What Is Financial Statement Analysis?

By Susan Kelly Updated on Aug 02, 2022
Internal and external stakeholders use financial statement analysis to assess business performance and value. All companies must create a cash flow statement, income statement, and balance sheet to be able to analyze financial statements.

Analyzing a company's financial statements is a process that allows the analysis of those statements to be used in decision-making. External stakeholders use it to assess an organization's financial health and evaluate its financial performance. Internal constituents use it to monitor and manage their finances.

How To Analyze Financial Statements

Financial statements are vital financial information that details every aspect of a company's operations. They can be evaluated based on past, present, and projected performance. Financial statements are generally based on the U.S. generally accepted accounting principles (GAAP). These principles require that a company create and maintain three major financial statements: the balance, income, and cash flow statements. Public companies must adhere to stricter reporting standards. GAAP is required for public companies. Private companies can prepare their financial statements more easily and have the option of using accrual or cash accounting.

Financial statement analysis can use a variety of techniques. Horizontal analysis, vertical analysis, and ratio analysis are three of the most important. Horizontal analysis is a horizontal comparison of data, which involves analyzing the values of line items over two years. The vertical analysis examines the vertical effects that line items have on other areas of the business and the proportions. Ratio analysis is a statistical relationship calculation that uses ratio metrics.

Different Types Of Financial Statements

To manage their operations and provide transparency to stakeholders, companies use the cash flow statement, income statement, and balance sheet. These three statements, which are interconnected, provide different perspectives on a company's activities as well as its performance.

Balance Sheet

The balance sheet shows a company's financial worth as a percentage of its book value. The balance sheet is divided into three sections to show the company's assets and liabilities and shareholders' equity. The short-term assets, such as cash or accounts receivable, can reveal much about an organization's operational efficiency. Liabilities include company expense arrangements and debt capital. Shareholder's equity details equity capital investments and earnings from periodic net income. The balance sheet must reflect assets and liabilities to equal shareholder's equity. This is a measure of the company's financial performance and can be used to determine if a company's net worth increases or decreases.

Income Statement

The income statement shows how revenue is divided against expenses to provide a bottom line. This gives a company's net profit or loss. The income statement can be broken down into three sections allowing you to evaluate business efficiency at three points. Determine gross profit; it begins with revenue and direct costs. Then it moves on to operating profit. This subtracts indirect costs such as marketing and general costs. After deducting interest costs and taxes, net income is achieved.

The basic analysis of an income statement typically involves the calculation of gross profit margin and operating profit margin. Each divides revenue by gross profit margin. The profit margin determines where company costs are high or low at different stages of operations.

Cash Flow Statement

The cash flow statement gives an overview of cash flows generated by operating, investing, and financing activities. The net income is carried to the cash flow statement, which is listed as the top line item in operating activities. The term investing activities refers to cash flows associated with firmwide investments. The financing activities section contains cash flows from equity and debt financing. The bottom line indicates how much cash a company currently has.

Free Cash Flow and other Valuation Statements

Analysts and companies also use free cash flow statements and other valuation statements when analyzing the company's value. The net present value of a company can be calculated using free cash flow statements. This is done by discounting the cash flow the company will generate over time. Private companies might keep a valuation statement if they decide to go public.

Financial Performance

Companies use financial statements daily and use them internally to manage their business. Both internal and external stakeholders generally use the same corporate finance methods to maintain business activities and evaluate overall financial performance.

Analysts often use many years of data when performing comprehensive financial statement analyses. This allows for horizontal analysis. Vertical analysis analyzes each financial statement and determines how it influences the results. Ratio analysis is a way to identify performance metrics within each financial statement and can also be used to bring together data points from multiple statements. Here is a list of some of the most popular ratio metrics:

  • Balance sheet: This includes asset turnover and quick ratio, receivables turn, days to sell, days to sales, debt-to-assets, and debt-to-equity.
  • Statement of income: These include gross and operating profit margins, net profit margin, tax efficiency, and interest coverage.
  • Cash flow: This includes cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics can be displayed per share.
  • Comprehensive: This includes return-on-assets (ROA), return on equity (ROE), and DuPont analysis.