Tips and Tools for Financial Statement Analysis: Become a Pro at Analysing Financial Statements​

Numbers tell stories, and financial statements are no exception. However, understanding these stories and their contexts requires more than just financial calculations. It’s about seeing the big (whole) picture.

Traditional ratios are just the beginning. The cash conversion cycle and debt service coverage ratio are just some hidden gems waiting to be discovered.

Financial statement analysis​ is not just theory. It’s highly essential for real-world applications. Let’s learn more.

Financial Ratios for Analysis

Here are a few ratios to consider:

Cash Conversion Cycle: This ratio reveals how efficiently a company manages its working capital. A lower cash conversion cycle indicates better cash flow management.

Debt Service Coverage Ratio: This ratio assesses a company’s ability to meet its debt obligations. A higher ratio suggests a stronger financial position.

Efficiency Ratios

  • Inventory Turnover Ratio: This ratio measures how efficiently a company manages its inventory. A high inventory turnover ratio indicates that a company sells its inventory quickly.  
  • Asset Turnover Ratio: This ratio measures how efficiently a company uses its assets to generate revenue. A high asset turnover ratio suggests that a company uses its assets effectively.

Profitability Ratios

  • Return on Sales (ROS): This ratio measures a company’s profitability relative to its sales. A high ROS indicates a high-profit margin on sales.
  • Operating Margin: This ratio measures a company’s operating profitability, excluding interest and taxes. A high operating margin suggests solid operating efficiency.

Solvency Ratios

  • Interest Coverage Ratio: This ratio measures a company’s ability to cover its interest expenses with earnings before interest and taxes (EBIT). A high-interest coverage ratio indicates that a company has a strong ability to meet its debt obligations.   
  • Quick Ratio: This ratio is a more stringent measure of a company’s liquidity than the current ratio, as it excludes inventory from current assets. A high quick ratio suggests that a company has a strong ability to meet its short-term obligations.

How to Analyze Financial Statements

Here is how we can dissect financial statements:

  1. Horizontal Analysis: Compare financial data across multiple periods to identify trends and changes.
  2. Vertical Analysis: Express each item on a financial statement as a percentage of a total figure to understand its relative importance.
  3. Ratio Analysis: Calculate financial ratios to assess a company’s profitability, liquidity, solvency, and efficiency.

Narrative Financial Analysis

Financial statements are more than just numbers; they tell a story. Let’s find out how to extract the narrative from financial statement analysis​.

  • Identifying Key Trends: Look for patterns and trends in revenue growth, profitability, and debt levels. These trends can reveal a company’s strategic direction and financial performance.
  • Understanding the Business Context: Consider the industry in which the company operates. Economic conditions, competitive landscape, and regulatory changes can significantly impact financial performance.
  • Analysing Cash Flow: Cash flow is often a more accurate indicator of a company’s financial health than net income. Analyse the different components of cash flow to understand how a company generates and uses cash.
  • Comparing to Industry Benchmarks: Compare a company’s financial ratios to industry benchmarks to assess its relative performance. This can help identify areas where a company is outperforming or underperforming its peers.

Analysing Financial Statements with Software

  1. Financial Modeling Software: Excel is a popular choice, but specialised software like Bloomberg Terminal and Capital IQ offers advanced features for financial analysis.
  2. Data Visualisation Tools: Financial analysis tools like Tableau and Power BI can help you create visually appealing and informative charts and graphs.
  3. Online Databases: Websites like Yahoo Finance, Google Finance, and Bloomberg provide access to financial data and analysis tools.

Case Studies: Financial Challenges and Lessons Learnt

  1. Enron Corporation: Corporate Fraud

Enron, once a darling of the energy industry, collapsed in spectacular fashion due to a complex web of financial fraud. Its financial statements, carefully manipulated to conceal massive debts and fraudulent activities, played a pivotal role in its downfall. A close examination of Enron’s financial statements revealed irregularities in revenue recognition, off-balance-sheet partnerships, and the use of special purpose entities to hide liabilities.

  1. Lehman Brothers: Mortgage Crisis

The collapse of Lehman Brothers in 2008 was a significant event that triggered the global financial crisis. The company’s financial statements, heavily reliant on mortgage-backed securities, masked the underlying risks associated with the subprime mortgage market. As the housing market began to decline, Lehman Brothers found itself in a precarious financial position, unable to meet its debt obligations.

Mistakes and Learnings: Lessons from Personal Experiences

Financial analysis is a skill that is honed through experience. Even seasoned professionals can make mistakes when interpreting financial statements. Here are a few tips for analyzing financial statements:

  1. Overreliance on Single Metrics: Focusing solely on a single metric, such as earnings per share, can lead to a distorted view of a company’s financial health. It’s essential to consider a broader range of financial ratios and metrics to get a complete picture.
  2. Ignoring Non-Financial Factors: Financial statements provide a quantitative snapshot of a company, but it’s crucial to consider qualitative factors such as industry trends, competitive landscape, and management quality. These factors can significantly impact a company’s financial performance.
  3. Misinterpreting Accounting Techniques: Accounting standards can be complex, and even experienced analysts can make mistakes in interpreting certain accounting techniques. It’s important to stay updated on accounting standards and consult with experts when necessary.

Wrapping Up

Mastering financial statement analysis​ is a journey, not a destination. You can become a financial analysis virtuoso by combining technical knowledge, analytical skills, and a touch of creativity. Remember, the true value of financial statements lies in the insights they provide, not just the numbers themselves.

If you wish to become an expert in the domain of banking and finance, enrol in Imarticus Learning’s Certified Investment Banking Operations Program. Solid investment banking courses such as this can open up doors for your career in finance.

