What Is Financial Statement Analysis?

Financial statement analysis is one of the most fundamental practices in financial research and analysis. In layman’s terms, it is the process of analyzing financial statements so that decision-makers have access to the right data.

Financial statement analysis is also used to take the pulse of a business. Since statements center on a company’s key financial details, they are useful for evaluating activities. This is essential to understanding the firm’s overall performance.

What Are Financial Statements?

According to the American Institute of Public Accounts, financial statements are prepared for the following purposes:

  • Presenting a periodical review or report on the progress made by the management
  • Dealing with the status of investments in the business and the results achieved during the period under review

Financial statements reflect a combination of recorded facts, accounting conventions, and personal judgments.

The judgments and conventions that are applied are dependent on the competence and integrity of those who make them and on their adherence to generally accepted accounting principles (GAAP) and conventions.

Public companies are forced to keep track of their financial statements in very specific ways through a balance sheet, income statement, and cash flow statement.

However, private companies often underestimate the importance of these statements because they are not required to keep track of them. It’s not that they don’t create them, but they typically don’t use them to their full benefit.

Let’s consider the following important financial documents:

  • Balance Sheet: Details a company’s value based on its assets, liabilities, and shareholder equity. We can learn a lot about the efficiency of a business’s operations from its short-term cash flow and accounts receivable.
  • Income Statement: An income statement breaks down a company’s earnings by comparing expenses and revenue. It is broken down into separate categories that businesses can use to help them identify profitable areas.
  • Cash Flow Statement: This report shows a company’s cash flow in terms of operational activities, financial ventures, and investments.

Tools and Techniques Used For Financial Statement Analysis

Financial statement analysis is centered on the balance sheet, income statement, and cash flow statement. It is the best way to gauge the overall health of a business. There are several tools and techniques with which this is done, including:

  • Fundamental Analysis: This analytical practice is used on a company’s most basic financial levels. It shows the health of the business on a financial level and helps provide insight into the overall value.
  • DuPont Analysis: This tool is used to help companies prevent conclusions that are misleading. Sometimes, looking at sheer profitability doesn’t tell the whole story, so DuPont Analysis is used to create a detailed assessment.
  • Horizontal Analysis: Here, we compare financial ratios, a specified benchmark, and a specified line item over a specific period. This allows firms to examine changes that have been made and compare them with other behaviors.
  • Vertical Analysis: This financial analytical practice shows items within the financial statement as a percentage of the base figure. It’s simple, so it’s the method that most businesses prefer.

Value of Financial Statement Analysis When Analyzing and Reporting Financial Statements

Now that we’ve gone over some of the basics, let’s dive deeper into financial research and analysis. Here’s what makes financial statement analysis such a powerful tool.

Identifying the Industry’s Economic Characteristics

Financial statement analysis can identify several important factors in a business’s marketplace, sometimes finding smaller niches that are other methods miss.

We can use financial statement analysis to determine market size, compare competitors, and investigate the growth rate of a market as it relates to a variable such as spending.

It’s also possible to look beyond your own company and find out how others are faring in new markets before you decide to invest in them.

Another powerful tool that a lot of brands are using is product differentiation analysis. This method crunches financial numbers to see how well a brand’s products and prices are holding up against others in the same market.

There are several factors at play here, including distribution, purchasing, and advertising costs.

Identifying Company Strategies

All entrepreneurs understand the importance of finding the right strategy to meet the needs of their business. They spend a lot of time searching for the perfect one.

When you break it all down, the blueprint is usually the same, whether it’s developing a business plan or developing advanced strategies. That blueprint is defined by data.

The only difference between the two is that a business strategy is focused more on the future and the development of the business. Once a strategy is established, then it has to be measured. The only true way to get accurate results is to compare financials.

Most strategies evolve, and financial analysis helps steer us in the right direction. For example, a detailed financial statement analysis will reveal the direction your company is moving. It will be the first indicator if growth is not where you want it to be.

Assessing the Quality of a Company’s Financial Statements

All businesses must have a method of efficiently analyzing their financial statements. This process requires three key points of understanding that must always be accounted for. These can all be found through a sound financial statement analysis.

  • Businesses must identify the economic characteristics of their industry and compare their finances to the average.
  • Companies must be able to identify which strategies are profitable and which are not.
  • Businesses must be able to gauge the quality of their financial statements.

Inaccurate financial statements are common in small businesses. If left unchecked, this will lead down a path of ruin. Financial research and analysis are the best way to ensure that these valuable reports are steering your growth in the right direction. 

Analyzing Profitability and Identifying Potential Business Risks

Every business strategy has risks, and the majority of those risks are felt on a financial level. Therefore, it’s important for businesses to devise ways to identify and mitigate these risks.

While it’s not possible to avoid every risk, we can identify them before they cause too much damage. This is done by keeping a close eye on profitability.

Noteworthily, then, financial statement analysis helps you to keep track of profitability ratios, enabling you to truly measure the overall value of a strategy moving forward.

Preparing Financial Statement Forecasts

Forecasts are how companies predict the direction in which their business is heading. These forecasts need to be aligned with the company’s overall goals.

Income, cash flow, and balance sheets must all be closely monitored to ensure that they are aligned with the organization’s overall growth objectives.

Conclusion

Financial statement analysis is the practice that the world’s leading businesses engage in to stay ahead of their competitors.

Frequently Asked Questions

What is the first step in financial statement analysis?

The first step is to identify the economic characteristics of your industry and compare your finances to the average.

What are the benefits of a financial statement analysis?

Financial statement analysis helps you to keep track of profitability ratios, enabling you to truly measure the overall value of a strategy moving forward.

What is the end goal of a financial statement analysis?

The end goal is to prepare forecast reports that are aligned with your business’s growth objectives.

What are some examples of an industry economic characteristics?

Examples include historical ratios, price-earnings ratios, and return on assets.

Can you identify a potential business risks through financial statement analysis?

Yes, businesses can identify and mitigate potential business risks by keeping a close eye on profitability ratios.

Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.