as debt, or
stockholders' equity, such as retained earnings and additional paid-in capital. Assets are listed
on the balance sheet in order of liquidity.

Liabilities are listed in the order in which they will be paid. Short-term or current liabilities
are expected to be paid within the year, while long-term or noncurrent liabilities are debts
expected to be paid in over one year.

Example of Items on a Balance Sheet

Below are examples of items listed on the balance sheet.

Assets

• Cash and cash equivalents are liquid assets, which may include Treasury
bills and certificates of deposit.
• Accounts receivables are the amount of money owed to the company by its customers
for the sale of its product and service.
• Inventory
Liabilities

• Debt including long-term debt

• Rent, tax, and utilities
• Wages payable
• Dividends payable

Shareholders' equity

• Shareholders' equity is a company's total assets minus its total

liabilities. Shareholders' equity represents the amount of money that would be
returned to shareholders if all of the assets were liquidated and all of the
company's debt was paid off.
• Retained earnings are part of shareholders' equity and are the percentage of net
earnings that were not paid to shareholders as dividends.

Real World Example of a Balance Sheet

Below is a portion of Exxon Mobil Corporation's (XOM) balance sheet as of September 30,
2018.

• Total assets were $354,628 (highlighted in green).

• Total liabilities were $157,797 (1st red highlighted area).
• Total equity was $196,831 (in red).
• Total liabilities and equity were $354,628, which equals the total assets for the period.
Exxon Balance Sheet example. Investopedia
Income Statement
Unlike the balance sheet, the income statement covers a range of time, which is a year for
annual financial statements and a quarter for quarterly financial statements. The income
statement provides an overview of revenues, expenses, net income and earnings per share. It
usually provides two to three years of data for comparison.

The Formula for an Income Statement Is

Net Income=(Revenue−Expenses)

How to Calculate the Income Statement

1. Total all revenue or sales for the period.

2. Total all expenses and costs of operating the business.
3. Subtract total expenses from revenue to achieve net income or the profit for the
period.

What Does the Income Statement Tell You?

An income statement is one of the three important financial statements used for reporting a
company's financial performance over a specific accounting period. Also known as the profit
and loss statement or the statement of revenue and expense, the income statement primarily
focuses on a company’s revenues and expenses during a particular period.

Once expenses are subtracted from revenues, the statement produces a company's profit
figure called net income.

Types of Revenue
Operating revenue is the revenue earned by selling a company's products or services.
The operating revenue for an auto manufacturer would be realized through the production
and sale of autos. Operating revenue is generated from the core business activities of a
company.

Non-operating revenue is the income earned from non-core business activities. These
revenues fall outside the primary function of the business. Some non-operating revenue
examples include:

• Interest earned on cash in the bank

• Rental income from a property
• Income from strategic partnerships like royalty payment receipts
• Income from an advertisement display located on the company's property

Other income is the revenue earned from other activities. Other income could include gains
from the sale of long-term assets such as land, vehicles, or a subsidiary.

Types of Expenses
Primary expenses are incurred during the process of earning revenue from the primary
activity of the business. Expenses include cost of goods sold (COGS), selling, general and
administrative expenses (SG&A), depreciation or amortization, and research and
development (R&D). Typical expenses include employee wages, sales commissions, and
utilities such as electricity and transportation.

Expenses that are linked to secondary activities include interest paid on loans or debt. Losses
from the sale of an asset are also recorded as expenses.
The main purpose of the income statement is to convey details of profitability and the
financial results of business activities. However, it can be very effective in showing whether
sales or revenue is increasing when compared over multiple periods. Investors can also see
how well a company's management is controlling expenses to determine whether a company's
efforts in reducing the cost of sales might boost profits over time.

Real World Example of an Income Statement

Below is a portion of Exxon Mobil Corporation's (XOM) income statement as of September
30, 2018.

• Total revenues were $76,605 for the period.

• Total costs were $67,525.
• Net income or profit was $6,240.

Exxon Income Statement 09-30-2018. Investopedia

Cash Flow Statement
The cash flow statement (CFS) measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments. The cash flow statement
complements the balance sheet and income statement.

What Does the Cash Flow Statement Tell You?

The CFS allows investors to understand how a company's operations are running, where its
money is coming from, and how money is being spent. The CFS also provides insight as to
whether a company is on a solid financial footing.

There is no formula, per se, for calculating a cash flow statement, but instead, it contains
three sections that report the cash flow for the various activities that a company has used its
cash. Those three components of the CFS are listed below.

