Last updated on July 25th, 2024 at 03:08 pm
Financial statements such as the balance sheet, cash flow and income statements are essential for understanding a company's financial health. These documents, like a financial report card, tell the story of a company's performance through numbers.
Financial statement analysis is the art of interpreting these statements to gain valuable insights. Investors use it to assess potential investments, creditors evaluate a company's ability to repay debts, and business owners gain a deeper understanding of their company's performance and identify areas for improvement.
We will cover the three key financial statement analysis techniques (ratio analysis, trend analysis and cash flow analysis) in this article. By mastering these techniques, you'll be able to understand the hidden stories within financial statements and make informed financial decisions. Let us dive in.
The 3 Main Financial Statements
Financial statements are the building blocks of financial analysis, offering a window into a company's financial health and performance. Each statement plays a specific role in telling the company's story:
1. Income Statement (Profit and Loss Statement)
This statement reveals a company's profitability over a specific period (usually a quarter or year). It is like a company's income report, detailing how much money it earned and spent. Here is a breakdown of the key information it provides:
- Revenues: This section captures all the income generated through a company's core business activities, such as sales of products or services.
- Cost of Goods Sold (COGS): For companies that sell products, COGS represents the direct costs associated with producing those goods.
- Operating Expenses: These are all the ongoing expenses a company incurs to run its business, including rent, salaries, marketing, and administrative costs.
- Gross Profit: This is calculated by subtracting COGS from revenues, reflecting the profit earned from the core business before accounting for other expenses.
- Operating Income (EBIT): This is gross profit minus operating expenses, showcasing the company's profitability from its core operations.
- Non-Operating Items: These include income or expenses not directly related to the core business, such as interest earned or paid.
- Net Income (Profit After Tax): This is the ultimate profitability metric, representing the company's bottom line after accounting for all expenses and taxes.
2. Balance Sheet
The balance sheet can be easily described as a company's financial photograph at a specific date. It captures a snapshot of everything the company owns (assets), everything it owes (liabilities), and the difference representing the owners' investment (shareholders' equity). Here is a closer look at its key components:
- Assets: These are all the resources a company owns that have economic value. They are usually categorised into current assets (cash, accounts, inventory or receivables which can be converted to cash within a year) and non-current assets (property, plant & equipment, intangible assets which are long-term holdings).
- Liabilities: These represent the company's financial obligations or what it owes to creditors. They are further categorised into current liabilities (short-term debts that must be paid within a year) and non-current liabilities (long-term debts such as loans or bonds).
- Shareholders' Equity: This represents the owners' claim on the company's assets. It is calculated as total assets minus total liabilities, reflecting the net investment by shareholders.
3. Cash Flow Statement
This statement tracks the movement of a company's lifeblood (which is cash). It categorises cash inflows and outflows from various activities over a specific period. Here is a breakdown of the three main sections:
- Operating Activities: This section reflects cash generated from the core business, including cash received from customers and cash paid for expenses.
- Investing Activities: This section tracks cash inflows from selling assets or investments and cash outflows for acquiring new assets or investments.
- Financing Activities: This section shows how a company raises or repays capital. It includes cash inflows from issuing new debt or equity and the outflow of cash for debt repayment or by paying dividends to shareholders.
By analyzing financial statements (all three statements) together, you can gain a comprehensive understanding of a company's financial health, its capacity for generating profit, managing debt, and sustaining its operations.
Ratio Analysis: Decoding the Numbers Behind Financial Health
Ratio analysis is a powerful financial statement analysis technique that transforms the raw data in financial statements into meaningful insights. It involves calculating ratios that assess a company's financial performance, liquidity, solvency, and profitability. By analysing these ratios, you can gain valuable information about a company's financial health and its ability to meet its obligations.
Here, we will delve into key financial ratios categorised into three essential areas:
1. Liquidity Ratios
Liquidity ratios assess if a company will be successful in meeting its short-term debt obligations using its current assets.
- Current Ratio:
- Formula: Current Assets / Current Liabilities
- Interpretation: A higher current ratio indicates better short-term liquidity. Generally, a ratio above 1 is considered healthy, but this can vary by industry.
- Industry Example: A grocery store with a high turnover of inventory might have a lower current ratio compared to a manufacturing company holding large quantities of raw materials.