Frequently Asked Questions

What is the difference between a balance sheet and an income statement?

Balance sheets show a company’s financial position at specific points in time, while income statements show its financial performance over certain periods of time.

How do you calculate the return on equity (ROE)?

ROE is calculated by dividing net income by the average shareholder’s equity.

What are the five components of the DuPont model?

The five components of the DuPont model are net profit margin, asset turnover, financial leverage, equity multiplier, and return on equity.

What is the difference between cash flow from operating activities and cash flow from investing activities?

Cash flow from operating activities is the cash generated or used by a company’s core business operations, while cash flow from investing activities is the cash generated or used by a company’s investments in long-term assets.   

What is the difference between a current asset and a non-current asset?

Current assets are assets that are to be converted into cash or used up within the duration of 1 year, while non-current assets are assets that are to be held for more than 1 year.   

What is the difference between liability and equity?

Liabilities are debts that a company owes to others, while equity represents the ownership interest in a company.

What are the Objectives of Financial Statement Analysis?

What Are The Objectives Of Financial Statement Analysis?

The main goals of financial statement analysis are to comprehend and analyse the data in financial statements in order to assess the firm’s profitability and financial stability and to predict its future possibilities. The goal of the analysis is determined by the individual conducting it and his subject.

To highlight the significance of such analysis, the following purposes or objectives of financial statements analysis may be stated:
1) To evaluate the firm’s earning potential or profitability.

2) To evaluate managerial effectiveness and operational efficiency.

3)  To evaluate the firm’s long- and short-term solvency condition.

4) To pinpoint the causes of the company’s changing

Financial Statement Types

Companies give transparency to their stakeholders by using the balance sheet income statement and cash flow statement. The three statements are related to one another. They produce various interpretations of a company’s operations and performance.
Below is a summary of these four financial statements.

Balance Sheet

The balance sheet reveals the assets of a company’s value (per GAAP). Either equity or debt (liabilities) can be used to finance assets. As a result, the fundamental accounting formula of assets (A) = liabilities (L) + shareholders’ equity is created (E). In general, assets are ranked according to how quickly they can be turned.
In general, liabilities are listed according to when they are due.
The reader will be able to identify a company’s ability to meet short- and long-term financial obligations by understanding the leverage and liquidity of the balance sheet via the use of certain ratios that will be covered in this book. Understanding the balance sheet can also help the reader get a sense of the company’s capacity to raise money through equity or debt in order to purchase new assets or settle existing debt.

Income Statement

The income statement displays the revenues and costs that a business incurs over a specific time period). Typically, these line items are prepared in accordance with GAAP. Transactions are recorded at the point of sale. Accrual accounting uses the matching principle. In essence, accrual accounting computes receipts rather than actual cash.

Despite the fact that the money isn’t collected for a few weeks or months after it was sold, accrual accounting still considers the transaction to have occurred at the time of sale. Alternative accounting techniques include the cash basis.
This less popular method only computes transactions (revenues and expenses) when money is actually exchanged.

The revenues (or sales) produced from the sale of goods and/or services during typical business operations make up the top line of the income statement. The direct costs associated with making those sales are usually listed on the next line. When we analyse profitability ratios later, the net figure of these two reveals the gross profits and gross margins.

These non-cash expenditures are made in order to spread out the price of large, long-term assets throughout the time that they are utilised. The bottom line displays a company’s net income (or loss) after all expenses, including taxes and other non-operating income, have been deducted. Once more, a company’s net income (or loss) is not always the amount of money it brought in through sales; rather, it is the difference between that amount and that period’s expense receipts.

Statement of Shareholder’s Equity:

The income statement and balance sheet are related by this statement. The equity component of the balance sheet can then be reconciled with distributions, dividends, or capital infusions.
After distributions and dividends, any remaining net income is reinvested in the company, which raises the retained earnings account in the equity column of the balance sheet. The statement of shareholders’ equity contains a complete list.

The statement of shareholders’ equity also includes information about other equity sales and purchases, like stock repurchases, and reconciles. Many privately held businesses lack a declaration of shareholders’ equity and instead use simple equity accounts.
The company’s net income is often equal to the variation in retained earnings from one period to the next. If the amount is smaller, the difference usually represents the amount of distributions or dividends that were taken; nevertheless, the correctness of this information should be confirmed with the corporation.

The current balance sheet and prior period balance sheet dates should coincide with the income statement date range for these computations.

Statement of Cash Flows

A statement of cash flows can inform a reader whether or not a corporation generated cash from these receipts. The income statement can indicate if a company made a profit based on receipts. Sales receipts cannot pay creditors on their own. Actual cash received is of utmost importance to many readers of financial statements.

The accrual method data from the income statement is used to create the statement of cash flows. It is then adjusted up or down based on the changes in the balance sheet accounts.
The accountant creates the statement of cash flows using the direct approach. It includes factors like money received from clients, interest, money given to suppliers, etc. that have an impact on cash flow.

The reader is given a complete picture of the sources of cash and the uses of that cash in the statement of cash flows.
In this manner, an analyst may quickly analyse a company’s cash flows and be able to examine operating cash flows independently of the other operations. In the end, this statement makes up the discrepancy between the cash on hand at the start of a balance sheet period and the cash on hand balance at the end of the period.

The Skills You Need for Success

There are several methods available to you if you want to learn how to analyse financial statements.
You might choose a self-taught path, reading through publicly accessible financial statements to become accustomed to how financial data is normally presented.

Conclusion

Take your career to the next level. Find out how improving your knowledge can make your organisation more productive.

Financial statement analysis takes a holistic approach to evaluating and assessing the financial well-being of an organisation.