What is one thing that creditors, investors, management, and regulatory authorities all have in common? In order to do their job well, all of them rely in one way or another on financial statement analysis.
Creditors rely on financial statements to evaluate whether a company or organization will be able to pay back a debt. Regulatory authorities, like the US Securities and Exchange Commission (SEC), rely on financial statements to determine whether a company meets the accounting standards required of a publicly traded company. Investors rely on financial statements in order to understand whether investing in a company would be profitable. And management relies on financial statements to make intelligent business decisions and communicate with investors and key stakeholders.
“Accounting is the language of business, and a company’s financial statements are its way of communicating accounting information to its owners and the taxing government,” says Thomas R. Ittelson, author of Financial Statement: A Step-by-Step Guide to Understanding and Creating Financial Reports and Visual Guide to Financial Statements: Overview for Non-Financial Managers & Investors. “This includes sales, costs, expenses, profits, and assets.”
Simply put, the business world could not exist in its current form without financial statements.
But what is financial statement analysis? What are the most common types of financial statements? And how do you conduct an analysis? Learn more about this fundamental business skill below.
What is Financial Statement Analysis?
Financial statement analysis is the process an individual goes through to analyze a company’s various financial documents in order to make an informed decision about that business.
While the specific data contained within each financial statement will vary from company to company, each of these documents is designed to offer insight into the health of the company. They are also essential to monitoring a company’s performance over time, as well as understanding how a company is progressing toward key strategic initiatives.
At its heart, says Ittelson, financial statement analysis allows an individual to “watch where the money, goods, and services go.”
Related: Finance vs. Accounting: What's the Difference?
Common Types of Financial Statements
Companies will often produce a number of financial statements, each of which is tailored to the needs of a particular audience. The information contained in each of these documents will vary by necessity.
The most common types of financial statements that you may encounter include: Balance sheets, income statements, cash flow statements, and statements of shareholder equity.
1. Balance Sheets
A balance sheet is designed to communicate the “book value” of a company. It’s a simple accounting of all of the company’s assets, liabilities, and shareholders’ equity, and offers analysts a quick snapshot of how a company is performing and expects to perform.
Most balance sheets follow this basic formula:
Assets = Liabilities + Shareholders’ Equity
An asset is anything the company owns which has a quantifiable value. This may include physical property (vehicles, real estate, unsold inventory, etc.), as well as non-physical property (patents, trademarks, etc.).
Liabilities refer to money the company owes to a debtor. This may include outstanding payroll expenses, debt payments, rent and utility payments, money owed to suppliers, taxes, bonds payable, and more.
Shareholders’ equity is a term that generally refers to the net worth of a company. It reflects the amount of money that would be left if all assets were sold and all liabilities paid. This money belongs to the shareholders, whether they are a private owner or public investors.
2. Income Statements
An income statement is a report that a company generates in order to communicate how much money it has earned over a period of time. They’re often found as quarterly and annual reports.
In addition to communicating top-line revenue, income statements detail a number of other metrics that can be helpful to analysts and investors. These include:
- Operating expenses, which detail every expense the company encountered during the reporting period
- Depreciation, which quantifies the extent to which a company’s assets (for example, aging equipment or vehicles) have lost value over time
- Net income, which subtracts the company’s expenses from its gross revenue in order to determine its total level of profits or loss
- Earnings per share (EPS), which divides net income by the total number of outstanding shares
3. Cash Flow Statement
A cash flow statement is a report that details how a company receives and spends its cash. These are also called cash inflows and outflows.
A company can only operate as long as it has the money to cover its expenses. Cash flow reflects a company’s ability to operate in both the short- and the long-term, and is used by investors, creditors, and regulators to determine whether a company is in good financial standing.
Cash flow statements are typically split into three sections:
- Operating activities, which details cash flow generated from the company delivering upon its goods or services, including both revenue and expenses
- Investing activities, which details cash flow generated from the buying or selling of assets, such as real estate, vehicles, and equipment (using free cash and not debt)
- Financing activities, which details cash flow from both debt and equity financing
4. Statement of Shareholders’ Equity
The statement of shareholders’ equity is a financial statement that details changes in the equity held by shareholders, whether those shareholders be public or private investors.