- Quick Ratio (Acid-Test Ratio):
- Formula: (Current Assets - Inventory) / Current Liabilities
- Interpretation: This ratio excludes inventory (considered less liquid than other current assets) from the calculation, providing a stricter measure of short-term liquidity.
2. Solvency Ratios
Solvency ratios measure whether a company will be successful in meeting its long-term debt obligations and its overall financial stability.
- Debt-to-Equity Ratio:
- Formula: Total Liabilities / Shareholders' Equity
- Interpretation: A lower debt-to-equity ratio indicates a company is financed more by equity (investor ownership) and less by debt, suggesting a more stable financial position. However, some industries, like utilities, may naturally have higher debt ratios due to the capital-intensive nature of their business.
- Debt Ratio:
- Formula: Total Debt / Total Assets
- Interpretation: This ratio shows the proportion of a company's assets that is debt-financed. A higher debt ratio suggests a greater risk of default if the company struggles to generate profits.
3. Profitability Ratios
These ratios measure a company's capacity for generating profit from its operations.
- Profit Margin:
- Formula: Net Income / Revenue
- Interpretation: This ratio indicates the percentage of revenue converted into net income. A higher profit margin suggests a company is efficient at generating profits from its sales.
- Return on Equity (ROE):
- Formula: Net Income / Shareholders' Equity
- Interpretation: ROE measures how much profit a company generates for each dollar of shareholder equity. It reflects the return on investment for shareholders.
4. Interpreting Ratios with Caution
It is important to remember that ratios should be analysed in context and compared to industry benchmarks or a company's historical performance. A solid financial report analysis can help companies make the right business decisions. Additionally, during financial report analysis, some ratios can be manipulated through accounting practices. Therefore, using multiple ratios and combining ratio analysis with other financial statement analysis techniques provides a more comprehensive picture.
Trend Analysis: Spotting the Trajectory Behind the Numbers
Financial statements provide a snapshot in time, but true financial health is revealed by trends over time. Trend analysis is a financial statement analysis technique that helps you identify these trends, allowing you to see how a company's financial performance has changed over a period (usually multiple years). By analysing these trends, you can gain valuable insights into the company's financial health and its future prospects.
There are two main methods for trend analysis:
1. Horizontal Analysis (Year-over-Year Analysis)
This financial statement analysis technique method focuses on comparing line items across multiple years within the same financial statement. Here is how to perform a horizontal analysis:
- Step 1: Prepare a Table: Create a table with columns for each year you are analysing and rows for each line item in the financial statement (e.g., income statement).
- Step 2: Fill in the Data: Enter the actual figures for each line item in the corresponding year's column.
- Step 3: Calculate the Change: For each line item, calculate the difference (increase or decrease) between the current year and the previous year. You can express this change as a dollar amount or a percentage change using the following formula:
- Percentage Change = ((Current Year Amount - Previous Year Amount) / Previous Year Amount) * 100
Example: Let us analyse a simplified income statement for a company over two years:
| Line Item | 2023 (USD) | 2022 (USD) | Change (USD) | Change (%) |
| Revenue | 1,000,000 | 800,000 | 200,000 | 25% |
| Cost of Goods Sold (COGS) | 600,000 | 500,000 | 100,000 | 20% |
| Gross Profit | 400,000 | 300,000 | 100,000 | 33.33% |
| Operating Expenses | 250,000 | 200,000 | 50,000 | 25% |
| Net Income | 150,000 | 100,000 | 50,000 | 50% |
2. Vertical Analysis (Common-Sise Analysis)
This financial statement analysis technique method expresses each line item in a financial statement as percentages of base figures, usually total assets or total revenue. This allows you to compare the relative composition of the financial statement across different periods or companies.
Here is how to perform a vertical analysis:
- Step 1: Prepare a Table: Similar to horizontal analysis, create a table with columns for each year and rows for each line item.
- Step 2: Calculate Percentages: For each line item in a year, divide its amount by the base figure (e.g., total revenue) and multiply by 100 to express it as a percentage.
Benefits of Trend Analysis
By analysing trends over time, you can identify:
- Growth patterns: Are revenues, profits, or expenses increasing or decreasing?
- Profitability trends: Is the company's profit margin improving or deteriorating?