Operating Activities
The operating activities on the CFS include any sources and uses of cash from running the
business and selling its products or services. Cash from operations includes any changes
made in cash, accounts receivable, depreciation, inventory, and accounts payable. These
transactions also include wages, income tax payments, interest payments, rent, and cash
receipts from the sale of a product or service.

Investing Activities
Investing activities include any sources and uses of cash from a company's investments into
the long-term future of the company. A purchase or sale of an asset, loans made to vendors or
received from customers or any payments related to a merger or acquisition are included in
this category.

Also, purchases of fixed assets such as property, plant, and equipment (PPE) are included in
this section. In short, changes in equipment, assets, or investments relate to cash from
investing.

Financing Activities
Cash from financing activities include the sources of cash from investors or banks, as well as
the uses of cash paid to shareholders. Financing activities include debt issuance, equity
issuance, stock repurchases, loans, dividends paid, and repayments of debt.

The cash flow statement reconciles the income statement with the balance sheet in three
major business activities.

Real World Example of a Cash Flow Statement

Below is a portion of Exxon Mobil Corporation's (XOM) cash flow statement as of
September 30, 2018. We can see the three areas of the cash flow statement and their results.

• Operating activities generated a positive cash flow of $27,407 for the period.
• Investing activities generated negative cash flow or cash outflows of -$10,862 for the
period. Additions to property, plant, and equipment made up the majority of cash
outflows, which means the company invested in new fixed assets.
• Financing activities generated negative cash flow or cash outflows of -$13,945 for the
period. Reductions in short-term debt and dividends paid out made up the majority of
the cash outflows.
Exxon CFS 09-30-2018. Investopedia
Key Takeaways

• Financial statements are written records that convey the business activities and the
financial performance of a company.
 • The balance sheet provides an overview of assets, liabilities, and stockholders' equity
as a snapshot in time.
• The income statement primarily focuses on a company’s revenues and expenses
during a particular period. Once expenses are subtracted from revenues, the
statement produces a company's profit figure called net income.
• The cash flow statement (CFS) measures how well a company generates cash to pay
its debt obligations, fund its operating expenses, and fund investments.

Limitations of Financial Statements

Although financial statements provide a wealth of information on a company, they do have
limitations. The statements are open to interpretation, and as a result, investors often draw
vastly different conclusions about a company's financial performance.

For example, some investors might want stock repurchases while other investors might prefer
to see that money invested in long-term assets. A company's debt level might be fine for one
investor while another might have concerns about the level of debt for the company. When
analyzing financial statements, it's important to compare multiple periods to determine if
there are any trends as well as compare the company's results its peers in the same industry.

VERTICAL ANALYSIS

What Is Vertical Analysis?

Vertical analysis is a method of financial statement analysis in which each line item is listed
as a percentage of a base figure within the statement. Thus, line items on an income statement
can be stated as a percentage of gross sales, while line items on a balance sheet can be stated
as a percentage of total assets or liabilities, and vertical analysis of a cash flow statement
shows each cash inflow or outflow as a percentage of the total cash inflows.

Vertical Analysis
How Vertical Analysis Works
Vertical analysis makes it much easier to compare the financial statements of one company
with another, and across industries. This is because one can see the relative proportions of
account balances. It also makes it easier to compare previous periods for time series analysis,
in which quarterly and annual figures are compared over a number of years, in order to gain a
picture of whether performance metrics are improving or deteriorating.

For example, by showing the various expense line items in the income statement as a
percentage of sales, one can see how these are contributing to profit margins and whether
profitability is improving over time. It thus becomes easier to compare the profitability of a
company with its peers.

[Important: Vertical analysis is used in order to gain a picture of whether performance

metrics are improving or deteriorating].

Financial statements that include vertical analysis clearly show line item percentages in a
separate column. These types of financial statements, including detailed vertical analysis, are
also known as common-size financial statementsand are used by many companies to provide
greater detail on a company’s financial position. Common-size financial statements often
incorporate comparative financial statements that include columns comparing each line item
to a previously reported period.

Example of Vertical Analysis

For example, suppose XYZ Corporation has gross sales of $5 million and cost of goods sold
of $1 million and general and administrative expenses of $2 million and a 25% tax rate, its
income statement will look like this if vertical analysis is used:

Sales 5,000,000 100%

Cost of goods sold 1,000,000 20%

Gross profit 4,000,000 80%

General and Administrative Expenses 2,000,000 40%

Operating Income 2,000,000 40%

Taxes (%25) 500,000 10%

Net income 1,500,000 30%

Vertical Versus Horizontal Analysis

Another form of financial statement analysis used in ratio analysis is horizontal analysis
or trend analysis. This is where ratios or line items in a company's financial statements are
compared over a certain period of time by choosing one year's worth of entries as a baseline,
while every other year represents percentage differences in terms of changes to that baseline.

