Introduction to Financial Statement Analysis

Financial statement analysis is the process of looking at a company’s financial reports to see how they’re doing, and how profitable they are. This is important for investors, stakeholders, creditors and management to make decisions about the company’s future. By looking at financial statements, they can make informed decisions about future investments, lending opportunities and business strategies.

This article will break down the basics of financial statement analysis, components, formulas and real world examples to explain its importance and process.

What is Financial Statement Analysis?

Financial statement analysis is looking at financial reports such as the balance sheet, income statement and cash flow statement. These reports show a company’s assets, liabilities, revenues and expenses and give insight into their financial position and profitability. The main goal is to see how well a company is doing and where they need to improve.

Key Financial Statements

There are three main financial statements that investors, stakeholders, creditors and management look at when doing financial statement analysis:

1. Balance Sheet

The balance sheet is a snapshot of a company’s financial situation at a point in time. It breaks down into three parts:

• Assets: Everything the company owns from cash and inventory to property and equipment. Assets are current (can be converted to cash within a year) and non-current (long-term).
• Liabilities: The company’s financial obligations. Like assets, liabilities are current (due within a year) and long-term.
• Shareholders’ Equity: The residual interest in the assets of the company after deducting liabilities. This is the net worth of the company and includes retained earnings and paid-in capital.

The balance sheet formula is: Assets = Liabilities + Equity

2. Income Statement

The income statement, also known as the profit and loss (P&L) statement, shows a company’s financial performance over a period of time. It shows revenues, expenses and profits (or losses), so you can see if the company is making money from its operations.

The income statement includes:

• Revenue: Total income from the sale of products or services.
• Cost of Goods Sold (COGS): Direct costs of the products sold by the company.
• Operating Expenses: Expenses not directly related to the products but necessary to run the business (e.g. rent, utilities, salaries).
• Net Income: This is the bottom line and is the company’s profit after all expenses have been subtracted from revenue.

Example: A company makes $1,000,000 in revenue and has $600,000 in COGS and $200,000 in operating expenses. Net income would be:

Net Income = Revenue − (COGS+Operating Expenses)

Net Income = 1,000,000 − (600,000 + 200,000) = 200,000

3. Cash Flow Statement

The cash flow statement shows the cash in and out over a period. It’s broken into three sections:

• Operating: Cash from the core business, like collecting revenue and paying bills.
• Investing: Cash from buying or selling long term assets, like property, equipment or investments.
• Financing: Cash from transactions with the company’s creditors or shareholders, like borrowing, paying back loans or paying dividends.

Example: A company has $300,000 in cash from operations, spends $100,000 on new equipment and pays back $50,000 in debt. The net cash flow is:

Net Cash Flow = Operating Cash Flow − Investing Cash Flow − Financing Cash Flow

Net Cash Flow = 300,000 − 100,000 − 50,000 = 150,000

Financial Statement Analysis

1. Horizontal Analysis

Horizontal analysis is comparing financial data over consecutive periods to see trends and growth. This will help you see if key numbers like revenue or net income are increasing, decreasing or staying the same.

Formula for Horizontal Analysis:

Percentage Change = (((Current Period Value − Previous Period) / Previous Period Value)) / Previous Period Value) * 100

Example: If a company reports $400,000 in 2022 and $500,000 in 2023 the percentage change is:

Percentage Change = (((500,000 − 400,000) / 400,000)) * 100 = 25%

So the company grew 25% in revenue year-over-year.

2. Vertical Analysis

Vertical analysis expresses each financial statement item as a percentage of a base figure. In the income statement, each item is usually expressed as a percentage of total sales, and in the balance sheet, items are shown as a percentage of total assets.

Formula for Vertical Analysis:

Vertical Percentage = (Line Item Value / Base Figure) × 100

Example: If a company has total assets of $1,000,000 and its inventory is $200,000, the vertical analysis would calculate inventory as a percentage of total assets:

Vertical Percentage = (200,000 / 1,000,000) × 100 = 20%

This means 20% of the company’s total assets are in inventory.

3. Ratio Analysis

Ratio analysis is the use of financial ratios to look at different aspects of a company’s financial performance, such as profitability, liquidity and solvency.

a. Liquidity Ratios

Liquidity ratios measure a company’s ability to pay short term debts. A common liquidity ratio is the current ratio.

Formula for Current Ratio: Current Assets / Current Liabilities

Example: If a company has Current Assets of $500,000 and Current Liabilities of $250,000, the current ratio would be: 500,000 / 250,000=2

This means the company has $2 of assets for every $1 of liabilities.

b. Profitability Ratios

Profitability ratios look at a company’s ability to make profits relative to its revenue, assets or equity. The net profit margin is one of the most popular ratios.

Formula for Net Profit Margin: (Net Income / Revenue) × 100

Example: If a company makes $100,000 in net income from $1,000,000 in revenue, the net profit margin would be:

Net Profit Margin = (100,000 / 1,000,000) × 100=10%

This means the company keeps 10% of its revenue.

c. Solvency Ratios

Solvency ratios, like the debt-to-equity ratio, look at a company’s long term financial stability by looking at its ability to meet long term obligations.

Formula for Debt-to-Equity Ratio: Total Liabilities / Shareholders’ Equity

Example: A company with $600,000 in total liabilities and $300,000 in shareholders’ equity would have a debt-to-equity ratio of:

Debt-to-Equity Ratio = 600,000 / 300,000 = 2

This means the company is using $2 of debt for every $1 of equity.

Financial Statement Analysis Steps

1. Get the Financial Statements: Collect the company’s financial statements for the period. Make sure you have the balance sheet, income statement and cash flow statement.
2. Horizontal and Vertical Analysis: Do horizontal analysis to see trends over multiple periods. Do vertical analysis to see the proportion of key items to totals, e.g. total assets or revenue.
3. Calculate Ratios: Calculate the key ratios like current ratio, net profit margin and debt to equity ratio to check liquidity, profitability and solvency.
4. Compare to Industry Benchmarks: It’s important to compare your results to industry averages or competitor metrics to see how the company stacks up.
5. Interpret Results: Once you’ve got the numbers, you need to interpret what they mean for the company. For example an improving current ratio might mean better liquidity, a declining net profit margin might mean rising costs or inefficiencies.
6. Make Decisions: Based on the analysis you can make informed decisions. For example:
   • • Investors: Investors can decide to buy, sell or hold the company’s stock. A strong debt to equity ratio combined with a healthy net profit margin might mean the company is a good investment.
     • Lenders: Creditors can use the company’s liquidity ratios to decide whether to approve loans or extend credit lines. A company with poor liquidity might struggle to meet short term obligations making it a higher risk for lenders.
     • Management: Internal decision makers can use financial analysis to identify strengths and weaknesses. For example if operating expenses are eating into profits management can look at cost cutting measures.
7. Compare to Historical: It’s important to not only compare a company’s financial ratios and metrics to industry standards but also to its own historical performance. This gives context to whether the company is improving or deteriorating over time.

The Bottom Line

Financial statement analysis is key to understanding a company’s financial state. By using horizontal analysis, vertical analysis and ratio analysis on balance sheets, income statements and cash flow statements, investors, creditors and managers can make informed decisions on investing, lending and managing businesses.