Five approaches to financial statement analysisPosted on: September 1, 2022
Financial reporting is integral to a business. Any organisation, big or small, is legally required to compile comprehensive documentation of their financial activities.
With ever-evolving legislation presenting a constant challenge to public companies, getting the stats right is essential. That’s where an analyst steps in – and as digital accounting and crypto currencies become more commonplace, the demand for new financial talent is high.
Not only is financial reporting a matter of compliance, but tracking and analysing financial performance equips business leaders and lenders with key intel to better assess the company’s current standing, predict future financial outcomes and make informed economic decisions regarding the management and direction of the organisation.
What is financial statement analysis?
Financial statement analysis is a component of accounting and key to understanding an organisation’s financial condition. External stakeholders use it to understand the overall performance and business value of an organisation, while internal constituents use it as a monitoring tool for managing finances.
Acting as a company’s financial health ‘report card’, it comprises the review of three significant financial statements that every company must maintain: the balance sheet, income statement and cash flow statement.
- Balance sheet: summary of the assets, liabilities (debt) and equity of a business at the end of an accounting period and a report of the company’s financial worth in terms of book value.
- Income statement: a detailed account of a company’s revenue earning (also known as the profit and loss statement).
- Cash flow statement: provides data on how much cash or cash equivalent circulates the company via various inflows and outflows, spanning ongoing operational activities, external investment sources and cash from financing.
As such, a financial statement analysis provides a comprehensive and unbiased overview of a company’s profitability, value, creditworthiness and financial security.
What are the five methods of financial statement analysis?
There are five commonplace approaches to financial statement analysis: horizontal analysis, vertical analysis, ratio analysis, trend analysis and cost-volume profit analysis. Each technique allows the building of a more detailed and nuanced financial profile.
Horizontal analysis compares historical data (such as ratios and line items) and is usually depicted as a percentage growth over the same line item in the base year. This allows financiers to easily spot trends and growth patterns and forecast future projections. This type of analysis also lends insight into the operational results of an organisation and whether it is operating efficiently and profitably, and makes it easier to compare growth rates amongst sector competitors.
Vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. For example, every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. This gives analysts an understanding of overall performance in terms of revenue and expenses.
Ratio analysis allows for meaningful comparison between the different elements of a financial statement and is used to reveal a general upward or downward trend. It’s a quick method to obtain an overview of a company’s financial health, but also more granular relationships between data, such as debt and equity or price versus earnings, in addition to liability areas such as staff turnover. Once a ratio has been calculated, it can be compared against the previous period, which is crucial for setting performance targets.
Trend analysis uses historical data (such as price movements and trade volume) to forecast the long-term direction of market sentiment. It’s based on the idea that what has transpired in the past will occur again in the future, which helps a business to better predict and prepare for upward trends and reversals within particular market segments. Trend analysis is a useful technique as moving with trends (and not against them) will result in profit for an investor.
Cost volume profit analysis
This analysis technique helps businesses better understand the relationship between sales, costs, and business profit. It examines the fixed cost and variable cost and establishes the relationship between sales and variable cost to help business leaders better plan and project profit.
How does financial statement analysis help an organisation?
Financial statement analysis is not only crucial for complying with business laws and regulations, but the data can serve the organisation in a multitude of ways.
Through financial statement analysis, business owners can identify and determine their financial strengths and weaknesses, keep current on their debts and determine their profit margins.
Financial statements are critical when seeking company partners and securing investment capital. The data determines if a company is making money, but also helps investors identify a reasonable cost per share. An unbiased financial profile is equally crucial when claiming funds or applying for loans from lending institutions.
Analysing the financial statements from quarter to quarter and year to year help business owners see trends in growth and formulate new strategies to consider any risks posed to the wider market.
Furthermore, the analysis helps to measure a company’s financial performance against the wider sector, giving business owners an understanding of how they compare to their top competitors.
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