How Do You Perform a Financial Statement Analysis?

Financial statement analysis is the process of reviewing a company’s financial documents to evaluate its performance and health. This analysis translates raw financial data into meaningful insights for investors, creditors, and internal management. Investors use it to assess investment viability, creditors to determine loan repayment ability, and management to identify strengths and weaknesses. The process involves dissecting financial statements to spot trends, measure performance, and forecast future outcomes.

The Core Financial Statements

Financial statement analysis relies on a set of standardized reports that companies prepare. Together, these documents provide a structured overview of a company’s financial activities and position.

Balance Sheet

The balance sheet presents a snapshot of a company’s financial position at a single point in time, governed by the equation: Assets = Liabilities + Shareholders’ Equity. This means a company’s resources (assets) are financed by borrowing (liabilities) or owner investments (shareholders’ equity). The statement provides a clear picture of what the company owns and what it owes.

Assets are categorized as current or long-term. Current assets, like cash and inventory, are expected to be converted to cash within one year, while long-term assets include property and equipment used for multiple years. Liabilities are also divided into current obligations due within one year and long-term obligations due after more than one year. Shareholders’ equity represents the owners’ residual claim on assets after deducting liabilities.

Income Statement

The income statement, or profit and loss (P&L) statement, reports a company’s financial performance over a specific period, like a quarter or year. It shows how revenue is transformed into net income by subtracting costs and expenses. The statement begins with revenue, the total money from sales.

The cost of goods sold (COGS), which includes direct production costs, is subtracted from revenue to determine gross profit. Following gross profit, operating expenses are deducted to find the operating income. This figure reflects profit from primary business operations before interest and taxes. After subtracting interest and taxes, the final figure is net income, representing the company’s total profit for the period.

Statement of Cash Flows

The statement of cash flows summarizes the cash inflows and outflows over a period. It is important because the income statement uses accrual accounting, recognizing revenue and expenses when incurred, not when cash is exchanged. The cash flow statement shows how money is actually moving through the business, organized into three main activities.

• Cash flow from operating activities includes transactions from principal revenue-producing activities, providing insight into cash generated by core operations.
• Cash flow from investing activities reports cash used for or generated from buying and selling long-term assets and other investments.
• Cash flow from financing activities shows cash movements related to debt, equity, and dividends, such as issuing stock or repaying debt.

Statement of Shareholder’s Equity

The statement of shareholder’s equity details changes in the equity section of the balance sheet during an accounting period. It shows how profits, dividend payments, and other transactions have impacted the owners’ stake. The statement begins with the opening equity balance, adds net income, and subtracts any dividends paid. Other items include the issuance of new stock or stock repurchases. The final line shows the ending balance of shareholder’s equity, which must match the figure on the balance sheet.

Key Analysis Techniques

Specific techniques are applied to the financial statements to extract insights. The primary methods are horizontal analysis, vertical analysis, and ratio analysis, each offering a different perspective.

Horizontal Analysis

Horizontal analysis, or trend analysis, involves comparing financial data across multiple accounting periods to identify performance patterns. The process involves selecting a base year and expressing subsequent years’ figures as a percentage of the base year. The formula is: ((Current Year Amount – Base Year Amount) / Base Year Amount) 100. For example, if revenue grew from $500,000 to $550,000, the analysis would show a 10% increase, highlighting the magnitude and direction of change.

Vertical Analysis

Vertical analysis, or common-size analysis, evaluates financial data by expressing each line item as a percentage of a base amount within the same period. On the income statement, each item is shown as a percentage of total revenue. On the balance sheet, each item is a percentage of total assets or total liabilities and equity. This technique is useful for comparing companies of different sizes or analyzing a company’s internal structure. For instance, expressing the cost of goods sold as a percentage of revenue helps assess profit margins and can indicate rising costs or pricing pressures.

Ratio Analysis

Ratio analysis is a quantitative method of gaining insight into a company’s liquidity, efficiency, and profitability. This technique involves calculating financial ratios by comparing financial statement accounts. The results can be compared to historical company data, industry averages, and competitors. Ratios are grouped into categories, such as liquidity, solvency, profitability, and efficiency, with the specific ratios used depending on the industry and the goals of the analysis.

Common Financial Ratios Explained

Financial ratios are calculations that relate two or more financial values from a company’s financial statements.

Liquidity Ratios

Liquidity ratios measure a company’s ability to meet short-term obligations due within one year. The Current Ratio is a primary measure, calculated by dividing current assets by current liabilities. A result greater than 1 suggests a company has more short-term assets than liabilities.

The Quick Ratio, or acid-test ratio, is a more stringent measure calculated as (Current Assets – Inventory) / Current Liabilities. This ratio excludes inventory because it may not be quickly converted to cash, providing a better view of a company’s ability to meet obligations without selling inventory.

Solvency Ratios

Solvency ratios evaluate a company’s ability to meet its long-term debt obligations and provide insight into its reliance on debt financing. The Debt-to-Equity Ratio compares total liabilities to shareholders’ equity (Total Liabilities / Shareholders’ Equity). A high ratio indicates aggressive debt financing, which can lead to volatile earnings.

Another measure is the Debt-to-Asset Ratio, calculated by dividing total liabilities by total assets. This ratio shows the proportion of assets financed through debt; a ratio greater than 1 signifies high financial risk.

Profitability Ratios

Profitability ratios measure how well a company generates earnings relative to its revenue, assets, or equity. The Net Profit Margin is calculated as Net Income / Revenue and represents the percentage of revenue left after all expenses are deducted. A higher margin indicates greater efficiency in converting revenue to profit.

Return on Equity (ROE) measures the profit generated for each dollar of shareholders’ equity (Net Income / Shareholders’ Equity). Investors often use ROE to assess the profitability of their investment.

Efficiency Ratios

Efficiency ratios, or activity ratios, measure how effectively a company uses its assets and manages its liabilities. The Asset Turnover Ratio is calculated as Revenue / Total Assets and measures how efficiently assets are used to generate revenue. A higher ratio suggests the company is effective at using its assets to produce sales.

Inventory Turnover is calculated as Cost of Goods Sold / Average Inventory. This ratio indicates how many times inventory is sold and replaced over a period, with a high turnover implying strong sales or effective inventory management.

Applying the Analysis A Case Study

To illustrate these techniques, consider a hypothetical company, “Innovate Corp.” Applying horizontal, vertical, and ratio analysis provides a comprehensive view of its financial health. Assume Innovate Corp.’s revenue grew from $1,000,000 in Year 1 to $1,200,000 in Year 2. A horizontal analysis shows a 20% revenue increase. However, if the cost of goods sold grew 30% (from $600,000 to $780,000), this suggests production efficiency may be declining.

A vertical analysis of the Year 2 income statement provides more context. The cost of goods sold ($780,000) is 65% of revenue ($1,200,000). If this figure was 60% in Year 1, it confirms a negative trend in gross margin, as a smaller percentage of each sale contributes to gross profit.

The analysis continues by calculating financial ratios for Year 2. With current assets of $400,000 and current liabilities of $200,000, the current ratio is 2.0, suggesting the company can cover its short-term debts. If total liabilities and shareholders’ equity are both $500,000, the debt-to-equity ratio is 1.0, indicating balanced financing.

Synthesizing these findings, the horizontal analysis showed strong revenue growth but a concerning cost increase, and the vertical analysis confirmed shrinking margins. The ratio analysis revealed a healthy liquidity position and manageable solvency. The overall assessment is that Innovate Corp. is growing but faces cost control challenges that are eroding profitability.