Accounting is the language of business — and financial statements are its storybooks. As with any good book, there is a lot going on under the surface of most financial statements. Financial statement analysis is a way to closely read those books to uncover the meaning of a company’s business activities.
By dissecting and reassembling the information in the financial statements, analysts gain a deeper understanding of a business’s trajectory, triumphs, challenges and risks. But financial statement analysis is more than a numbers game; it requires skillful interpretation. When analysts combine numerical investigation with interpretation, financial analysis offers a window into historical performance that can be used to help inform decision-making that shapes future outcomes.
Let’s crack open the binding of the financial statement storybook and explore how to decode financial statement analysis and the benefits it can yield.
What Is Financial Statement Analysis?
Financial statement analysis is the process of extracting additional information from the financial statements by using a variety of analytical techniques, including vertical, horizontal and ratio analyses. These techniques are applied to the three main financial statements: the balance sheet, income statement and statement of cash flows, which provide information about a company’s financial position, profitability and liquidity, respectively. Examining the components of these statements and the relationships among and within them portrays a clearer picture of a company’s financial health.
Financial statement analysis can also consider information from other financial statements, such as the statement of equity, as well as the notes to the financial statements and management discussion and analysis (MD&A). Internal and external stakeholders use financial statement analysis to set business strategy, improve operations, evaluate creditworthiness and measure investment risk and potential.
Key Takeaways
- Financial statement analysis unlocks additional information from key business statements using vertical, horizontal and ratio analyses.
- Deeper insights into a company’s financial health, including its liquidity, leverage and profitability, drive better decision-making for managing, investing, lending and valuing a business.
- Understanding the 10-step financial analysis process helps business managers identify areas for growth or increased efficiency and measure progress against the business’s goals.
- Using the right reporting technology reduces the data gathering and calculations required when analyzing financial statements, leaving more time for interpretation and action.
Financial Statement Analysis Explained
Financial analysis is a general term that refers to the study of any financial instance, such as a business, project or industry, using any type of financial and economic data. Financial statement analysis is a specific type of financial analysis that primarily relies on a company’s financial statements. Most often, financial statement analysis examines one (or more) of five dimensions: profitability, efficiency, liquidity, valuation and leverage. It can be conducted over time, against benchmarks or against competitors, to help analysts better understand what an organization is doing well and where improvements can be made. Financial statement analysis also informs forecasts for the future.
Objectives of Financial Statement Analysis
Financial statement analysis is conducted for a variety of reasons, depending on the stakeholder. A company’s management may undertake financial statement analysis to assess its own operating performance and make changes to maximize success and minimize risk. They might also analyze a new supplier’s or customer’s financial statements to assess their financial health before doing business with them. Lenders perform financial statement analysis to assess a borrower’s creditworthiness and set credit limits and interest rates. Investors rely on financial statement analysis to assess a company’s performance and make decisions about buying, selling or holding its stock. And financial statement analysis is a primary step in the evaluation of potential acquisition candidates.
Types of Financial Statement Analysis
There are three types of financial statement analysis: vertical, horizontal and ratio analysis. Each type employs multiple techniques and can be used independently or in conjunction with others. Typically, the analysis starts with the income statement (also known as the profit and loss statement), which reflects a company’s operating performance. However, all three types of financial statement analysis can be applied to all financial statements.
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Vertical Analysis
Vertical analysis is the process of examining relationships between different items on the same financial statement for the same period. The term “vertical” comes from the top-to-bottom, columnar layout of financial statements. An income statement, for example, lists revenue at the top, followed by expenses, gains and losses, and net income at the bottom. Gross margin percentage, which measures a company’s profitability from its core business, is an example of vertical analysis because it divides gross profit by total revenue, two line items on the same income statement.
Applying “common size” to a financial statement is a type of vertical analysis. Common sizing means expressing every item on a financial statement as a percentage of a common base, such as total revenue (generally used for income statements and cash flow statements) or total assets (used for balance sheets and statements of equity). This results in a column of percentages next to each of the line item values. For example, a common-sized income statement would express each line item as a percentage of sales, making it easy to see the relative mix of revenue and expenses. Common sizing can be applied to any financial statement.
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Horizontal Analysis
Horizontal analysis involves comparing a piece of financial information over different accounting periods. Horizontal analysis makes it easy to see trends as the same data point changes over time. For example, comparing a company’s total revenue for each quarter in a year would show whether sales are increasing, decreasing or staying the same. This type of analysis reveals the direction and magnitude of changes over time and is useful for setting budgets, making projections or preparing forecasts. Horizontal comparisons can be made for any line item or ratio from any financial statement. They can also include comparisons to budgets and forecasts, as well as historical accounting periods. In addition, horizontal analysis is often used to compare a company’s performance to that of other companies in the same industry or against industry benchmarks.
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Ratio Analysis
Ratios are calculations that show the relationship between two or more data points. Analysts use financial statement ratios because they are a fast, quantitative way to gain a lot of insight into complex business processes. For example, the quick ratio (quick assets / current liabilities) shows how quickly a business can generate cash to pay off its short-term obligations if it runs into cash flow problems.
There are many different financial statement ratios available to measure every aspect of a business, from profitability to liquidity to efficiency. Most of the time, the data needed for ratio analysis can be found right on a financial statement, although some ratios require additional information that can be located in a company’s general ledger by using its chart of accounts. Ratio analysis is useful on its own but is even more powerful when combined with horizontal analysis. For example, looking at the quick ratio across the past three years can show whether the company’s liquidity is improving or worsening.
