Financial statement analysis is the first major step in dealing with a company’s finances and essentially facilitates attaining future income goals. Its importance lies in the notion that the financial statement analysis of a company showcases the complete monetary facts associated with it.
A complete financial statement analysis involves a collective analysis of a company or organization’s income statement, notes to accounts, balance sheets, cash flow statements, and statements of equity changes.
What is Financial Statement Analysis?
Financial Statement Analysis or simply Financial Analysis is an analyzing process that deals with all income and outflow statements of the finances of a company. It is utilised in reviewing the current financial status of the company, comparing it with its past and ideal state, and then using it to make financial gains.
It can be defined as a process of examining the complete financial statements of a company and its financial status in a comprehensive manner. For this process, several approaches are used in its work.
Financial Statement Analysis deals with accounting for an organization’s income, expenses, cash flow, and equity changes. Consequently, it is studied as a part of accounts. We shall understand the following things associated with financial statement analysis as given below.
Financial Statement Analysis: Key Takeaways
- Financial Statement Analysis is a bundle of recorded facts acquired via accounting of a company’s finances. It includes significant information on debtors, creditors, cash flow accounts, fixed asset accounts, etc.
- There are five components of financial statement analysis. These include liquidity analysis, profitability analysis, solvency analysis, market analysis, and efficiency analysis.
- Five approaches are incorporated in the working of a financial statement analysis: Vertical analysis, Horizontal analysis, Ratio analysis, Trend analysis, and cost-volume analysis.
What are the major approaches to analyzing Financial Statements?
Several approaches are used in understanding the work structure leading to the preparation of the financial statement analysis of a company. These methods help in preparing a detailed financial record. You must be familiar with these methods.
- Horizontal Analysis
Horizontal analysis uses a comparison method and is shown as a percentage growth over a particular line item as per the base year. It compares the financial data of a company over the past four months or years. It compares the current financial statement to a previous one, say the income statement, and then looks for visible variations, which can be lower or higher earnings. Horizontal analysis allows financiers to notice growth or fall patterns and make suitable decisions for improved finances.
- Vertical Analysis
Vertical analysis is the comparative percentage analysis of a line item with another line item. For instance, every item on the balance sheet represents the percentage of total assets, whereas every item on the income statement lists the percentage of total sales.
Thus, vertical analysis deals with the proportionate analysis of a financial statement. It is also known as the common sizing or normalization method of financial statement analysis.
- Financial ratio Analysis
Financial ratio analysis is an extremely important tool in making a financial statement analysis.
It makes a useful comparison between the different items in a financial statement with each other and is utilised to depict a growing or falling trend. Four major categories of financial ratios are analyzed over time and across competitors in the finance industry. These are:
| Ratio | Details |
| Liquidity Ratio | It depicts how fast a company can turn bankrupt and is measured by:
(Days to liquidate x Trade Receivables) + (Days to liquidate x Inventory)/Trade Receivables + Inventory. |
| Profitability Ratio | This ratio depicts how profitable a company is and gives a view of expected revenue. It measures via gross profit ratios break-even point. |
| Activity Ratio | It depicts how properly are the resources of a company managed.
Accounts receivable turnover and accounts payable turnover show how fast a company pays off or receives its payments. |
| Leverage Ratio | This ratio depicts the debt reliance of a company to fund its operations. It is measured via the debt-to-equity ratio given by:
(Short-term debt + long-term debt + leases)/Equity |
- Trend Analysis
Trend analysis is used to forecast the long-term movement of the market and bases its financial statements on historical data such as trade volume and movements of price. It is based on the notion that market movements follow a pattern over time and thus recurrences occur. If one follows the market trend appropriately, profits can be made.
- Cost Volume Profit Analysis
The cost volume profit analysis involves understanding the relationship between costs, sales, and profit. It incorporates the examination of variable and fixed costs, and using an established relationship between variable costs and sales to make a substantial business profit.
What is the significance of Financial Statement Analysis?
Financial statement analysis is a quintessential tool in the adept management of financial data and utilise it for drawing greater profits. It is done by reviewing the cash flows, profitability, past sales, debt and equity structures, operating expenses, and ROI (return on investments). A financial statement analysis holds great significance for all stakeholders. We shall look further into it:
- Financial managers analyze these financial statements in making decisions for the company. By reviewing the position of an entity, types of liabilities and assets, operational costs, and other such data, they review the financial weakness or strength of an item.
- The top management of a company uses financial statement analysis to understand the current financial status of the company, the chances of its success, and the best possible use of all available resources.
- Lenders can determine credit risk and loan amount if and when sanctioned to the company based on its survivability and repaying ability which can be known from its financial analysis.
- Financial statement analysis is crucial for trade payables in understanding the company’s ability to fulfill its long-term and short-term obligations.
- Financial statement analysis is used by labour unions to decide if they can wager for a price rise based on the trends of the company’s financial performance and its profitability.
- By analyzing any prospects of failure in fulfilling debts or insolvency via annual financial reports, investors assess the safety and profitability of the money they have invested.
Besides, several other applications of financial analysis make it highly significant.
Key Applications of Financial Statement Analysis
- The most fundamental application of financial statement analysis of a company is to review its performance over the past few years or quarters. This helps in deciding if a further investment be made in the company or not.
- A financial statement analysis is used to examine the present financial status of a company. It includes finding out about the earning capacity or profitability of the company and the operational costs.
- A comprehensive analysis of the financial statement can be used to predict the future financial status of a company i.e.; the prospects of its likely profitability or chances of bankruptcy. As stated above, the profitability ratio and liquidity ratio help depict these prospects well.
- Financial statement analysis is used by banks and other authorities in the division of loans given to the company following the credit risks.
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Financial Statement Analysis FAQs
Q1. What is the first step in financial statement analysis?
Ans: The collection of all financial statements of a company is the first step in financial statement analysis. It mainly incorporates the balance sheets, the income statements, and the cash flow statements.
Q2. What are the objectives of financial statement analysis?
Ans: The objectives of financial statement analysis involve the assessment of the current financial position of the company, looking into its operational and managerial working, filtering out any prospects of bankruptcy, and finding ways to make considerable business profits.
Q3. What is the scope of financial statement analysis?
Ans: Financial statement analysis incorporates comprehensive information of a company’s financial assets, liabilities, operational capability, the performance of the entity, and entire financial strata.
And so, it can be used to know about the company’s success rate, its profitability, prospects of insolvency or failure of debt fulfillment, chances of profit on invested money, and many others.
