What is Financial Statement Analysis?
The term ‘financial statement analysis‘ refers to determining the firm’s financial position by reviewing and analysing the balance sheet items, profits and loss accounts, cash flow statements, funds flow statements, etc.
The financial analysis aims to understand the company’s financial health to judge the firm’s profitability. Several groups of stakeholders are interested in the analysis of financial statements.
Owners are interested in knowing how their business is performing, and trends help them determine whether to expand the business or discontinue a particular product or service. Investors are interested in knowing whether it is worth investing in the shares of a particular company.
Similarly, bankers, lenders and financial institutions want to gauge the financial performance and position before offering their financial assistance in loans and advances.
Just like a doctor examines his patient by recording his body temperature, blood pressure, etc., before making a conclusion regarding the illness and giving his treatment, a financial analyst uses various tools to judge the soundness of the firm.
Tools/ Methods of Financial Analysis
There are many methods and tools of financial statement analysis. Some of the most common and popular techniques have been discussed below:
Comparative statements
In this method, either the financial statements of two or more years are presented in a comparative form or they are presented for two or more firms for the same years. It helps to understand which year performed better or which firm performed better.
Comparative financial statements typically include information like the income statement, balance sheet, and cash flow statement for different periods, allowing you to compare key metrics such as revenue, expenses, assets, and liabilities. By reviewing these statements, you can gain insights into a company’s financial health and identify areas that require attention or improvement.
One of the main benefits of comparative financial statements is that they enable businesses to track their performance and measure growth over time. They allow you to see if your revenue is increasing, expenses are decreasing, or if your assets are growing. This information is vital for making informed decisions and planning for the future.
Trend analysis
Trend analysis is all about looking at the data from financial statements over a period of time and identifying any patterns or trends that emerge. This can give you some really valuable insights into your business and how it’s performing.
By comparing data from different periods, you can see if your business is heading in the right direction. Are your revenues increasing? Are your expenses going down? Are your assets growing? These are all important questions that can be answered through trend analysis.
Not only does it help you track your performance, but trend analysis also allows you to spot any consistent changes or fluctuations that may impact your business. Maybe you notice that your costs tend to go up during a particular month, or that your profit margins are always higher in certain quarters. Understanding these trends can help you make smarter decisions and plan for the future.
Common size statements
A common-size income statement is a useful financial tool in which all the line items are presented as a percentage of a base number, usually the total revenue. This type of income statement helps to identify trends and changes in different expense items over time.
It also provides a better understanding of the overall financial health of the business by highlighting areas that require attention. In contrast, a split-size income statement presents the absolute dollar amount for each line item, making it more challenging to compare and analyze the data. Therefore, companies often use common-size income statements to supplement traditional financial statements and provide a more comprehensive view of their financial performance.
This is sometimes referred to as total revenues or total sales. In a similar way to the financial ratio analysis, a common-size income statement serves a similar goal. In addition, it allows for comparable comparisons across periods, companies, and industry sectors.
Funds flow analysis
A funds flow statement, also known as a cash flow statement, is a financial document that summarizes the movement of cash and cash equivalents in and out of a business or organization over a specific time. It provides insights into the sources and uses of a company’s cash, helping investors and analysts assess its financial health and liquidity.
Cash flow analysis
Cash flow analysis helps to analyse cash and non-cash activities to ascertain net actual cash movement that happened during the year.
Put simply, it’s a process of reviewing your business’s cash inflows and outflows in order to better understand your financial health. This can be done on a monthly or yearly basis and will give you a clear picture of where your money is coming in and going out.
There are several different methods you can use to track your cash flow, but one of the simplest is to create a cash flow statement. This document summarizes your cash inflows and outflows for a specific period, which can be monthly, quarterly, or yearly.
One of the main benefits of cash flow analysis is that it can help you make better use of your working capital. By tracking your cash inflows and outflows, you can better manage your inventory levels and accounts payable, which can free up cash flow and improve your bottom line.
Ratio analysis
Ratio analysis is a financial analysis tool used to evaluate a company’s financial performance. Ratios are calculated by dividing one financial statement item by another. Financial ratio analysis can be used to assess a company’s liquidity, solvency, profitability, and efficiency.
This is the most popular and powerful tool which can be used to analyse several performance-related indicators such as sales, profitability, return on investment, share price etc.
Cost-volume-profits analysis
CVP analysis helps executives to determine the level of sales needed to cover fixed and variable costs. By understanding the break-even point, managers can make informed decisions regarding pricing, cost-cutting measures, and overall profitability. This technique is especially useful for small businesses and startups that are trying to establish themselves in a highly competitive market.
Profitability is conveyed to company decision-makers through the use of changes in selling prices, costs, and volume of sales (in the short term).
Conclusion
The best financial analysis technique to use will depend on your specific needs and goals. If you are looking for a quick overview of a company’s financial health, horizontal and vertical analysis may be a good place to start. If you are looking for more in-depth analysis, ratio analysis or DCF analysis may be more appropriate.
No matter which technique you choose, it is important to remember that financial analysis is not an exact science. There is always a degree of uncertainty involved, and you should never make investment decisions based solely on the results of a financial analysis.
