Financial statement analysis is the use of analytical procedures to evaluate the financial health, risks, performance, and future potential of a business. Even the smallest business can benefit from the results of financial statement analysis as a guide for the business owner.
There are several types of financial statement analysis ranging from the most general to very specific. Business owners can choose the level of detail they need in order to make good decisions for the business. If a business is publicly held, or if it is for sale, external parties, like investors, use the results of financial statement analysis to make their investing decisions.
What Is a Financial Statement?
A financial statement is a document that contains information that communicates the financial position and performance of a business to management and external parties. The three most important financial statements that are generally used for financial statement analysis are:
- Income statement: The income statement shows a firm's financial position over a period of time. It is a statement of the firm's revenue and expenses. It is also called the profit and loss statement.
- Balance sheet: The balance sheet shows a firm's financial position at a point in time. It shows the firm's assets, liabilities, owner's equity, as well as the company's net worth.
- Statement of cash flows: The statement of cash flows shows the firm's cash inflows and outflows at any given point in time.
Analyzing these financial statements gives visibility into your company's financial position and trends. The financial data that you generate allows you to make changes to steer your company towards more profitability and efficiency.
Types of Financial Statement Analysis
There are a number of financial statement analysis techniques depending on the information you need:
Basic Financial Ratio Analysis
Financial ratios are useful tools that help business managers and investors analyze and compare financial relationships between the accounts on the firm's financial statements. Here are the most useful ratios for a basic financial ratio analysis:
Liquidity ratios show how easily a firm's current assets can be converted to cash in order to pay off short-term liabilities. The most important 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
Efficiency ratios let you see how well your business uses its assets. Common efficiency ratios are:
- Inventory turnover: How often your inventory is sold and restocked 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
- Total asset turnover: Shows how well you use your total assets to generate revenue
Solvency ratios demonstrate the ability of a business to pay its long-term debt obligations. Common solvency ratios are:
- Debt to equity: The amount of equity that can cover debts
- Debt to asset: Indicates the percentage of assets that are funded by debt
Coverage ratios measure the ability of a business to service its debt. The most often-used coverage ratio is:
- Interest coverage ratio: Measures the ability of the business to meet its interest charges on debt
Profitability ratios are measurements of whether a company is turning a profit and maximizing shareholder wealth and how much is being generated. The most often-used ratios are:
- Return on assets: Describes the return that assets are creating for a company
- Return on equity: Most used for shareholders and investors, and indicates whether the owner's equity is being used to create wealth for the shareholders
There are a plethora of financial ratios beyond those listed for more advanced financial ratio analysis.
Financial ratios give you very limited information unless you have something to compare them to, preferably ratios from other time periods or ratios from other companies in your business sector or industry.
Trend or time-series analysis is analyzing a company, using financial ratios, by comparing multiple time periods of financial information. Financial ratio analysis is only one type of trend analysis. Using other financial information, a company can also compare the current year's performance to previous years' performance.
Trend analysis is usually performed using a company's income statement and balance sheet.
Financial ratio analysis provides owners with data on changes during time periods in the same year or compares a time period with the same time period in previous years. For example, if you were to look at your debt-to-asset ratio from the fourth quarter of one year and compare it to the first quarter of the next year, you will see whether or not the amount of debt you have used to finance your assets has increased or decreased.
Trend analysis using financial ratios allows the financial manager to determine if positive or negative changes are occurring in the liquidity, efficiency, solvency, coverage, and profitability financial positions of the business firm and take the appropriate action.
Industry analysis, also called cross-sectional analysis or benchmarking, is analyzing a company by comparing the financial ratios to those of an entire industry to see how the company performs in comparison. Time periods are matched and industry average ratios are used for purposes of comparison. Industry average ratios are publicly available.
Industry analysis gives the financial manager a different picture of the company than trend analysis. The company is compared to a sample of companies in the same industry rather than by time period against itself. Industry analysis is valuable because the financial manager can get at least a rough idea if the company is on the right track.
Horizontal analysis is analyzing a company by comparing multiple time periods of financial information. The financial manager can compare the current year's performance to previous years' performance. This type of analysis is usually performed using a company's income statement and balance sheet.
This analysis provides owners with data on changes during time periods in the same year or compares a time period with the same time period in previous years. Horizontal analysis can be performed in three different ways, in addition to financial ratio analysis:
- Direct comparison: This type of horizontal analysis compares the income statement and balance sheet on a line-by-line basis. For example, compare each line of the financial statements for two years. Determine the absolute dollar amount by which each line item increases or decreases. This gives you a quick look at the financial position of your firm and helps you determine which line items, or accounts, need to be investigated further.
- Percentage method: If you analyze the financial statements of a company using this method, it is generally easier to interpret than the direct comparison method because percentages are easier to interpret than absolute dollars. You use two periods of financial data and compare the accounts you feel are concerning. Divide the first year by the second year and multiply by 100. You will see how much the change was in the second period on a percentage basis.
- Variance method: Using the variance method, you can choose your time periods in order to glean more information from the financial statements for creditors or investors. You calculate the difference, or variance, between the amounts of any given line item. Next, you use a variation of the percentage method formula to find the percentage increase or decrease between the first, or base, year and the year in which you are interested. Divide the variance by the value in the second year and multiply by 100, and you will have the percentage change between the time periods.
Horizontal analysis allows you to spot trends in your company's financial position between years. It shows you where your company is doing well and where any red flags might lie. It is not only helpful to financial managers but also to investors and creditors.
Vertical analysis is simpler than a horizontal analysis. The most basic vertical analysis deals with a one-year period from the firm's balance sheet and income statement. To do a vertical analysis, you prepare common-size income statements and balance sheets. In other words, to prepare the income statement, sales are considered 100%. Every other line item is stated as a percentage of sales. For the balance sheet, total assets are considered to be 100% and every other line item is stated as a percentage of total assets.
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 line item percentages of your total assets.
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 can provide.