How to Analyze Financial Statements Step-by-Step

Financial statement analysis is the process of reviewing a company’s financial documents to make informed decisions. For an investor, business owner, or creditor, this skill helps in understanding a company’s financial health. Analyzing these statements provides a structured way to assess a company’s stability, profitability, and future prospects, and to compare it with others.

Deconstructing the Balance Sheet

The balance sheet offers a snapshot of a company’s financial position at a specific point in time. It is governed by the accounting equation: Assets = Liabilities + Shareholders’ Equity. This equation shows that a company’s resources (assets) are financed by either debt (liabilities) or owner contributions (equity).

Assets are economic resources a company owns, categorized by how quickly they can be converted into cash. Current assets are resources expected to be converted to cash within one year, including cash, accounts receivable, and inventory.

Non-current assets are not expected to be converted to cash within a year. This category includes tangible items like property, plant, and equipment (PP&E). It also includes intangible assets, which lack physical substance but hold value, such as patents and trademarks.

Liabilities are a company’s financial obligations, split into current and non-current categories. Current liabilities are obligations due within one year, such as accounts payable, short-term loans, and the current portion of long-term debt.

Non-current liabilities are obligations not due for at least one year. This group includes long-term debt like bonds and mortgages, as well as deferred tax liabilities.

Shareholders’ equity is the residual interest in assets after deducting liabilities. It is what would be returned to shareholders if all assets were sold and all debts paid. Its components include common stock and retained earnings, which are profits reinvested in the business. The footnotes provide details about the accounting policies used.

Interpreting the Income Statement

The income statement, or profit and loss (P&L) statement, reports a company’s financial performance over a period, like a quarter or year. It details revenues and expenses to show how a company generated a profit or loss. The statement starts with total revenue and subtracts costs to arrive at net income.

Analysis begins with revenue, the total money from sales. Subtracting the Cost of Goods Sold (COGS), which are the direct production costs, yields the gross profit. This figure indicates a company’s production efficiency and pricing power.

Next, operating expenses like Selling, General & Administrative (SG&A) and Research & Development (R&D) are deducted. This results in operating income, or Earnings Before Interest and Taxes (EBIT). This measures profitability from core business activities before financing and taxes.

Finally, after subtracting non-operating items like interest expense and income taxes, the result is net income. This “bottom line” is the final profit remaining for owners. The footnotes provide details on revenue recognition and expense breakdowns.

Analyzing the Statement of Cash Flows

The statement of cash flows summarizes a company’s cash inflows and outflows over a period. It reconciles the accrual-based net income with the actual change in cash. The statement is divided into three sections that categorize cash transactions.

Cash Flow from Operating Activities (CFO) reflects cash generated by core business operations. It starts with net income and adjusts for non-cash items like depreciation and changes in working capital. A positive CFO indicates the business can generate enough cash from its primary activities to sustain itself.

Cash Flow from Investing Activities (CFI) reports cash used for or generated from buying and selling long-term assets. Outflows include capital expenditures on property, plant, and equipment. A negative CFI can signify investment in future growth.

Cash Flow from Financing Activities (CFF) includes cash transactions with owners and creditors. Inflows come from issuing stock or borrowing money. Outflows result from repurchasing stock, paying dividends, or repaying debt.

Examining all three sections gives a picture of a company’s liquidity. A healthy company might show a positive CFO, a negative CFI (reinvestment), and a negative CFF (debt repayment or dividends). The sum of the net cash flows from these activities, plus the effect of exchange rate changes, equals the net change in cash for the period.

Applying Key Financial Ratios

Financial ratios use values from financial statements to provide insights into a company’s performance. They standardize information for comparison and are grouped into categories that measure different aspects of a business.

Liquidity Ratios

Liquidity ratios measure a company’s ability to cover its short-term liabilities. The Current Ratio is calculated as Current Assets divided by Current Liabilities. A more stringent test is the Quick Ratio, which is (Current Assets – Inventory) / Current Liabilities, as it excludes inventory.

Profitability Ratios

Profitability ratios gauge a company’s ability to generate earnings. The Net Profit Margin (Net Income / Revenue) shows what percentage of revenue is left after all expenses. Return on Equity (ROE), which is Net Income divided by Shareholders’ Equity, measures how effectively management uses investor money to generate profits.

Leverage Ratios

Leverage ratios evaluate long-term stability by examining debt use. The Debt-to-Equity Ratio (Total Liabilities / Shareholders’ Equity) indicates the proportion of debt and equity financing. The Debt-to-Asset Ratio (Total Liabilities / Total Assets) shows the percentage of assets financed through debt.

Efficiency Ratios

Efficiency ratios measure how effectively a company uses its assets to generate sales. The Inventory Turnover ratio (Cost of Goods Sold / Average Inventory) indicates how many times inventory is sold and replaced over a period. The Asset Turnover Ratio (Net Sales / Average Total Assets) measures how efficiently a company uses its assets to generate revenue.

Conducting Trend and Benchmarking Analysis

Analyzing financial data in isolation provides limited insight. Value comes from comparing this information over time and against industry peers. Two methods for this are trend analysis and benchmarking, which provide context for judging a company’s performance.

Trend analysis involves comparing a company’s financial data over multiple periods, like the last three to five years. This historical perspective helps determine if performance is improving or deteriorating. By tracking metrics like revenue growth and profit margins over time, an analyst can identify patterns, growth rates, and potential concerns.

Benchmarking is the process of comparing a company’s financial ratios against its direct competitors and industry averages. This provides an external reference to evaluate if performance is strong or weak relative to its peers. To perform this analysis, one must identify comparable companies and use data from financial providers or industry publications to compare metrics like profitability and leverage. This comparison highlights a company’s competitive strengths and weaknesses.