For example, the amount of cash reported on the balance sheet on December 31 of 2018,
2017, 2016, 2015, and 2014 will be expressed as a percentage of the December 31, 2014,
amount. Instead of dollar amounts, you might see 141, 135, 126, 118, and 100.

This shows that the amount of cash at the end of 2018 is 141% of the amount it was at the
end of 2014. By doing the same analysis for each item on the balance sheet and income
statement, one can see how each item has changed in relationship to the other items.

Key Takeaways

• Vertical analysis makes it easier to understand the correlation between single items
on a balance sheet and the bottom line, expressed in a percentage.
• Vertical analysis can become a more potent tool when used in conjunction with
horizontal analysis, which considers finances of a certain period of time.

Horizontal Analysis

What is a Horizontal Analysis

Horizontal analysis is used in financial statement analysis to compare historical data, such as
ratios, or line items, over a number of accounting periods. Horizontal analysis can either use
absolute comparisons or percentage comparisons, where the numbers in each succeeding
period are expressed as a percentage of the amount in the baseline year, with the baseline
amount being listed as 100%. This is also known as base-year analysis.

Volume

BREAKING DOWN Horizontal Analysis

Horizontal analysis allows investors and analysts to see what has been driving a company's
financial performance over a number of years, as well as spotting trends and growth patterns
such as seasonality. It enables analysts to assess relative changes in different line items over
time, and project them. By looking at the income statement, balance sheet and cash flow
statement at the same time, one can create a complete picture of operational results, and see
what has been driving a company’s performance and whether it is operating efficiently and
profitably.

The analysis of critical measures of business performance, such as profit margins, inventory
turnover and return on equity, can detect emerging problems and strengths. For example,
earnings per share (EPS) may have been rising because the cost of goods sold have been
falling, or because sales have been growing strongly. And coverage ratios, like the cash flow-
to-debt ratio and the interest coverage ratio can reveal whether a company can service its debt
and has enough liquidity. Horizontal analysis also makes it easier to compare growth rates
and profitability among different companies.

Horizontal Analysis Cons

Depending on which accounting period an analyst starts from, and how many accounting
periods are chosen, the current period can be made to appear unusually good or bad. For
example, the current period's profits may appear excellent when only compared with those of
the previous quarter, but are actually quite poor if compared to the results for the same
quarter in the preceding year.

A common problem with horizontal analysis is that the aggregation of information in the
financial statements may have changed over time, so that revenues, expenses, assets, or
liabilities may shift between different accounts and therefore appear to cause variances when
comparing account balances from one period to the next. Indeed, sometimes companies
change the way they break down their business segments, in order to make the horizontal
analysis of growth and profitability trends harder.

Also, accurate analysis can be affected by one-off events and accounting charges.

Horizontal Analysis Example

Horizontal analysis typically shows the changes from the base period in dollar and
percentage. For example, when someone says that revenues have increased by 10% this past
quarter, that person is using horizontal analysis. The percentage change is calculated by first
dividing the dollar change between the comparison year and the base year by the item value
in the base year, then multiplying the quotient by 100%.

For example, assume an investor wishes to invest in company XYZ. The investor may wish
to determine how the company grew over the past year. Assume that in company XYZ's base
year, it reported net income of $10 million and retained earnings of $50 million. In the
current year, company XYZ reported net income of $20 million and retained earnings of $52
million. Consequently, it has an increase of $10 million in its net income and $2 million in its
retained earnings year over year. Therefore, company ABC's net income grew by 100%
YOY, while its retained earnings only grew by 4%.

Vertical Analysis vs. Horizontal Analysis

While horizontal analysis looks at how the dollar amounts in a company’s financial
statements have changed over time, vertical analysis looks at each line item as a percentage
of a base figure within the statement. Thus, line items on an income statement can be stated
as a percentage of gross sales, while line items on a balance sheet can be stated as a
percentage of total assets or liabilities, and vertical analysis of a cash flow statement shows
each cash inflow or outflow as a percentage of the total cash inflows. Vertical analysis is also
known as common size financial statement analysis. For more, read The Common-Size
Analysis of Financial Statements.