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Techniques and Methods of Financial Statement Analysis

•6 min read•by Angel One
Analysing financial statements is an important factor when it comes to successful investment in the stock market. Let us understand various methods in brief.
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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. This analysis provides a detailed review of the financial documents of any company, such as the cash flow statement, balance sheet, and income statement. 

Apart from assessing an organisation's financial stability, this analysis evaluates key metrics that help determine a company's operational efficiency and potential. At the core, financial statements are the health report card that helps investors predict the company’s performance in the long run.  

Also, check out the Basics of Share Market here. 

Key Takeaways

  • Financial statement analysis helps gauge the liquidity, profitability, and operational efficiency of a company 

  • This enables investors, management, and lenders to make strategic decisions 

  • The analysis evaluates the key metrics of an organisation, such as cash flow statements and balance sheets 

  • It also helps assess the company’s ability to mitigate risks and manage potential opportunities 

  • Financial statement analysis also has some drawbacks due to data manipulation 

What is Financial Statement Analysis?

In simple words, financial statement analysis is a process of analysing financial conditions for decision-making purposes. It allows external stakeholders to evaluate the financial performance of the company and its business value. This analysis serves as a guide, enabling investors to make strategic decisions to safeguard their financial well-being. 

Understanding the financial statement analysis meaning is crucial as it evaluates key metrics of an organisation, such as: 

  • Profits earned by a company 

  • Revenue generated 

  • Total assets and liabilities 

These parameters help investors, lenders, and management assess the organisation's strengths and weaknesses before making informed decisions. The purpose of financial analysis can be briefly summed up as follows: 

  • The structured process examines a company’s financial well-being minutely, helping stakeholders to gain accurate insights. 

  • This also enables investors or lenders to assess the ability of an organisation to generate cash flows or manage debts. 

  • While the statement helps analyse a company’s financial capability, it also helps compare its performance in the market against industry standards. 

  • Stakeholders can effortlessly understand the profitability, solvency, liquidity or the operational efficiency of an organisation. 

 Also, check out How do Operating Income and Revenue Differ here. 

Objectives of Financial Statement Analysis 

Analysing financial statements is crucial to a company's overall health, as it helps assess its ability to withstand market swings and meet its responsibilities. 

Below are a few objectives of financial statement analysis: 

  • Helps evaluate the profitability of a business 

  • Helps check if the organisation has been maintaining transparency in financial reporting 

  • Helps review if the company adheres to financial regulations 

  • Helps forecast the future performance of an organisation, helping you make accurate decisions 

  • Helps allocate the company's resources in a way that the budget aligns well with its  financial goals 

  • Helps gain insights into the possible investment opportunities that can help an organisation grow 

  • Helps determine the operational efficiency of a company 

Simply put, analysing financial statements not only supports strategic planning but also helps you evaluate an organisation's risk exposure. 

Also, Learn How to Analyze Companies Playing Financial Numbers here. 

Advantages of Financial Statement Analysis

The importance of financial analysis lies in the benefits it offers. For instance, they help understand key metrics of any organisation, which enables stakeholders to identify the right opportunity and make strategic decisions. Here are some other benefits of financial statment analysis: 

  • Enables you to get a better grasp of the organisation’s  financial condition 

  • Let's you determine the strength areas of the business while focusing on the areas needed for improvement 

  • Enables you to comply with financial reporting standards 

  • Helps you gauge possible hazards by evaluating cash flow patterns and the financial stability of the company 

  • Encourages you to design long-term plans that aid in the sustainable growth of the company 

  • Helps improve the operational efficiency of the business by identifying cost-saving measures and areas for improvement 

The benefits of analysing financial statements are many, and they help increase the confidence of stakeholders. With timely analysis, investors, management or lenders are able to make strategic decisions based on the data-driven financial reports. 

Also, Learn How To Read Company Annual Report here. 

Limitations of Financial Statement Analysis 

While analysing these statements is an effective tool, know that there are some drawbacks, too. Before making crucial decisions pertaining to a business, it is essential to assess the limitations of financial statement analysis.  

One of the biggest drawbacks of anaylsing financial data is that it is always a one-dimensional perspective. This simply means that analysis is completed on the basis of financial indicators and does not focus on other factors such as client satisfaction, employee involvement, etc. 

