How Do You Do Financial Statement Analysis?

A number of useful techniques involving simple math and a bit of research can help you perform some qualitative and quantitative financial statement analysis for your business, depending on the type of information you want to investigate.

You'll use the three main financial statements, balance sheet, income statement, and statement of cash flows. Make sure, especially if you're using financial statements from more than one reporting period, that each financial statement has been prepared the same way so that you have data that's directly comparable from one period to another. Take this into consideration also if you choose to compare your financial data to that of outside firms or industry averages.

Each of the following methods gives visibility into business trends, variances, and issues, raising questions about the company that needs to be answered. Examining the business, finding the explanations for variances and making changes based on positive or negative trends is the real outcome of financial statement analysis. 

01
Trend Analysis

Trend analysis is also called time-series analysis. Trend analysis helps a firm's financial manager determine how the firm is likely to perform over time, based on trends shown by past history.

Trend analysis uses historical data from the firm's financial statements, along with forecasted data from the company's pro forma, or forward-looking, financial statements, to assemble a longer-term view of its financial activity and look for variations over time.

One popular way of doing trend analysis is through financial ratio analysis. If you calculate financial ratios for a business firm, you'll want to calculate at least two years of ratios to compare side-by-side to provide any meaningful information.

Ratios mean nothing unless you have something to compare them to, such as other years of data. Trend analysis is even more powerful if you have and use several years of financial ratios. Some firms also compare data to average ratios for their industry or competitors.

02
Common-Size Financial Statement Analysis

Common-size financial statement analysis involves analyzing the balance sheet and income statement using percentages. All income statement line items are stated as a percentage of sales. All balance sheet line items are stated as a percentage of total assets.

For example, on the income statement, every line item is divided by sales and on the balance sheet, every line item is divided by total assets. This type of analysis enables the financial manager to view the income statement and balance sheet in a percentage format, making it easier to interpret.

Looking at an income statement, for example, you can turn it into a common-size income statement easily. If you calculate net income as a percentage of total sales, it would look like this example: $64,000 net income / $1,000,000 total sales = 6.4 percent.

Apply that formula to every line item on the income statement to develop your common-size income statement. In other words, set each line item as a percent of sales, with sales equal to 100 percent of itself.

As with financial ratio analysis, you can compare the common-size income statement from one year to other years of data to see how your firm is doing. It is generally easier to make that comparison using percentages rather than absolute numbers.

Using percentages also makes it easier to compare two firms of very different sizes. Even if one firm's three times larger than its competitor in sales terms, percentage-wise, it probably spends the same proportions of expenses, for example.

03
Percentage Change Financial Statement Analysis

Percentage change financial statement analysis gets a little more complicated. When you use this form of analysis, you calculate growth rates for all income statement items and balance sheet accounts relative to a base year.

This is a very powerful form of financial statement analysis. You can actually see how different income statement items and balance sheet accounts grew or declined in relation to the growth or declines in sales and total assets.

For example, say that XYZ, Inc. has $500 in inventory on its balance sheet in 2015 and $700 in inventory on its balance sheet in 2016. How much has inventory grown in 2016?

The formula to calculate the growth rate in inventory is the following: (2016 ending inventory - 2015 beginning inventory) / 2015 beginning inventory = $200 / $500 = 0.40, or 40 percent. The growth or change in inventory for XYZ, Inc. in 2016 is 40 percent.

If you do a percentage change analysis for all balance sheet and income statement items, compare two or three years' worth of data side by side to spot important trends in items such as excessive spending or improved sales growth.

04
Benchmarking

Benchmarking is also called industry analysis. Benchmarking involves comparing a company to other companies in the same industry to see how one company is doing financially compared to others in the industry.

This type of analysis is very useful to the financial manager as it helps them see if they have a competitive advantage or spot inefficiencies relative to others in the same business.

Financial ratio analysis is often used for benchmarking. Financial ratios for individual, mainly public companies, can be obtained from a number of sources. A few publications offer industry average ratios, although they may require a paid subscription, such as Risk Management Association's  Annual Statement Studies.

You can also obtain industry average ratios from Value Line and Dun and Bradstreet. Check for all three of these publications at your local public library or a local college business library.

To do benchmarking, compare the ratios for one company to the ratios of other companies in the same industry. Make sure that the industry average ratios are calculated in the same way the ratios for your company are calculated when you perform benchmarking. 

Using these four financial statement analysis techniques can assist financial managers in understanding a business firm's financial state both internally and as compared to other firms in its industry. Together, these methods provide powerful analysis tools that can help companies gain insight into staying solvent and profitable.