In order to assess or improve a company’s financial health and performance, you need to analyze its financial statements. While financial reporting regulations and customs vary by country and industry, there are certain documents that companies are required to produce. These documents provide interested parties with relevant information about the company’s finances.
In this article, you’ll learn about the three fundamental financial statements and five of the most commonly used methods to analyze financial statements. You will also learn about the importance of examining multiple aspects of the company’s finances by using different analytical methods.
What is Financial Statement Analysis?
Financial statement analysis consists of thoroughly and critically evaluating the information available in a company’s financial statements. The balance sheet, income statement, and statement of cash flows are commonly used. This allows you to make informed decisions whether you are part of the company’s management, a creditor, or a potential investor.
What are the 3 Types of Financial Statements?
As mentioned above, the three required financial statements are the balance sheet, the income statement, and the cash flows statement. Each one focuses on different aspects of the company’s finances. By analyzing these statements, you can gain insight into the company’s financial health and performance.
Balance Sheet
The balance sheet provides a balanced view of the company’s assets, liabilities, and equity. While other financial statements, like income or cash flows, reflect a period of time, the balance sheet reflects the company’s financial position on a given date.
Both creditors and investors are interested in the contents of the balance sheet since it provides information on the company’s ability to pay both current and future obligations, as well as its liquidity. However, the usefulness of the balance sheet is limited, as the information becomes outdated quite quickly.
Income Statement
The income statement is often referred to by other names, including the profit and loss (P&L) statement and the statement of operations. The income statement reports the company’s operations during a given period of time, providing information on revenue, expenses, profit, and loss.
In many cases, companies produce these statements at different rates for internal and external users. While external reports may be required quarterly or annually, weekly or monthly reports are sometimes produced for internal use. Given the contents of income statements and the continuity they provide, all parties are usually extremely interested in analyzing them.
What Is a Cash Flow Statement (And How to Prepare It)
Everything you need to know about cash flow statements, what they are, how to use them, how to prepare them, and the best methods to do so.
READ MOREStatement of Cash Flows
The statement of cash flows reflects how the company’s activities affect its cash and cash equivalents. In other words, it explains the change in cash between accounting periods. The statement is meant to provide information about three types of activities: operating, investing, and financing.
While the statement of cash flows is of great interest to all parties, it is rarely analyzed in isolation. Generally, the contents provide more context to the analysis of the balance sheet or income statement.
Other financial statements focus on different aspects, as needed. For example, the Shareholders’ Equity statement and the Management’s Discussion & Analysis (MD&A). Depending on your industry and business model, you may need to provide more than the three basic statements.
What are Common Financial Statement Analysis Techniques?
Financial statements can be analyzed in different ways depending on the purpose of the analysis and the financial statements used. In other words, it’s not a matter of selecting a preferred method, as each method provides insight into different aspects of the company’s finances. Below, you have the main methods used to analyze financial statements.
Horizontal Analysis
Horizontal analysis focuses on changes over time to specific variables, like total revenue or current assets. The difference in values between periods is expressed both as an absolute and relative difference.
Comparative statements refer to the horizontal analysis of past and current periods, with both absolute and relative variances for all line items. Since they are expressed as percentages, it’s possible to compare your values to similar companies in the industry. Both income statements and balance sheets can be analyzed using this method.
Financial Statement Analysis: Here’s How It Works - Horizontal Analysis
To learn more about the horizontal analysis of financial statements and see some examples, check out the post on Horizontal Analysis of Financial Statements.
Vertical Analysis
The vertical analysis of financial statements focuses on how much each line item contributes to the same period's total. This type of analysis is carried out on both the balance sheet and the income statement.
Financial Statement Analysis: Here’s How It Works - Vertical Analysis Income Statement
Common-size statements are those used in the vertical analysis of financial statements, where all line items are expressed as a percentage of the total. For example, line items in the balance sheet can be expressed as a percentage of current assets, and line items from the income statement as a percentage of revenue.
Financial Statement Analysis: Here’s How It Works - Vertical Analysis Balance Sheet
To learn more about the vertical analysis of financial statements, including examples, take a look at Vertical Analysis of Financial Statements.
Leverage Ratio: Definition And How To Calculate
A leverage ratio provides you with information on how much a company depends on borrowed capital. Here’s what leverage ratios are and how to calculate them.
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Ratio Analysis
Ratio analysis relies on the relationships between different financial figures, most of which appear in the company’s financial statements. Ratios are calculated to express the relationships between different variables by dividing one value by another. This makes them extremely useful, as you can easily compare them to those of similar companies and industry standards.
Depending on the purpose of your analysis, some ratios are more relevant than others. Financial ratios tend to be grouped according to the aspect they focus on. For example, profitability, liquidity, leverage, and activity are the most commonly used ratio categories.
Financial Statement Analysis: Here’s How It Works - Liquidity Ratios
Trend Analysis
Trend analysis aims to identify potentially significant patterns in historical data. While it is not exclusive to the analysis of financial statements, it is frequently used for this purpose. In fact, horizontal analysis is a specific type of trend analysis.
This method is also often used in the technical analysis of stock, which uses multiple metrics and techniques, including technical indicators, percentage of change, moving averages, and different types of charts and visualizations.
Financial Statement Analysis: Here’s How It Works - Liquidity Ratios
To learn more about how this method is used in finance and see some examples, check out the article on Trend Analysis: Definition & Examples.
Base-Year Comparisons
Base-year comparisons allow you to make meaningful comparisons between multiple periods. First, select a base year or period, and assign a value of 100% to the figures for that period. Once this is done, subsequent periods are compared as a percentage of the figures for the base year.
Financial Statement Analysis: Here’s How It Works - Base-Year Comparisons
When making base-year comparisons, selecting an appropriate base year is essential. Avoid using an exceptional year, as results can be misleading. If that year was an exceptionally bad one, comparisons would seem unrealistically positive.
Why is Financial Statement Analysis Important?
Financial reporting and analysis are crucial in any industry. In order to optimize financial performance, it’s necessary to analyze current and historical financial data. The analysis of financial statements allows you to identify potential problems and opportunities, better understand your use of resources, and improve financial planning and performance.
Conclusion
As you have seen, the analysis of financial statements is crucial to multiple parties. Whether you are a business owner, a creditor, or an investor, analyzing financial statements provides insight into many aspects of the company’s financial health and performance.
You now know about the fundamental financial statements - balance sheet, income statement, and cash flow statement - as well as the methods most commonly used to analyze them. You can set up the calculations using the data from your financial statement templates on Microsoft Excel or Google Sheets. By using Layer, you can easily synchronize the data from your financial statements and analyze it using multiple methods. You can also automatically share the resulting reports with all interested parties.
To learn more about specific methods for the analysis of financial statements, check out the articles below.