How Do You Do Financial Statement Analysis?
There are some useful techniques involving simple math which can help you perform a financial statement analysis for your business. You'll need the three main financial statements for reference—the balance sheet, income statement, and statement of cash flows.
Each of the following methods gives visibility into trends that your business may have. The information you receive can allow you to make changes to steer your company towards more profitability and efficiency.
There are many different types of ratios developed when conducting a financial analysis. Efficiency ratios let you see how well your business uses its assets.
Common efficiency ratios are:
- Inventory turnover—how often your inventory turns over in a year
- Accounts receivable turnover—how often your accounts receivable are collected and paid
- Accounts payable turnover—measures how fast you pay off your creditors
- Asset turnover—exhibits your asset utilization in generating revenue
Liquidity ratios are ratios that indicate whether a company can pay off its short term debts by converting current assets into cash.
The most common liquidity ratios are:
- Current ratio—describes the ability to pay off current liabilities
- Quick ratio—subtracts inventory from current assets to express a more strict indicator of the ability to pay current liabilities
- Cash ratio—the percentage of cash you have for short term debts
Solvency ratios demonstrate the ability of a business to pay its long term obligations. Common solvency ratios are:
- Debt to equity—the amount of equity that can cover debts
- Debt to asset—indicates assets that are funded by debt
Profitability ratios are measurements of whether a company is turning a profit and how much is being generated. The most used ratios are:
- Return on assets—describes the return that assets are creating for a company
- Return on equity—one of the most used for shareholders and investors, it indicates whether assets are being used to create profit
There are more ratios than those listed. The multitude of ratios in each category can make things very confusing. Stick with the most common ratios unless you need to use others.
Horizontal analysis is conducting by comparing multiple periods worth of financial information. Using financial ratios, a company can compare current years performance to previous years performance.
This type of analysis is usually performed on income statements and balance sheets.
This analysis provides owners with data on changes. For example, if you were to look at your debt to equity ratio (from your balance sheet) from this year and compare it to the last year, you may see a positive or negative change.
You may not see any change. If your debt to equity is the same as the period previous, you will not see a change. However, if your debt had gone up without an increase in equity you would see your debt to equity ratio go down.
This could indicate a problem, or not, depending on the decisions you had made throughout the year.
Net profit, from your income statement, is a very popular method of viewing the changes in profitability between periods. Differences, in accounting called variances, can also be compared between different periods.
If net profit for years one and two had a variance of $55,000 and years two and three had a variance of $25,000, it could be an indicator something changed.
This is when the ratios and metrics are most valuable. They give you a visual representation of something you may need to investigate.
Vertical analysis is much more simple than a horizontal analysis. It deals with a one year period, revealing the outcomes of the income statement and balance sheet as percentages of sales and assets, respectively.
An income statement vertical analysis provides you with a look at the cost of goods sold, gross margin, and your expenses as a percentage of the value of sales for the period.
A balance sheet vertical analysis is used in the same manner as the income statement. It can be used to show the percent any of the line items are of your total assets. The categories on the balance sheet are assets, liabilities, and equity.
For instance, if you had total assets of $2,000,000 and $200,000 in cash, your cash is 10% of your total assets. Likewise, if your current liabilities were $500,000, then your liabilities are 25% of your total assets.
As you become more familiar with the ratios and financial statements, you'll be able to make more sense of the information horizontal and vertical analysis provide.