The Basics of Financial Statement Analysis
Understanding and analyzing a company's financial statements is an essential skill to make investment decisions. By doing a financial statement analysis, you'll be allowed to recognize the impact of all business activities on the top and bottom line (revenue, costs, and profit). The balance sheet, income statement, and cash flow statement are the most valuable. By the end of this article, we aim to answer the following questions:
- What exactly is a financial statement?
- What types of analysis should be performed?
- What are balance sheets, income statements, and cash flow statements?
- Why are they the most important, and how can we analyze those statements?
- Where can I find Financial Statements?
What is a Financial Statement?
Financial statements are the official records of the financial activities and position of a business. They aim to provide people outside and inside the company information about the company's financial situation, performance, and changes in financial position. Financial statements have different purposes and standards depending on whether they are for external reporting or internal management. That's why financial analysis of a company is not to forget steps while you're making an investment decision, to earn exceptional profitability at the end.
In this article, we will be focusing on how financial statements are beneficial to people outside the business looking to make investment decisions.
The financial statements that businesses produce for external parties are highly regulated and have to follow government-mandated rules. In North America, GAAP (Generally accepted accounting principles) used for regulations. Companies audited to ensure they comply with these regulations. As a result, public financial statements are an accurate source of financial information for external investors and are arguably the most potent quantitative data investors can use. The three most important statements are the balance sheet, the income statement, and the cash flow statement; we'll be diving into these later in this article.
But first, let's answer; why is analyzing financial statements necessary to make an accurate investment decision?
Why is Financial Statement Analysis Important?
No investor can deny the importance of financial statement analysis. This command to critically interpret individual financial statements adds to the accuracy of the terminal plan of investment. To understand it by going a bit in-depth, take an example of assets, liabilities, equity capital, total debt, etc., and their fluctuations across changing periods of a company. One of three financial statements (balance sheet) is responsible for giving a comprehensive detail of these components essential to negotiate for an investment plan. So financial ratios analysis of six months gap balance sheets of the same company will give the profitability to lose graph, which drives further attention for investors whether they will invest or not.
Similarly, income statements and balance sheets combinations provide access to measure annual profit earned by companies and build a convincing plot for investors to get their position.
Example of financial statement analysis?
In analyzing financial statements, each statement analysis has multiple steps and ratios to focus on one crucial component of the company's financial background.
Let's suppose the balance sheet analysis of any company which will provide the following ratios, particularly to create a final evaluation plan for investors:
1. Liquidity ratios
Include: Quick ratio, current ratio, and net working capital
2. Leverage ratios
Include: Debt to equity, debt to capital, debt to EBITDA, interest coverage, fixed charge coverage ratio.
3. Operational Efficiency ratios
Include: Inventory turnover, Accounts receivable days, Accounts payable days, Total asset turnover, Net asset turnover.
To understand it more closely, let's take an example of balance sheet interpretation of an ABC Company which comes as follows:
To analyze the liquidity ratios of ABC Company, which states whether the company is eligible to clear its current debts with liquid assets or not, two ratios come as under:
1. Current ratio = Current Assets / Current Liabilities
To analyze the current ratios from both fiscal years (2018 & 2017), the values would be different.
For the year 2017:
Current ratio = 150,765 / 56,193 = 2.68
For the year 2018:
Current ratio = 157,287 / 47,355 = 3.32
Hence, by comparing both the ratios, the year 2018 has a higher current ratio value which means that this year the company has more chances to clear debts than the recent year 2017.
2. Quick ratio = (Current Assets - Inventory) / Current Liabilities
Analysis of both years quick ratios will have different values such as:
For the year 2017:
Quick Ratio = (150,765 - 8,580) / 56,193 = 2.53
For the year 2018:
Quick Ratio = (157,287 - 10,396) / 47,355 = 3.10
The comparison shows that the year 2018 has a higher quick ratio than the recent year 2017.
Conclusion: The current and quick ratio indicates that in 2018, the company is ranking at a better financial position than the year 2017 and can compensate with current obligations/debts to make them clear due to having more liquid assets than the previous year record.
