Analysts apply several methods in judging the financial stability of a company to decide its valuation in the stock market. Analysing financial statements is one of them. At the core, financial statements are the health report card that helps investors predict the company’s performance in the long run.
Financial statement analysis is a process of analysing financial condition for decision making purpose. It allows external stakeholders to evaluate the financial performance of the company and its business value.
Types of financial statements
There are three significant financial statements that every company needs to maintain. – balance sheet, income statement, and cash flow statement. Let us discuss them one by one.
It is a report card that reveals a company’s worth in terms of book value at the end of a specific year. It consists of three main parts, namely, assets, liabilities (debt), and shareholder’s equity. The most straightforward formula to arrive at book value or shareholder’s equity is to subtract debt from assets. The book value is an important performance metric, which rises or falls with increased or decreased financial activities of the company.
Cash flow statement
It is an account of how much liquid cash or cash equivalent circulates in the company. It is a report card that shows how well a company manages its cash position. Cash flow statement is an important document to evaluate a company’s financial health and compliments balance sheet and income statement.
It is a detailed account of company’s revenue earning. Also known as the profit and loss statement, it provides the bottom line for decision making, whether the company is making profit or loss.
Methods of financial statement analysis
There are several techniques used by analysts to develop a fair understanding of a company’s financial performance over a period. The three most commonly practised methods of financial analysis are – horizontal analysis, vertical analysis, and ratio and trend analysis.
Performance of two or more periods are compared to understand company’s progress over a period. Each component of a ledger is compared with the previous period to gather a general understanding of trends.
For example, if the cost of final goods rises by 20 percent in a year, but it is not reflected in the revenue earned, then there may be some components which are costing the company more.
Vertical analysis helps to establish a correlation between different line items in a ledger. It gives analysts an understanding of overall performance in terms of revenue and expenses. The results are reviewed as a ratio.
Ratio methods of financial analysis is used to compare one financial component against another and reveal a general upward or downward trend. Once the ratio is calculated, it can be compared against the previous period to analyse if the company’s performance is in accord with set expectations. It helps management highlight any deviation from set expectations and take corrective measures.
It helps to analyse trends over three or more periods. It takes into account incremental change patterns, considering the earliest year as the base period. A change in a financial statement will either reveal a positive or negative trend.