A statement of shareholders’ equity will typically report changes in the number of shares and value of common and preferred stock, as well as details about whether or not the company has purchased back any stock previously held by shareholders (called treasury stock) and other data points.
5. Management’s Discussion and Analysis (MD&A)
The MD&A is a document written by the company’s management, which is designed to accompany financial reports.
While it is not a financial document in and of itself, an MD&A will typically provide additional context about why the company performed the way that it did during the reporting period, which can be incredibly helpful to investors, analysts, and creditors.
According to the SEC, “The purpose of MD&A is to provide investors with information that the company’s management believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations. It is intended to help investors to see the company through the eyes of management.”
While an MD&A should always be taken with a grain of salt, the Sarbanes-Oxley Act of 2002 mandates that senior corporate officers personally certify in writing that the company's financial statements comply with SEC disclosure requirements and fairly present, in all material aspects, the operations and financial condition of the issuer.
“Officers who sign off on financial statements that they know to be inaccurate will go to jail (if and when caught),” Ittelson says.
How to Conduct Financial Statement Analysis
Typically, professionals will follow one of two common methods to analyze a company’s financial statements: Vertical and horizontal analysis, and ratio analysis.
Vertical and Horizontal Analysis
Vertical and horizontal analysis are two related, but different, techniques used to analyze financial statements. They each refer to the way in which a financial statement is read, and the comparisons that an analyst can draw from that reading. Both types of analysis are critical to gaining an accurate understanding of the information provided in a financial statement.
- Vertical analysis is the process of reading down a single column in a financial statement. Whereas horizontal analysis is used to identify trends over time, vertical analysis is used to determine how individual line items in a statement relate to another item in the report. For example, in an income statement, each line item might be listed as a percentage of gross sales.
- Horizontal analysis, on the other hand, refers to the process of reading current financial data in comparison to previous reporting periods. Also called “trend analysis,” reading a financial statement in this way allows an individual to see how different financial metrics have changed over time: For example, whether liabilities have increased or decreased from Q1 to Q2.
Ratio Analysis
Ratio analysis is the process of analyzing the information in a financial report as it relates to another piece of information in the same report.
There are many different kinds of ratios which can help you gain insight into the health of a company. These are generally broken into the following broad categories:
- Profitability Ratios: These ratios offer insight into how profitable a company is. Some important profitability ratios include gross profit ratio, return on equity, break-even point, return on equity, and return on net assets.
- Liquidity Ratios: Liquidity ratios offer insight into how liquid a company is, which is important in measuring a company’s ability to stay in business. Some important liquidity ratios include cash coverage ratio, current ratio, and liquidity index.
- Leverage Ratios: Leverage ratios offer insight into how much a company is dependent on debt to maintain its operations. Some important leverage ratios include debt to equity ratio, debt service coverage ratio, and fixed charge coverage.
- Activity Ratios: Activity ratios offer insight into how well a company is utilizing resources. Some important activity ratios include accounts payable turnover rate, accounts receivable turnover rate, inventory turnover rate, and working capital turnover rate.
Once you have calculated a ratio for the current period, you can compare it against previous periods to understand how the company is performing over time. It’s also possible to compare the ratio against industry standards to understand if the company in question is under- or over-performing.
Learning the Skills You Need for Success
If you want to learn how to perform financial statement analysis, either for your own interest or to better perform the duties of your job, a number of options can help you gain the skills you need.
You could pursue a self-taught route, reviewing publicly available financial statements in order to familiarize yourself with the way that financial data is typically presented. Paired with mentorship opportunities at your organization, this can be a great way of learning the basics, but it isn’t your only option.
Taking an online class focused on finance or financial accounting are other potential paths you can take to gain the skills you need.
Do you want to take your career to the next level? Download our free Guide to Advancing Your Career with Essential Business Skills to learn how enhancing your business knowledge can help you make an impact on your organization and be competitive in the job market.