Similarly, income statements and cash flow statements can be analyzed using rational methods to quantify each component rank compared to others. Hence, a calculated and accurate procedure executes a visually observable difference of the company's historical status with current and helps investors negotiate if the company generates more in the current year.
What Are the Different Forms of Analysis?
Instead, you ponder and get confused about how to analyze financial statements. Let's make it easy in another way!
There's a multitude of ways for analyzing financial statements, but to start with it's only worth mastering the two most important forms. These are vertical and horizontal analysis.
By definition, vertical analysis of financial statement analysis requires us to compare various financial statement lines of the same period against another line in that same financial period.
Therefore recorded as one of the most effective For example, we could look at various yearly expenses as a percentage of annual revenue. This type of analysis enables us to understand the strengths and weaknesses of a firm's financial performance and start to understand the company's strategy for that period. It's instrumental in allowing investors to quantitatively see if a firm's margins align with what would be expected in a particular industry.
So, if vertical analysis involves comparing information in a financial period against other information, you can probably guess what horizontal analysis is. The horizontal analysis consists of looking at historical financial performance and, more explicitly, analyzing the changes. It's useful for several reasons. Firstly, it provides a basis for us to forecast what implementation might look like in the future and therefore understand whether a company will be more valuable (A signal that stock price will increase). Horizontal analysis is also a tool for understanding the longer-term strategy of a company to see how management intends to grow the firm. Finally, horizontal analysis allows us to know how successful management coped with tough times (and good times), which signals how well they will perform in future periods of economic stress (which are unfortunately inevitable in the long term).
Among all three important financial statements, investors follow the vertical analysis technique, either using API management or manual effort, to gather historical data movement. Before investing in shares of companies operating internationally, shareholders are preferably recommended to inquire about assets, liabilities, debts, and shares' ups and downs, involving balance sheet and income statement vertical analysis. This way, a profitable decision could be concluded.
The Balance Sheet
What is a balance sheet?
The balance sheet records a firm's assets, liabilities, and shareholders' equity at a specific point in time. The balance sheet displays a company's total assets and the balance of debt and equity that finances this. Essentially, it tells us what a business owns, what it owes, and the amount of investment from owners (shareholders). In doing so, it provides us a snapshot of the worth of a firm at a given point in time. You can consider balance sheet analysis a must-have constituent in the entire procedure of analyzing financial statements.
The balance sheet follows a crucial formula in finance:
Assets = Liabilities + Shareholders Equity
This means that what the company owns must be equaled by the debt owed plus the equity held by shareholders.
How can you analyze the balance sheet?
Balance sheet analysis brings compatibility graphs of companies with competitive ones. The principal components you negotiated above, which the balance sheet supports, add underlying importance to the investment plan. Consequently, the in-depth understanding of the balance sheet individual component, i.e., Debt, equity, and shares rate, conceives better opportunities for investors to compare the historical position of a company with current conditions, which leads them further focus on financial accounting analysis
In the context of financial reports and analysis, most commonly, items on the balance sheet are compared with items on the income statement to understand critical aspects of business performance. These are liquidity, leverage, and operational efficiency. We've written comprehensive articles on these parts of business performance, so here we'll show some of the most important. Be sure to click the relevant links to go into more depth on each.
- Current Ratio - A firm's ability to pay off its short-term financial obligations.
- Quick Ratio - A more conservative current ratio that excludes inventory and other current assets, which are generally more difficult to turn into cash.
- Cash Ratio - A firm's ability to pay off debts with cash and cash equivalents such as marketable securities.
- Debt to equity ratio - The proportions of a company's financing between debt (liabilities) and equity.
- Net Debt - The company's ability to pay off debts today.
- Fixed asset turnover - How efficiently a company is producing sales from its fixed assets.
- Asset Turnover - The efficiency with which a company is deploying its assets in generating revenue.
What is the income statement?
Widely regarded as the key financial statement, the income statement shows how much profit your business made in a period. It shows the makeup of your revenue, expenses, and losses ending with net income (Revenue minus expenses and losses). The typical period is either a year for annual statements or three months for quarterly reports. It is also known as the profit and loss statement or the statement of earnings. This statement analysis has an explicit focus on a business's revenues and expenses over a given period, thereby giving us a clear view of the company's performance in that period.
