Financial statement analysis is used by analysts to evaluate an investment in some kind of security such as equity or debt. In order to arrive at a decision or recommendation, analysts are required to evaluate the financial performance, position and true value of the company from its financial statements.
The role of these financial analysts is to take the published financial report of companies including income statement, balance sheet, statement of cash flow, notes to accounts, supplementary schedules and then combine with other available information to evaluate the past, current and future prospects.
The process that these analysts follow to assess a company’s financial health by understanding its fundamentals is called financial statements analysis.
Creditors and regulatory authorities are also using financial statement analysis to evaluate whether a company will be able to pay it’s debts, has the company complied with accounting rules and regulations as stipulated by law.
Even the internal management prepares financial statements periodically to understand financial position and to take business decisions.
The main goal of financial analysis is to predict the future.
In simpler terms, financial statement analysis means a step by step process which is used to analyse a company’s balance sheet, income statement, cash flow statement and other financial documents in order to make an informed business decision.
To evaluate a company’s financial position the first piece of information used by these analysts are financial statements and other data published in annual reports.
If you look at a company’s financial statements published in a newspaper, website or annual report, you will find it covers at least 2 periods. The simple reason for providing data related to more than one period is that no one can evaluate a company by examining only one year’s data. Many financial analysts prefer to cover at least 5 years of data.
Before understanding the tools used in financial statements analysis, we have to understand what financial statements are.
What is the company’s financial statement?
As you are analysing financial statements of a company to find out the performance and its future outlook, to get started you must have a firm understanding of the information presented in the company’s financial reports.
Accounting system of a company prepares statements for outside stakeholders every quarter and year to give them the financial information and data to make a decision.
As per law, a listed company is required to maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement as per the generally accepted accounting principles.
Therefore, a financial statement has following three major parts;
- Balance sheet (also known as statement of financial position)
- Income statement (also known as statement of comprehensive income or profit and loss account)
- Statement of cash flow
In addition to the above three reports, you have plenty of data available in the company’s annual report like management discussion section and auditors report to understand the financial position better.
The balance sheet reports a company’s financial worth in terms of book value as on a particular date in three parts: Assets, Liabilities and Shareholder equity. The balance sheet must balance assets and liabilities to equal shareholders equity.
The balance sheet discloses all the resources company controls (assets) and what it owes to outsiders (liabilities) at a specific point of time. Owners equity represents the net assets of the company.
A company’s balance sheets follow this basic formula: Assets = Liabilities + Shareholders’ Equity.
Income statement shows how much a company has earned as revenue against the expenses to arrive at the bottom line. Gross, operating, and net profit margins help to analyse business efficiency.
The basic equation of the income statement is net profit = revenue + other income – expenses.
The cash flow statement of a company provides an overview of the company’s cash flow from operating, investing and financing activities.
What are the different types of financial statement analysis?
The primary purpose of financial statements is to provide information and data about a company’s financial health and performance for a particular period. All these can be obtained from the company’s annual reports. After getting this information and data, it’s up to the analysts to analyse and interpret.
Several techniques are used to analyse these financial statements.
Horizontal, vertical and ratio analysis are the three major techniques used by analysts for analysing a company’s financial statements. Let’s examine some financial analysis tools.
Horizontal analysis
In financial websites and newspapers you must have seen headlines like;
- Revenue of Company XYZ limited increased by 20% from last year
- Profit gone up by 45% YoY
- Operating margin is up by 25% YoY / QoQ.
If we consider the change in percentage YoY or QoQ, it helps us a lot to make a financial decision for future investments.
This study of percentage change from year to year is called horizontal analysis. In order to find the percentage change, analysts take the dollar amount of change and divide it by the base year to find the change in percentage.
For instance if a company’s revenue for the year 2022-23 is 9,561 Crore INR and in 2021-22 it was 9349 Crore INR, then percentage change is 2.3% (i.e. (9561-9349)/9349 *100).
Similarly, the company’s bottom line and other important parameters compared YoY or QoQ to find out the percentage of change.
This change in percentage indicates the direction of a company’s business.
In horizontal analysis, you compare this year’s financial statements’ line items with previous years figures. It’s also known as trend analysis.
For instance if you want to see the trend of EPS over the years, then in a comparative analysis you can take earnings per share of the last 10 years and start analysing the trend. Growth in EPS year over year shows a positive trend to invest.
Similarly, you can analyse high cost items, revenues and other line items to know how business is having an impact on the financial health and how a company can manage it in future.
You can also compare line items of each quarter in comparison to earlier quarter’s figures to analyse quarterly trends.
In simpler terms, horizontal analysis can be defined as a comparison of company’s data between two or more periods.
Vertical analysis
In vertical analysis, investors or creditors show the relationship of a financial statement item to its base. In order to do that all items on the statement are reported in percentage of the base.
