Financial Statement Analysis
What Is Financial Statement Analysis?
Financial statement analysis is one of the most fundamental financial research & analysis practices. To put it in layman’s terms, it’s the process of analyzing financial statements so that decision-makers have access to the right data. It’s also used as a method for taking the proverbial pulse of the business. Since statements are centered on a company’s important financial details, they can be used to evaluate all of their activities. This is essential to understanding the performance of overall business operations.
What Are the Financial Statements?
According to the American Institute of Public Accounts, financial statements are prepared for the purpose of presenting a periodical review or report on the progress by the management and deal with the status of investment in the business and results achieved during the period under review.
They reflect a combination of recorded facts, accounting conventions, and personal judgements, and the judgement and conventions applied affect necessarily depends on the competence and integrity of those who make them and on their adherence to generally accepted accounting principles 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. But private companies often underestimate the importance of these statements because they are not forced to keep track of them. It’s not that they don’t create them, but they are not using them to their full benefit. Let’s look at these important financial documents:
- Balance Sheet: Details a company’s value based on its assets, liability, 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’s 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 all of these statements and is the best way to gauge the overall health of a business. There are a few tools and techniques in which this is done.
- 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 analytical tool is used to help companies prevent conclusions that are misleading. Sometimes looking at sheer profitability doesn’t tell the whole story, so we use the DuPont Analysis 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 business leaders to look at any 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.
Why Financial Statement Analysis Is the Best Method for Analyzing and Reporting Financial Statements
Now that we’ve gone over some of the basics let’s dive deeper into financial research & analysis. Here’s what makes financial statement analysis such a powerful tool.
It helps in 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 determine market size, compare competitors, and see the growth rate of a market as it relates to 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 pricing are holding up against others in the same market. There are several factors at play here including distribution, purchasing, and advertising costs.
It Helps to Identify 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 development of the business. Once a strategy is founded, 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 show you the exact direction your company is moving. It will be the first indicator if growth is not where you want it to be.
Assesses 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 a bit too common in small businesses, and it will lead down a path of ruin if left unchecked. Financial research & analysis is the best way to ensure that these valuable reports are steering your growth in the right direction.
Analyzes Profitability and Identifies Potential Risks to the Business
Every business strategy has risks, and the majority of those risks are felt on a financial level. So it’s important that businesses develop ways to identify and mitigate those risks. While it’s certainly not possible to avoid all risks, we can identify them before they hurt too badly. This is done by keeping a close eye on profitability. Financial statement analysis helps you keep track of profitability ratios so that you can truly measure the overall value of a strategy moving forward.
Prepares Financial Statement Forecasts
Forecasts are how businesses predict the direction their business is heading. These forecasts need to be in alignment with the overall goals of a company. Income, cash flow, and balance sheets must all be closely monitored to ensure that they are in alignment with the overall goals as they pertain to growth.
Financial statement analysis is the way top businesses stay ahead of their competitors.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, 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.