Financial Statement Analysis – A Brief Guide For Analysis

Financial Modeling and Analysis

Financial Statement Analysis is the process of analyzing the company’s financial documents or information to determine whether the company is financially sound or not. This is one of the most crucial assessments in the financial section of a business since it shows investors, lenders, and other stakeholders how efficient the company is. It delivers the company’s level of credibility to the outside world. A financial analyst will perform the analysis of financial statements to meet the legal regulations and help maintain the company’s financial health. This article explains its importance, the types of analysis, and how to perform them efficiently.

 

Financial Statement Analysis

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Financial Statement Analysis – Definition

The financial statements analysis is the process of evaluating or reviewing the financial records to understand a company’s financial position and maintain its financial health and stability. This evaluation is much anticipated by the business stakeholders, investors, managers, and creditors. Since this statement will point out the credibility of the company. Henceforth, financial performance evaluation is a vital process for every business. 

Financial performance evaluation will evaluate the company’s budgets, other financial-related cash transactions, and business projects. Evaluation of the financial statements will also enhance the ability of a business to identify future risks, vulnerabilities, and challenges. Identifying and preparing for these risks and challenges will enable your business to prepare for their impact. It will help to protect the company’s financials from financial mishaps.  

There are numerous advantages to performing a financial statement analysis in a business. Some of them are very helpful in proper decision-making, evaluating the performance of a business, assessing the possible financial business risk, and enhancing the allocation of resources.

 

Financial Statement Analysis And Its Objectives

Some of the objectives that a business can achieve by analyzing its financial statements are:

  • Allocation of Business Resources – By analyzing the financial statement you can enhance the allocation of resources and achieve business goals without any hindrances.
  • Maintaining Financial Health – One of the main objectives is to attain financial stability in the business. It will help your business to face challenges and opportunities.
  • Future Performance – Analysis of financial statements will help you in predicting the future performance of your business.
  • Analyzing Profitability – Financial Statement Analysis will help you to analyze the profitability of your company. You can know your company’s ability to make revenue/income from the business operations.
  • Efficiency In Business Operations – Identifying the operational efficiency of the business will help your company to perform better. You can also make cost-effective utilization of resources and find out the areas required for improvement.
  • Opportunities for Investment – Analyzing a financial statement will help you to identify investment opportunities and provide related business insights. You can identify and mitigate risks and challenges related to investments.
  • Exposure to Risks – After assessing and evaluating the liquidity ratios and level of company debts, you can prepare and plan for future risks in your business. 
  • Supporting Strategic Planning – The insights from the analysis of financial statements will help in making long-term strategies that will go in line with the company’s goals and financial position.
  • Enhancing Communication with Stakeholders – After the analysis, you will get well-informed financial insights about the company. This will help you to communicate and make well-prepared business decisions with stakeholders, creditors, and investors.
  • Facilitating Compliance with Regulatory – Complying with financial regulations will enhance the transparency of financial reporting. A financial analyst who is responsible for evaluating financial statements will make sure that the company’s financials are adhering to the rules and regulations.

 

Types Of Financial Statement Analysis

There are different types of financial performance evaluation used for the analysis of financial statements. Each type of financial statement analysis provides a unique point of view in understanding the company’s financial position, stability, and performance. Each of the analyses listed below has its uniqueness and advantage of its own. Some of them are briefly explained below:

