In order to arrive at a decision or recommendation, analysts 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 company’s financial health by understanding its fundamentals is called financial statements analysis.
Before understanding the tools used in financial statements analysis, we have to understand what is financial statements.
What is financial statements
Accounting system of a company prepares statements for outside stakeholders every quarter and year to given them the financial information and data to take a decision. Following three main reports are known as financial statements;
- 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
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.
The basic equation of the income statement is net profit = revenue + other income – expenses.
Methods of Financial Statements Analysis
The primary purpose of financial statements is to provide information and data about company’s financial health and performance for a particular period. All these can be obtained from company’s annual reports. After getting these information and data, it’s up to the analysts to analyse and interpret.
We have following three methods of financial statements analysis:
- Horizontal Analysis
- Vertical Analysis
Horizontal Analysis of financial statements
In horizontal analysis, you compare this year 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 last 10 years and start analyzing 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 a impact on the financial health and how company can manage it in future.
You can also compare line items of each quarter in comparison to earlier quarter’s figure to analyse quarterly trend.
In simpler term, horizontal analysis can be defined as a comparison of company’s data between two or more periods.
Vertical Analysis of line items
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 dividing the earlier figure with the later and multiply its 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 statement, all incomes are expressed as a percentage to total income and all expenses as a percentage to total expenses. Similarly, in 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.
In ratio analysis, line items of one statement or report are compared with line items from another to find a meaningful percentage to take a decision. This is the most common method used to analyse organisation’s leverage, liquidity, solvency, profitability and asset turnover.
For instance, if you want to compare return with total assets and equity share capital to know how well 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 company is moving its inventory faster than industry standards. A low ratio, indicates that 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