For an income statement, total revenue is considered as base. For a balance sheet, total assets and total liabilities are considered as a base.
For instance, in an income statement, net profit is shown as a percentage of total revenues to know how much the company is able to earn after taking its expenses out of revenue.
Suppose a company’s average net profit is 10% of revenue. A drop to 6% this year may cause panic in the stock market as a result company’s stock price may fall.
Vertical analysis percentage for income statement = Each income statement item / total revenue.
A statement which presents line items of income statement and balance sheet in percentage to its base is called a common-size statement. Which means, in a common-size income statement, financial analysts present each line item as a percentage of the revenue amount. Here, total revenue is the common size. In a common-size balance sheet, total assets are considered as a base.
A common size statement is used to compare different companies as amounts are stated in percentage.
For instance, suppose you want to invest in XYZ food limited, a FMCG company. A direct comparison of XYZ food limited’s financial statement with a FMCG giant company is not meaningful because of the size of both the companies. If you convert both company’s income statement and balance sheet to common size to compare the percentages, then the comparison will be meaningful.
You can perform horizontal and vertical analysis on the statement of cash flows. A simple comparison of cash provided by the operations and net income signals the company’s ability to collect receivables or sell inventory.
In vertical analysis, each line item of these financial statements is listed as a percentage of its total category. For instance if you want to know a particular type of expenses as a percentage of the total expenses, then divide the earlier figure with the later and multiply it with 100 to get you the exact percentage.
Similarly, you can find out cash balance as a percentage of total assets or revenue from a particular product as a percentage of the total revenue.
For income statements, all incomes are expressed as a percentage to total income and all expenses as a percentage to total expenses. Similarly, in the balance sheet, each asset line item can be shown as a percentage to total asset and each liability as a percentage to total liabilities. Vertical analysis means looking at a company’s financial statements in a single reporting period.
How do ratios help us in financial analysis?
Financial ratios are considered as the most important tool of an analyst. It expresses the relationship of one line item to another.
One of the important balance sheet ratios is the current ratio, which is calculated by dividing current assets to current liabilities. It indicates the company’s ability to pay its short term liabilities.
Similarly we have financial ratios to know the ability of a company to sell inventory and collection receivables, pay long term debt and profitability.
Almost all listed companies include key financial ratios in a special section while publishing their corporate results. Most of them show key financial ratios in the summary section of their investor presentation.
As an analyst, you should always try to figure out what causes the ratio to fall or increase. Blindly you can not go by fall or rise in ratios.
How to measure a Company’s Financial Health?
A company’s financial health is measured through different parameters. We have a number of financial ratios to review a company’s overall financial health.
In ratio analysis, line items of one statement or report are compared with line items from another to find a meaningful percentage to make a decision. This is the most common method used to analyse organisation’s leverage, liquidity, solvency, profitability and asset turnover.
Here are four key areas of financial health that are examined by financial analysts.
- Liquidity: How the company owns to manage its short-term debt obligations.
- Solvency: Can the company meet its debt obligations on an ongoing basis, not just over the short term.
- Operating efficiency: it tells you how well the company’s management is able to control costs.
- Profitability: It measures the company’s ability to survive in the long run. Better net profit margin compared to industry peers indicates that the company has a better financial position to commit capital to growth and expansion.
If you want to compare return with total assets and equity share capital to know how well a company has performed, then return on assets (ROA) and return on equity (ROE) might be helpful to you.
Similarly, if you want to see how inventory is managed by the company then you can calculate inventory turnover ratio. A high inventory turnover ratio means a company is moving its inventory faster than industry standards. A low ratio indicates that the company has lots of inventory and they have problems in selling it.
Here is a list of important ratios that can help you in company’s financial statements analysis:
- Debt to equity
- Return on equity (ROE)
- Current ratio
- Liquidity ratios
- Dividend payout
- Profitability ratios
- Accounts receivable turnover
- Accounts payable turnover
- Fixed assets turnover
- Inventory turnover
- Gross profit margin
- Net profit margin
- Return on total assets
- Return on total investments
- Interest coverage ratio
You can learn how to perform financial statement analysis either for your own investments or to understand the business better. To start with, you can download a listed company’s annual report from their website’s investor section in order to familiarise yourself with the way financial data are presented.
Also read: Technical Analysis for the stock market – A Beginners guide
Frequently Asked Questions – FAQs
See below for answers to most frequently asked questions on financial statement analysis:
What is a zero debt company?
Zero debt means the company has no debt on its balance sheet, it’s also known as debt free company.
In other words, a zero debt company means that company has not taken any external debt or any kind of external borrowings to its balance sheet.
All the funds required by the company are internally generated.
Interest cost can have a huge impact on the company’s profitability. In an economic downturn, a high debt company can struggle to survive. We have seen this kind of situation in recent lock-downs due to COVID-19 restrictions.
In this type of situation a zero debt company has a better chance of survival than a highly debt company.