  1. Horizontal Analysis – This type of analysis will compare the financial data across multiple periods. This is done to identify changes and updated trends in the financial statements. You can identify changes in the expenses, revenue, and other financial items using horizontal analysis.
  2. Ratio Analysis – This type of financial performance evaluation compares various items of the financial statements and calculates the financial ratios. Several financial ratios like leverage, debt-to-equity ratio, liquidity ratios, profitability, and others provide in-depth analysis and insights into the financial performance of the company.
  3. Vertical Analysis – A vertical analysis will take each line of item on the financial statement and represent them as a percentage of the case financial item. It will help in pointing out the significance of specific financial areas. This analysis will also help in providing a perception of the relative proportions of various components within the same period.
  4. Industry Comparative Analysis – This financial statement analysis is mainly used for getting insight into the company’s weaknesses and strengths. It will benchmark the company’s financial position and performance against the market averages. In this way, you will be able to assess how well your company is performing compared to your business competitors in the industry.
  5. Trend Analysis – This kind of financial performance evaluation will allow you to examine the orientation of your company’s financial data over multiple periods. This will enable organizations to find out the possible changes and identify new patterns in the company’s financials. It will also help in the prediction of the future performance of company financials based on the early-year financial information.
  6. Common Size Analysis – This analysis presents every item on the statement as a percentage of the common base like assets or total revenues. It will allow a much easier comparison along different periods and with different companies in the industry.
  7. Valuation Analysis – Valuation analysis will examine the natural value of the company’s assets or stocks. The investors who are interested in buying or selling the securities will look forward to this type of analysis to make informed and better decisions.
  8. Qualitative Analysis – We know that a company’s quantitative financial data forms its foundation. A qualitative analysis will give thought to the non-financial factors such as market trends, management quality, and industry dynamics. This comprehensive type of analysis focuses on the company’s performance. 
  9. Credit Analysis – As the name suggests, this financial performance evaluation is done to find out the company’s ability to pay its debt obligations and creditworthiness. Several financial factors are taken into account while analyzing the fact that whether your company can pay back the debts or loans. Some of these factors are the financial stability of the company, debt levels, and cash flow transactions. 
  10. Scenario Analysis – Here you can find out the possible financial outcomes based on various external factors and assumptions. Scenario analysis is an approach that will help your company to get prepared for various scenarios and their possible impacts on the performance of business financials.

 

Who Will Perform The Analysis Of Financial Statements?

The person responsible for analyzing financial statements is a financial analyst. The information recorded in the financial reports such as management’s comments, financial statements, and other related notes will aid the financial analyst in performing a proper evaluation. The main aim is to find out the company’s financial position by considering both credit analysis and equity analysis.

A company can perform a financial performance evaluation of its statements for a variety of reasons such as the assessment of credit risk, the valuation of equity securities, the evaluation of the subsidiary’s performance compared to other companies, and the achievement of due diligence on an investment.   

 

Common Financial Ratios

In the above section, we have already explained what ratio analysis is. As explained several ratios are to be evaluated. But these financial ratios are applicable for various other types of analysis also. Hence understanding each of them is also essential while performing the analysis of financial statements. The list of some common financial ratios is given below:

  • Profitability Ratios – This ratio measures the ability of a company to generate profit from its business activities. Profit can be any financial item like assets, returns, and gross profit margin.
  • Efficiency Ratios – This is the factor that shows how efficiently the company has made use of its resources or assets. Assets can be accounts receivable turnover or inventory turnover.
  • Liquidity Ratios – It evaluates the potentiality of a company to meet its short-term moral imperatives. These can be either the current ratio or the quick ratio.
  • Leverage Ratios – This is similar to liquidity ratios, but it evaluates the company’s capacity to meet long-term obligations like debt-to-equity ratio. It makes use of the company’s debt information for this assessment.

 

Steps In Financial Statement Analysis

Analyzing financial statements is a crucial process for identifying the company’s financial health. It involves a detailed, structured, and systematic approach. It will uncover the financial insights of the company. The steps are listed below:

  1. Gather accurate information: Make sure to obtain the latest and updated financial statements and records. They should be error-free for better analysis. These records are the base and starting point of a financial statement’s analysis. All the necessary financial information records recorded recently are taken into account.
  2. Understand the accounting principles: For the accurate analysis of financial financial statements, you must familiarize yourself with the standards and accounting principles. This knowledge is important in this process analysis. 
  3. Normalize the data: Find out and adjust the accounting anomalies and irregularities for a clear analysis. Make sure to exclude non-recurring or one-time items for better financial reporting. It will ensure a clear base for the comparison.
  4. Horizontal comparison: This is used to detect changes, patterns, and trends in the financial performance of a particular period by comparing the financial data across different periods.
  5. Vertical analysis: It includes expressing each line item as a percentage ratio of the base item. This will help to understand the relative significance and composition of different financial components. It is one type of financial performance evaluation of the financial documents that needs to be done with accurate methods.
  6. Ratio calculation: Several financial ratios such as financial leverage, profitability, and liquidity are also considered. These will provide valuable insights during the analysis.
  7. Quantitative interpretation: This step will analyze the ratios calculated in the previous step and compare them against the past data or benchmarks of the related industry. It will help to identify the fluctuations which point out the company’s strengths and weaknesses.
  8. Common size perspective: For the ease of cross-period or cross-company comparisons you can convert the line items into percentages of total assets or revenues. This step is essentially done with proper care.
  9. Trend identification: Evaluate the trajectory of your company’s financial information over some time to identify trends or consistent patterns. It will support the future performance evaluation.
  10. Consider the industry performance: To find out the company’s competitive position in the market, you can benchmark its performance against the industry averages. This will help the management to devise new competitive strategies.
  11. Qualitative factors: Consider the non-financial factors such as industry dynamics, quality of management, and market trends. Such factors are important regarding the business activities. Neglecting these non-financial factors is a common mistake.
  12. Cash flow evaluation: Scrutinize the cash flow statement to analyze the company’s ability to produce and manage the business funds. The cash flow statement will have a record of transactions in and out of the business activities. This statement must be error-free for the proper evaluation.
  13. Assessment of scenario: Anticipate and evaluate different scenarios to obtain the potential impact of the company’s financial statements. This will enable the business to prepare and enhance its options for different financial situations.
  14. Creditworthiness evaluation: This is an important step in the financial statement analysis. Assessing the overall financial stability and cash flow will show the credibility of the company. This credibility statement is the transparency of a business to attain trust among the stakeholders, investors, creditors, and other related parties.
  15. Determining the intrinsic values: The inherent values of a company are its stocks and assets. You can make use of different valuation methods to estimate these intrinsic values of the company.
  16. Conclusion formation: Once the evaluation is properly done according to the above steps, you can summarize the findings. A brief conclusion is formulated using these insights. It will show the company’s financial performance, stability, operational efficiency, financial health, and growth aspects in the future.
  17. Effective communication: The above-derived findings and conclusions must be effectively communicated before the stakeholders. An effective communication to the stakeholders is necessary to convey the company’s financial performance.

 

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Conclusion

This article on financial statement analysis shows how important it is for making accurate business decisions about investments, crediting, business management strategies, and credibility. It will enable businesses to evaluate the company’s financial stability and maintain sustainable growth. A proper evaluation and analysis of financial statements will enhance the decision-making ability of the company and forecast the future finances. Risk mitigation can be enhanced if financial statements are analyzed periodically

 

FAQs-

1.What Are The Applications Of Financial Statement Analysis?

There are lots of applications for financial record analysis for a business. Some of them are:

  • Identify the financial level of your business
  • Evaluating the previous year’s financial statements and performance
  • To gain credit from lenders and do the business expansion
  • To aid fundraising events and investors in the decision-making process
  • Maintain business credibility
  • To help policy-making for the government in taxation and regulations
  • To maintain credibility among the stock traders

2. What Is The Importance Of Financial Statements?

There is no doubt that financial statements play a crucial role in the business. Two major areas where its significance can be considered are:

  • Stakeholders

A clean sheet of well-laid financial statements is the main source of credibility for a business. If an accurate financial performance evaluation is performed then your company is categorized under a sustainable financial growing business, which is exactly what stakeholders or investors will look at at the end of the day.

  • Management

Company management is responsible for the progress, positioning of the business, division of new business strategies, and updating the business according to the market trends. A perfectly evaluated financial statement will help the company management in making these decisions precisely and keep updated with the business goals.

3. What Are The Key Components Of Financial Statements Used In The Evaluation?

An organization is responsible for preparing four types of financial statements. They are:

  • Income Statement – It will have three major components – Revenues, Expenses, and Profit or Loss
  • Statement of financial transactions – Cash flow in and out of the business which is classified into 3 types – Operating activities, Financing activities, and Investing activities
  • Statement of financial position or balance sheet – The components included in a balance sheet are equity, liabilities, and assets.
  • Disclosure of financial statements – These notes to accounts will contain information regarding provisions, depreciation, reserves, inventory, share capital, etc.

4. What Is A Financial Statement?

A financial statement of a company is a financial document that represents its financial position, business activities, and performance. These are mainly used by investors or lenders to check the financial stability of a company. It is mostly devised for a particular period like monthly, quarterly, or yearly. However, it can be prepared to cover any time. Four types of financial statements are Cash flow statements, profit and loss statements, statements of changes in equity, and balance sheets.

5. What Is A Balance Sheet?

A balance sheet is a company’s financial statement that contains information on liabilities, total debt, equity capital, and assets at a specific point in time. This one is one of the most important financial statements of a company. The balance sheet is used for the analysis of business performance. It is an important financial record used by regulators, executives, analysts, and investors to understand the present financial position of an organization.

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