- Efficiency changes: Is the company managing its costs effectively?
- Potential risks: Are there any warning signs of declining performance or increasing debt?
Cash Flow Analysis: Understanding the Bloodstream of the Business
Cash flow analysis is one of the most important financial statement analysis techniques out there. The cash flow statement is a vital financial statement that reveals the movement of a company's lifeblood (cash). Unlike the Income Statement, which focuses on profitability on paper, the cash flow statement tracks the actual cash coming in (inflows) and going out (outflows) over a specific period. This information is crucial for understanding a company's ability to generate cash, pay its bills, and invest in future growth.
The cash flow statement is divided into three main sections:
1. Operating Activities
This section is the heart of the cash flow statement. It details the cash generated from a company's core business activities. Key inflows include cash received from customers for goods or services sold, while outflows include cash paid for expenses like salaries, rent, and supplies. A positive cash flow from operating activities indicates the company is generating enough cash to cover its ongoing expenses.
2. Investing Activities
This section tracks cash inflows and outflows related to the company's investments in assets. Inflows might include proceeds from selling property, plant & equipment (PPE) or investments. Outflows include cash spent on acquiring new PPE or intangible assets like patents. Analysing this section reveals how the company is investing in its future growth.
3. Financing Activities
This section shows how a company raises or repays capital. Cash inflows include proceeds from issuing new debt or equity (selling shares). Outflows include cash used to repay debt or pay dividends to shareholders. This section reveals how the company is financing its operations and how much it is returning to investors.
A Simplified Approach: Cash Flow and Profitability
While all three sections are important, a simplified approach to cash flow analysis focuses on Operating Cash Flow (OCF) and its relation to profitability. Here is why:
- OCF reflects a company's ability to generate cash from its core business, independent of accounting treatments. Unlike Net Income on the Income Statement, OCF considers actual cash receipts and disbursements.
- A positive OCF is essential for a company to sustain its operations and growth. Even if a company shows a profit on paper, if it is not generating enough cash from operations, it might struggle to pay its bills or invest in the future.
Here are some key metrics to consider when analysing OCF:
- Operating Cash Flow Margin: This ratio shows OCF as a percentage of revenue, indicating how much cash a company generates for every dollar of sales.Â
- Free Cash Flow (FCF): This metric goes a step further by subtracting capital expenditures (money spent on PPE) from OCF. FCF represents the excess cash available for dividends, debt repayment, or future investments.
By analysing OCF and related metrics, we can gain valuable insights into a company's ability to convert profits into cash and its overall financial health. We should also remember that a strong OCF, even with moderate profitability, can be a positive sign for a company's long-term sustainability.
Wrapping Up
By applying these financial statement analysis techniques, we can unlock the hidden stories within financial statements and gain valuable insights into a company's financial health, performance, and future prospects.
Remember, there are additional analysis techniques available such as the DuPont analysis for a deeper dive into profitability. Sign up for a solid CFA course to learn more advanced financial analysis techniques. Financial statement analysis is a skill that improves with practice. The more you analyse statements, the better you'll become at interpreting the financial health of a company. Research further, explore financial statements of companies that interest you, and put your newfound knowledge to the test. By mastering financial statement analysis, you will be well on your way to making informed investment decisions and navigating the complex world of finance.
You can enrol in the Chartered Financial Analyst (CFA) Certification programme by Imarticus to become a CFA. This comprehensive CFA course will teach you everything you need to know to use different financial statement analysis techniques effectively.
Frequently Asked Questions
What are the 3 main financial statements?
The 3 main statements are income statement (tracks profitability), balance sheet (shows a company's financial position at a specific date), and cash flow statement (tracks cash inflows and outflows).
What is ratio analysis used for?
Ratio analysis helps assess a company's financial health by calculating ratios that measure liquidity, solvency, and profitability. It uses numbers from the financial statements to gain insights.
What is the difference between horizontal and vertical analysis?
Horizontal analysis compares line items across multiple years within a statement, showing trends. Vertical analysis expresses each line item as a percentage of a base figure (e.g., total revenue) in a single year.
Why is analysing cash flow important?
Cash flow analysis is crucial because, unlike profitability, it reflects a company's ability to generate actual cash from its operations, which is essential to sustain its business.
