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What Is Financial Statement Analysis?

Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization as well as to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of retained earnings, balance sheet, and statement of cash flows, among other financial information, can be analyzed.

The information obtained from financial statement analysis help in the decision-making for internal and external stakeholders and can give a company valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital investments opportunities.

Why Should You Learn Finance and Accounting?

Today’s managers depend on performance evaluation and learning finance and accounting is crucial to understanding your business, how you’re measured, and how you can effectively manage your own performance.

Student pursuing career in finance and accounting have to learn how to conduct financial statement analysis. According to Thomas R. Ittelson, “Accounting is the language of business, and a company’s financial statements are its way of communicating accounting information to its owners and the taxing government.” The business world could not exist in its current form without financial statements.

When considering the outcomes of financial statement analysis, it is important for a company to understand that data produced needs to be compared to others within industry and close competitors. The company should also consider their past experience and how it corresponds to current and future performance expectations. Three common analysis tools are used for decision-making; horizontal analysis, vertical analysis, and financial ratios.

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Typically, When conducting financial statement analysis professionals will follow both or one of two common methods: Vertical and horizontal analysis, and ratio analysis.

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Guide to Financial Statement Analysis

Horizontal Analysis

In the realm of financial statement analysis, Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A company will look at one period (usually a year) and compare it to another period. For example, a company may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a company valuable information on overall performance and specific areas for improvement.

It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year. The dollar change is found by taking the dollar amount in the base year and subtracting that from the year of analysis.

Dollar change equals Year of analysis amount minus Base year amount.

The percentage change is found by taking the dollar change, dividing by the base year amount, and then multiplying by 100. Percent change equals dollar change divided by base year amount, multiplied by 100. Financial Statement Analysis

Vertical Analysis

In the realm of financial statement analysis, Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years.

Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments.

The company will need to determine which line item they are comparing all items to within that statement and then calculate the percentage makeup. These percentages are considered common-size because they make businesses within industry comparable by taking out fluctuations for size.

Note: Vertical analysis is the process of reading down a single column in a financial statement. Whereas horizontal analysis is used to identify trends over time, vertical analysis is used to determine how individual line items in a statement relate to another item in the report.

It is typical for an income statement to use net sales (or sales) as the comparison line item. This means net sales will be set at 100% and all other line items within the income statement will represent a percentage of net sales.

On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities and stockholders’ equity. Total assets will be set at 100% and all assets will represent a percentage of total assets. Total liabilities and stockholders’ equity will also be set at 100% and all line items within liabilities and equity will be represented as a percentage of total liabilities and stockholders’ equity. The line item set at 100% is considered the base amount and the comparison line item is considered the comparison amount. The formula to determine the common-size percentage is:

Common-size percentage equals comparison amount divided by base amount, multiplied by 100.

For example, in the income statement shown below, we have the total dollar amounts and the percentages of each line item as a proportion of revenue, which make up the vertical analysis.

Ratios Analysis

Ratio analysis is the process of analyzing the information in a financial report as it relates to another piece of information in the same report.

Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis.

Once you have calculated a ratio for the current period, you can compare it against previous periods to understand how the company is performing over time. It’s also possible to compare the ratio against industry standards to understand if the company in question is under- or over-performing.

Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions.

Categories of Financial Ratio

Profitability Ratios: These ratios offer insight into how profitable a company is. Some important profitability ratios include gross profit ratio, return on equity, break-even point, and return on net assets.
Liquidity Ratios: Liquidity ratios offer insight into how liquid a company is, which is important in measuring a company’s ability to stay in business. Some important liquidity ratios include cash coverage ratio, current ratio, and liquidity index.
Leverage Ratios: Leverage ratios offer insight into how much a company is dependent on debt to maintain its operations. Some important leverage ratios include debt to equity ratio, debt service coverage ratio, and fixed charge coverage.
Activity Ratios: Activity ratios offer insight into how well a company is utilizing resources. Some important activity ratios include accounts payable turnover rate, accounts receivable turnover rate, inventory turnover rate, and working capital turnover rate.

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