Why is financial statement analysis important?

Financial statement analysis is a skill which is usually the reserve of accountants and financial specialists. Yet understanding these key documents that offer a snapshot of a company’s financial health is a desirable skill for anyone in business including managers, entrepreneurs, and investors. 

Being able to read and analyse financial statements is key to unlocking insights about financial performance and being equipped to carry out successful decision making.

What are the main types of financial statements?

The main statements that financial analysts look at are the balance sheet, the income statement, the cash flow statement, and the annual report. Read together, they offer the full story on a company’s financial performance.

• The balance sheet

This financial document offers an immediate understanding of assets, current liabilities, and owners’ equity. In other words, what the company owns, owes, and the amount invested by shareholders. In isolation, the balance sheet doesn’t show anything other than a summary of the company’s performance. Viewed alongside other documents such as the cash flow statement, the balance sheet can provide more financial information.

• The income statement

This is also known as the profit and loss (P&L) statement and it summarises the cumulative impact of revenue, expense, gain, and loss transactions for any given period. Unlike the balance sheet, this statement alone can share insights into financial trends, business activities (revenues and expenses), and provide comparative data. Information provided by an income statement includes revenue, expenses, cost of goods sold (COGS), gross profit, operating income, income before taxes, net income, earnings per share (EPS), depreciation, and EBITDA (earnings before interest, taxes, depreciation, and amortisation).

• The cash flow statement

The statement of cash flow provides an in-depth record of what has happened to a business’ cash during a specific accounting period, which may be short-term or long-term. The statement breaks down cash flow into three categories: from operating activities, from investing activities, and from financing activities. Although cash flow and profit are important figures to know in financial analysis, they are not the same thing. Cash flow is simply that – money which comes into the company and leaves it. Profit is what is left after expenses. Positive cash flow indicates stability and is usually the result of operating income exceeding net income, but it doesn’t automatically equate with profitability.

• The annual report

Most people are familiar with the annual report which is a public document that offers operational and financial reporting to shareholders, stakeholders, investors, and anyone else with an interest in the company’s activities. Annual reporting became a legal requirement after the stock market crash of 1929. These documents are increasingly well considered in their design and their content as they should ultimately be accessible and easy for the layperson to understand. They also often include details on the company’s CSR (corporate social responsibility) initiatives and sustainability achievements.

What are the main methods of financial statement analysis?

There are many different methods of financial statement analysis that can be applied in various scenarios depending on what information is most useful. Three of the most common methods of analysis are:

Horizontal analysis

In horizontal analysis, a period of time is compared with another or several. This could be the financial years of the company, for example, to analyse year-on-year increases or decreases. Analysts also often compare one quarter of the calendar year with a consecutive quarter or a particular quarter from one year to the next. It is called horizontal analysis because time is generally represented as a line measured on the horizontal axis.

Vertical analysis

Vertical analysis compares line items with one another, so entries in the ledger along a vertical axis. Each item can be expressed as a proportion of a more prominent line item. For instance, an item can be calculated as a percentage of total assets on the balance sheet. Or a line item can represent a percentage of revenue or sales in the income statement. These percentages can be compared with previous years to identify patterns and trends. Key metrics that can be measured as a percentage of revenue in vertical analysis include:

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

Ratio analysis

Ratio analysis is one of the most popular methods of financial statement analysis. Different types of ratios help managers and analysts to drill down into the financial data and uncover meaningful information.

There are six main categories of financial ratios:

• Profitability ratios – including return on equity (ROE) ratio and DuPont analysis.

These are a class of metrics that assess a business’s ability to generate earnings relative to revenue, operating costs, balance sheet assets, or shareholders’ equity over time using data from a specific accounting period. Profitability ratios can be compared with activity ratios, which consider how well a company uses its assets internally to generate income. The most useful way to use profitability ratios is in comparison with similar companies, with accounting periods in the company’s own history, or with the average ratios for the company’s sector.

 

• Liquidity ratios – including quick ratio, current ratio, and net working capital ratio.

These financial metrics are used to figure out a debtor’s ability to pay off current debt obligations using working capital without needing to raise external capital. Liquidity ratios measure whether a company will be able to pay debts and what its margin of safety is. More specifically, liquidity is the ability to convert assets into cash quickly and cheaply. Like profitability ratios, liquidity ratios are most useful when they are used in comparisons of data either internally or externally.

 

• Leverage ratios – including debt to equity ratio (D/E), debt to assets ratio (D/A), debt to capital ratio (D/C).

The leverage ratio category is important because companies rely on a mixture of equity and debt to finance operations. The main factors considered in leverage ratios are debt, equity, assets, and interest expenses. Too much debt is considered dangerous for a company and its investors. Nevertheless, if the company’s operations can generate a higher rate of return than the interest rate on its loans, the debt may actually fuel growth. Uncontrollable debt levels can affect lines of credit, but too few debts can also raise questions. Reluctance or inability to borrow can signal that operating margins are tight and growth is restricted.

 

• Coverage ratios – including interest coverage ratio, debt service coverage ratio, and asset coverage ratio.

Coverage ratios are utilised in helping to identify potentially troubling financial situations. Multiple statements are used to determine these ratios including net income, interest expense, debt outstanding, and total assets. Because low ratios alone are not always an indication that something is wrong, other figures to look at include liquidity and solvency ratios, because they assess a company’s ability to pay short-term debt.

 

• Activity ratios (also known as efficiency ratios) – including inventory turnover ratio, accounts receivable turnover ratio, accounts payable turnover ratio.

Activity or efficiency ratios indicate how efficiently a company is leveraging the assets on its balance sheet to generate revenues and cash. Financial analysts look at these ratios to gauge how well a company manages its inventory, which is vital to operational fluidity and the overall health of financial activities.

 

• Valuation ratios – including price to earning (P/E) ratio, price to sales (P/S) ratio, price to cash flows (P/CF) ratio.

These ratios are often used in the media because they offer a quick understanding of whether it’s worth investing in a company by incorporating the price of a company’s publicly traded stock. Generally speaking, the lower the ratio level, the more attractive investment in a company becomes.

Find your niche with an MSc Management with Sustainability

As businesses become more aware of the need for transparency in their operations and transactions, financial reporting is an ideal way of communicating this. A company’s financial statements provide key documents for investors, regulators, customers, and employees. Learning how to read them gives a depth of knowledge that offers a competitive advantage beyond basic accounting information. 

Discover more about financial statement analysis with an online MSc Management with Sustainability from Keele University.