Remember how our dads used to remind us to keep track of our expenses? For dads, a financial statement would be the perfect scorecard to size you up and track where exactly the pocket money went that month. In the corporate world, though, financial statements track and display the financial health of an organization.
Basically, the financial statement that an organization uses to assess its financial stability has three elements.
- The balance sheet helps to track the valuable holdings of a business and how they are divided in terms of assets, liabilities, and shareholders’ equity. Put simply, it shows what a firm owes and owns.
- The income statement shows if the company is profitable or not after running business operations. The income statement starts at zero at the beginning of every fiscal year and records all income and expenditure that has a bearing on the company’s net profit throughout the year.
- The cash flow statement tracks how the company generates cash and where exactly that money is deployed in the business.
What is financial statement analysis?
To use an analogy, financial statement analysis is much like that well-planned trip with a proper itinerary and everything else in place. When you’re contemplating and preparing the to-do’s for each day of travel, it may seem a bit tedious, but it sure does make your trip more enjoyable.
Financial statement analysis is mostly used by external stakeholders such as analysts to estimate a company’s future prospects by examining its past financial records. It helps them make decisions about investing, lending, borrowing, or doing business with that organization.
Objectives of financial statement analysis
Financial statement analysis is done keeping certain objectives or outcomes in mind. While the primary objective remains analyzing a company’s future financial prospects, there are other more specific goals that it seeks to achieve. Some of them are:
- To review an organization’s performance over the past financial year or compare multiple annual financial statements to find ways to boost growth.
- Financial statement analysis helps to assess a company’s operational efficiency and find reasons for increased or decreased profitability.
- More importantly, the analysis often helps an organization identify potentially serious issues such as bankruptcy or insolvency early.
- It can be useful in comparing firms operating in the same sector.
Types of financial statement analysis
There are several types of financial statement analyses, ranging from ratio analysis which is used to measure the outcome difference between separate financial components, to horizontal analysis, which tracks the financial health of a company over a period of time. Here, we discuss four financial analysis methods commonly used by businesses and analysts.
Horizontal analysis or long-term analysis uses comparative financial statements to assess a company’s performance over a period of time. In this method, information about comparative financial statements for more than one reporting period is made available to the stakeholder. This is especially useful in long-term planning as it compares growth in the current financial year to the year before, identifying potential opportunities as well as issues.
Horizontal analysis can be used by both internal and external stakeholders to identify trends and patterns in financial data and devise business strategies accordingly. Furthermore, it can be used to assess more than one kind of financial statement, including balance sheets and income statements.
Vertical analysis or common-size analysis uses percentages to compare current financial statement figures to that of the base figure. An enterprise employs this method to find out how it has utilized its resources across different financial statements.
In this method, analysts insert data vertically, not horizontally, in columns across time periods. So, one line on the financial statement will show the base figure of 100%, as opposed to the other lines representing a percentage of the base figure. For instance, it uses total sales from the income statement as the base value and restates each sales category as a percentage of the base value. To sum up, vertical analysis makes it easier for businesses to perform inter-firm comparisons as well as internal comparisons.
This method is especially useful when organizations have to collect data from multiple periods based on historical trends. The information collected is then inserted on a horizontal line to identify patterns in performance across financial years based on varying trends. In order to conduct financial trend analysis, a company would need at least two years’ financial statement data to discern a pattern through comparison.
It is essential for any business to maintain liquidity in order to meet its short-term or urgent financial requirements. Liquidity analysis measures an organization’s ability to meet these financial obligations and takes a close look at its strategy to pay off debt and remain solvent. It uses three kinds of ratios to quantify liquidity.
Current ratio — It showcases the immediate liquidity of a company by determining how much inflow it has to pay off short-term loans due within the next year or so.
Quick ratio — It is popularly known as the acid test ratio as it determines the liquidity of an organization’s most liquid assets to repay its short-term debt.
Cash ratio — As the term indicates, it measures the ability of a company’s cash or cash equivalent assets to pay off short-term debt.
The importance of financial statement analysis
Long story short, financial statement analysis is a useful tool for individuals and entities alike. It helps businesses, financial institutions, and investors to size up a company’s financial position, its ability to repay debt, and its worth as an investment. As far as a firm is concerned, it is a tough act to strike a balance between capital structure, investor returns, and investment. Be it managing your pocket money or managing big firms, the financial statement is an invaluable scorecard that would help you make informed decisions.