The effects of inflation may lead to incorrect valuation of assets, liabilities or earnings, as a financial statement will not be able to consider such factors accurately. This is one of the important drawbacks of analysing financial data that you must not ignore. 

That said, financial situation of a company may get affected by external factors, such as geopolitical changes or variations in consumer approach. Such parameters would not have been included in the financial analysis. This also forms a critical part of the limitations of financial statement analysis.  

One of the crucial drawbacks of analysing financial data is that these statements may be fabricated by businesses to paint a positive picture to stakeholders. Remember, the accuracy can always be tampered to suit personal interests. 

Must Read: Tools of Financial Analysis 

Types of Financial Statements 

There are three significant financial statements that every company needs to maintain. –  Balance Sheet, Income Statement, and Cash Flow Statement. 

Balance Sheet: 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 shareholders’ equity. The most straightforward formula to arrive at book value or shareholders’ 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. 

Income Statement: It is a detailed account of the company’s revenue earnings and expenses in a particular past period, such as a financial year. Also known as the profit and loss statement, it provides the bottom line for decision-making, whether the company is making a profit or loss. 

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. A cash flow statement is an important document to evaluate a company’s financial health and complements the balance sheet and income statement. 

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 four most commonly practised methods of financial analysis are horizontal analysis, vertical analysis, ratio analysis, and trend analysis. 

Horizontal Analysis: The performance of two or more periods is compared to understand the 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 per cent in a year, but it is not reflected in the revenue earned, then there may be some components that are costing the company more. 

Vertical Analysis: 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 analysis: Ratio methods of financial analysis are 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 accordance with set expectations. It helps management highlight any deviation from set expectations and take corrective measures. 

Trend analysis: 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 a negative trend. 

Conclusion 

Understanding financial statement analysis is vital for successful stock market investments. Financial statements serve as a company's health report card, aiding investors in predicting its long-term performance.   

To analyse a company's financial health, analysts employ four primary methods. These techniques empower investors and stakeholders to make informed decisions about a company's financial stability and its value in the stock market. Successful investors employ these methods to navigate the complex world of finance and achieve their investment goals. 

FAQs

Financial statement analysis is the process of evaluating a company's financial statements to assess its financial health and performance. It is essential for investors, creditors, and management to make informed decisions about investing, lending, or managing a business.

The three primary types of financial statements are the Balance Sheet, Income Statement, and Cash Flow Statement. The Balance Sheet provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. The Income Statement shows revenue, expenses, and profits over a period. The Cash Flow Statement details cash inflows and outflows.

Ratio analysis involves comparing different financial metrics to assess a company's performance. It helps in understanding the relationships between various financial variables, such as profitability, liquidity, and leverage. Ratio analysis provides insights into a company's strengths and weaknesses and helps in benchmarking against industry standards.

Trend analysis involves studying financial data over multiple periods to identify patterns and trends. You can use it by selecting a base year and comparing subsequent years to it. Positive trends indicate improvement, while negative trends may signal issues that need attention. Trend analysis helps in assessing the direction and consistency of a company's financial performance.

Horizontal analysis compares financial data over different time periods, such as comparing this year's revenue to last year's. It focuses on changes in financial figures over time. In contrast, vertical analysis looks at the proportion of each line item on the financial statements relative to total revenue or assets. It helps in understanding the composition of financial statements.

It is ideal that a company performs financial analysis at least once in a year. For accurate, timely insights and to make the required adjustments, analysising on a monthly or quarterly basis is ideal. 

Some of the tools better for financial statement analysis include Oracle NetSuite, Microsoft Dynamics, Sage Intacct, and QuickBooks.  

 

Financial statement analysis for investors is of paramount importance, as it is a powerful tool for evaluating a company’s financial stability and operational efficiency. The analysis helps them understand the key metrics of the organisation.

Comparing qualitative vs quantitative analysis helps you understand measurable and subjective data pertaining to the health of a company. While the former focuses on factors such as market position and business model, the latter emphasises on numerical data like financial statements. 

Yes, it is possible. While Financial analysis may not be a sole indicator of bankruptcy, it can help identify early warning signs of a company’s financial position. Since a statement provides insights into the liquidity and profitability of an organisation, it can help you gauge the potential threats to its operations. 

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