All About Financial Statement Analysis

In this blog, we will learn about the analysis of financial statements and their importance in improving the efficiency of business operations. In this article, we will learn what is financial statement analysis, its requirement, process of analysis of financial statements and its phases.

Table of Contents

• What is financial statement analysis?
• Need for financial statement analysis
• Financial analysis process
• Phases of analysis of financial statements
• Types of analysis
• Benefits of the financial statement analysis
• Limitations of financial statement analysis

What is Financial Statement Analysis?

A financial statement is an accounting document that helps in understanding the financial situation and cash flows in a business. There are different types of statements that serve different purposes. The analysis of financial statements is a study of the relationship between the financial facts and figures in the financial statements. It estimates the current and past financial positions along with the results of the operation of an enterprise. It determines the best possible predictions about future conditions. This analysis regroups and analyses information in financial statements to identify the strong and weak points of a business enterprise.

Why do firms need an analysis of financial statements?

Financial statement analysis is crucial due to the following reasons:

• It indicates significant facts related to the efficiency of firms and their managerial performance. 
• To identify the strengths and weaknesses of the firm.
• For making forecasts about future prospects of the firm to make decisions related to operations and investments in the firm.
• To assess the operational efficiency of a firm and its current profitability.
• To understand the importance of components of the financial position of the firm.

Process of Analysis of Financial Statement

The analysis of financial statements takes place in three major steps including: 

1.  Restating Financial Statements: This is the process of presenting the financial statements for better analysis and accurate interpretation of the company’s performance. For instance:

• Income statement: It involves dividing reported items into recurring and non-recurring items and the separation of earnings into core and transitory. 
• Balance sheet: It involves segmentation of the balance sheet into operating and financial assets/liabilities. 
• Cash flow statement: It involves omitting financial activities from cash flow from the operations. 

2. Adjustment of errors: The adjustment of measurement errors removes any redundancy/noise from the input data. This enhances the quality of reported accounting numbers. 

3. Financial Ratio Analysis: This analysis is performed on adjusted financial statements. It involves ratio calculation for analyzing the performance of the company. 

Phases in Analysis of Financial Statements

The following are the phases that ensure a detailed analysis of financial statements:

Phase 1: In this phase, the purpose of the analysis is defined. Analysts identify questions that must be answered in the analysis. The analyst defines the nature and content of the report. Institutional guidelines related to work product development are used as information sources in this phase.

Phase 2: Data collection takes place in this phase. Analysts use financial statements questionnaires and industry data. Discussions among the management, with customers and suppliers, also help in extracting crucial data for analysis. Once this data is collected, analysts can prepare financial tables, statements, and required questionnaires. 

Phase 3: After the data is collected and organized, data processing takes place in the third phase. Here the data collected is used to create common-size statements, adjusted financial statements, forecasts, ratios, and graphs.

Phase 4: In this phase, the input and processed data are interpreted. Once the analysis of the data is completed, analytical results are presented by analysts.

Phase 5: Here, conclusions are provided by analysts based on the analytical results and institutional guidelines. They provide analytical reports to answer the questions defined in the first phase. They also offer recommendations related to investments and credit grants.

Phase 6: Once analysts provide reports and recommendations, follow-ups take place. This ensures that reports and recommendations are based on changes and updates in the information. It leads to more updated and relevant reports.

Types of Financial Statement Analysis

Financial analysts perform the financial statement analysis. The analyst usually starts with the analysis of the income statement. Let us learn about income analysis first. 

1. Income Statement Analysis

The income statement is analyzed in two ways: vertical and horizontal analysis. 

Vertical Analysis

In this method, the analysis takes place in vertical directions. Analysts will look up and down the statement to check how each line item compares to the revenue as a percentage. The following metrics are considered while analyzing the statement: 

• Tax
• Interest 
• Net earnings 
• Earnings Before Tax (EBT) 
• Gross profit Depreciation 
• Cost of Goods Sold (COGS) 
• Selling General & Administrative (SG&A) 

Horizontal Analysis

Through the horizontal analysis, we look at the income statement at year-over-year (YoY) change in every line item. To do so, we take the value in Period P and divide the value by one minus the period (P – 1). After that, we subtract 1 from the number to the percent change.

2. Analysis of Cash flow statement

Through the analysis of the cash flow statement, one can understand the cash inflows and outflows over a specific time period. It consists of cash used in investing and from operations and financing. These three components indicate the use of cash during the time of evaluation. It is one of the most important indicators of the company’s performance.  

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3. Analysis of Pyramid of Ratio

Analysts use a pyramid of ratios to showcase efficiency, profitability, and leverage drivers for any business. The following insights are driven by the pyramid of ratios: 

• Dupont analysis
• Return on equity ratio (ROE)
• Rates of return and profitability analysis
• Profitability, efficiency, and leverage ratios

Learn more about leverage in finance 

4. Analysis of Balance Sheet

Through a balance sheet, one can determine the operational efficiency of the business. For this purpose, components from the income statement are compared with the company’s capital assets on the balance sheet. Through different financial ratios from the balance sheet, one can determine how efficiently the company is generating revenue and selling its inventory. 

Benefits of Analysis of Financial Statements

• Through financial statement analysis, businesses can make decisions related to the operations of the firm.
• It helps in learning about the profitability and operational efficiency of the firm for assessing financial health. 
• Useful in decision-making involving cross-sectional analysis and time series analysis.

Limitations of Financial Statement Analysis

Analysis of financial statements does have certain limitations such as the following:

1. Does not consider price level changes.

2. Lacks the knowledge of changes in accounting procedures followed by firms.

3. Non-monetary aspects are ignored during the analysis of financial statements.

5. Does not reflect the current position since financial statements are prepared based on concepts of accounting.

5. Analysis of Statement of Shareholder's Equity

This financial statement details changes within the equity that is held by public or private shareholders. This statement reports changes in shares number and value of preferred and common stocks. It also includes details related to whether the company has purchased back stocks previously held by shareholders. 

Benefits of Analysis of Statement of Stockholder's Equity

Analysis of statement of stockholder's equity has the following benefits:

1. It shows changes in ownership structure through the issuance or repurchase of shares.
2. This statement reveals how much profit the company retains versus distributes as dividends.
3. It provides insights into the company's dividend distribution strategy over time.
4. The statement shows changes in paid-in capital, indicating how the company finances its operations.
5. It includes other comprehensive income, showing a better understanding of the company's financial performance.
6. The statement reveals the impact of stock options and other equity-based employee compensation.

Advantages of Analysis of Statement of Stockholder's Equity

1. The analysis offers a limited scope, focusing only on historical financial data. It does not predict future trends or company performance.
2. It relies on a company's chosen accounting policies, which can influence how equity is reported. This can make comparisons between companies challenging.
3. Companies may use accounting methods to "window dress" their financial statements, potentially inflating shareholder equity.
4. It lacks non-financial insights, not considering factors that impact company value such as brand reputation, customer satisfaction, or employee morale.
5. This analysis is most valuable when combined with other financial statement analysis techniques for complete analysis.

Conclusion

Analysis of financial statements is extremely important for every business to grow and increase its revenue. It should not be compromised since it increases the efficiency of business operations. Better processes and expert analysts can help in the detailed analysis process.