How do you analyze the Income Statement?
Income Statement analysis done both vertically and horizontally. A typical income statement vertical analysis is done by comparing different income statement line items to revenue to give us margins. This vertical analysis of the income statement is often referred to as profitability analysis, so I'll talk about a couple of them. Net profit margin is the mother of all profitability ratios and the one most commonly used by analysts. It looks at the percentage of net income to revenue. The operating profit margin shows the percentage of profit made before deducting taxes and interest charges.
We wrote an extensive article about financial profitability ratios
When analyzing the income statement, we must also perform horizontal analysis for at least three years back. It's not good enough to look at one year of performance in isolation because we can't trust this level of performance to continue. This historical analysis allows investors to see whether performance is likely to continue at current levels, decline, or grow to new heights in the best-case scenario. We want to see that the raw figures and the ratios calculated in the vertical analysis are trending in the right direction.
Cash Flow Statement
What is the cash flow statement?
The Cash Flow Statement is the final financial statement that we'll provide you with a basic understanding of today. The Cash Flow Statement tells us how much cash is coming in and out of the company due to operating, financing, and investing activities. It allows investors to see if a business is on a solid footing and can cover its expenses and debt repayments with the cash it generates. Operating activities on the cash flow statement involve selling the firm's products/services and running the business.
Financing activities include cash received from investors or banks and the cash paid to shareholders. Investing activities are those involved in investments made for the long-term future of the firm.
How do you analyse the cash flow statement?
Among all the financial statement analysis techniques, the best way to analyze cash flow is by using financial analysis ratios. Cash flow ratios compare the company's cash flows to other aspects of the enterprise's financial statements. These cash flow ratios provide insight into the overall performance of the company. When a company has a higher cash flow ratio, the revenues are accelerating, and the entity can pay its bills. Also, it can better withstand the decline in performance at the given time.
Rates of return and profitability analysis
In the terminal course of the financial statement analysis, the following categories of analysis techniques are required to open the explanations behind the company's financial performance. These categories of statement analysis guide you through the pyramid of ratios, describing how investors can apply the pyramid to reveal the profitability, efficiency, and leverage components of any company. Understanding of these components demands expert command of the pyramid of ratios to investigate any business financial approach.
To get nearer to companies financial score per year and its comparison with previous fiscal years, the following terms must be interpreted:
- Understanding the triggers of the return on equity ratio provides profitability expectations on shares invested.
- Inspect the profitability, efficiency, and leverage ratios that run and approach the pyramid of ratios.
- Comprehension of the connections between the pyramid's primary, secondary, and tertiary ratios.
- Develop a pyramid of ratios utilizing an assemblage of issued financial statements and make a thoroughgoing financial investigation.
- Return on Equity (ROE) and Dupont analysis which is used to examine which factors change the ROE components (revenue, profit, costs, sales).
Where Can I find Financial Statements?
Publicly traded companies must produce financial statements regularly, so finding these is relatively straightforward. You can search google for a company name + financial statements, and you'll likely find the statements within the first search results. However, the information is often found in a PDF document making it difficult to analyze quickly.
Financial Modelling Prep has got all financial statements of companies since 1990 in an easy-to-use format. Search the company's stock ticker you'd like to analyze, and then click on the financial statements section. You can download the quarterly and yearly financial statement data in ZIP or CSV format!
Check it out now here and start doing your analysis!
Financial statement analysis is a powerful tool to understand and probe to make the best financial decisions. Among the available types of financial statement analysis, the balance sheet analysis informs what a company owns relative to the debt and equity in the company.
The income statement analysis tells us how profitable a business is. Finally, the Cash Flow Statement tells us how much cash is going and out of business, giving us an understanding of their financial sustainability.
However, financial statements have their limitations because the analysis is up for interpretation by individual investors. As such, different analysts can come to vastly different conclusions about the financial performance of a company. It's essential to get a deep-rooted understanding of finance and financial statements before making investment decisions!