How to Analyze Financial Statements
Analyzing financial statements is an important part of running a business or evaluating whether to partner with one, invest in one or lend to one. Whether you’re a seasoned investor or a new financial manager, understanding how to analyze financial statements is a foundational skill. The following 10 steps can guide you through the process.
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Gather Financial Statements
Start by gathering the relevant financial statements. It’s usually best to begin with the most recent financial statements, as they will contain the most current information. You may also need to gather financial statements from previous periods and from other companies for comparison. Balance sheets show a company’s financial position, including assets, liabilities and equity, as of a specific date. Income statements show a company’s financial performance over a specific period, including revenue, expenses, gains, losses and net income. The cash flow statement shows how a company generated and used cash over a specific period for operating, financing and investing activities. The statement of equity shows changes over a specific period in the amount of money invested in a company by its owners, as well as past income that has been retained.
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Perform an Initial Review
After gathering the financial statements, perform an initial review. During this review, make sure the statements reflect the correct periods you plan to analyze, especially when comparing different companies. Confirm that the statements were prepared using the same accounting principles, such as Generally Accepted Accounting Principles or International Financial Reporting Standards. Additionally, look for any unusual activity in the statements that could distort the analysis, such as a merger, divestiture or labor strike. Finally, take a high-level look at the big picture: Was the company profitable during the period? What is its equity profile? Was it cash positive? It’s best to use statements that have been audited by independent auditors to minimize any risk of inaccuracies.
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Conduct Ratio Analysis
Conducting ratio analysis is a common first step in analyzing financial statements. Choose the ratios that best align with the analysis objectives. For example, potential lenders may start with solvency and debt coverage ratios, while internal managers may focus on efficiency ratios, such as accounts receivable turnover, and investors may start with valuation ratios, such as earnings per share and price-to-earnings ratio. Financial software can easily and quickly calculate the ratios.
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Analyze Trends and Perform Comparative Analysis
After all the information is gathered and the ratios are calculated, it’s time to start interpreting the data. This step includes reviewing trends over time and analyzing their underlying origins within the company. Interpreting these trends requires a deep understanding of how a business operates, and making meaningful comparisons to peers requires knowledge of the industry sector. Additionally, consider the results of the financial statement analysis in the context of the broader macroeconomic environment and industry benchmarks.
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Evaluate Cash Flows
Understanding how a company generates its cash is particularly important for anyone focused on the company’s long-term sustainability. Analyze the cash flow statement to determine whether the company’s core operations generate enough cash to meet its obligations and invest in future growth. To do so, analysts customarily look at various ratios, such as operating cash flow to total liabilities, over time and compared to other companies in the same industry.
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Assess Quality of Earnings
Not every dollar of net income is equally valuable. Financial statement analysis helps assess the quality of a company’s earnings by drilling down to see where the profits come from. For example, profits derived from normal business operations are more valuable than those from investment gains because they substantiate the sustainability of the core business. Vertical analysis is particularly useful for this step because it shows the percentages of revenue, expenses and nonrecurring gains and losses. While earnings quality offers valuable insights to any analyst, potential investors are particularly interested in understanding the quality of earnings as a proxy for a company’s long-term viability and ability to pay dividends.
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Understand Management’s Discussion and Analysis
Reading a company’s MD&A can be a helpful step in financial statement analysis because it is management’s own analysis of the financial statements and other disclosures. While an MD&A must adhere to specific reporting guidelines, it is intended to be company-specific, and it can be helpful to get the company’s leaders’ perspectives. The guidelines to which an MD&A discussion must adhere include discussing liquidity; results of operations; changes in product mix, volume and price; unusual transactions; significant items; and any significant trends that might impact the company in the future. It’s important to note that the MD&A is not audited.
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Consider Nonfinancial Factors
When analyzing financial statements, it’s important to consider nonfinancial factors. That may sound counterintuitive, but the analysis interpretation really benefits from understanding the company holistically. Consider how the financial statements analysis tells the story of the business’s brand strength or market share, employee/supplier/vendor relationships, customer satisfaction and level of innovation. At the same time, consider how these factors influence the financial narrative.
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Prepare Forecasted Financial Statements
The knowledge gained from financial statement analysis can then be put to work to improve future performance. Quantitative, unbiased analysis often reveals opportunities and challenges in the business model, helping decision-makers adjust their company’s course. These adjustments can be large or small, such as operational tweaks, sweeping organizational restructuring or even changes in a company’s go-to-market strategy. Proposed changes can be combined with observed market trends and modeled through scenario analysis to prepare a new forecast of the most likely outlook for a company. The forecast can become a basis of comparison for future financial statement analysis, bringing the process full circle.
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Use Valuation Techniques to Estimate Company Value
Prospective investors often conclude a financial statement analysis by determining an economic value for the company. For public companies, this often involves assessing the price of a company’s stock. Such valuations guide investors’ decisions about whether to invest, based on their desired return. There are several techniques for estimating a company’s value, such as discounted cash flow (also known as net present value), enterprise value and market capitalization. The insight into a company’s business model gained through financial statement analysis helps guide the selection of the most appropriate valuation technique. One technique that leans heavily on financial statement analysis, called comparable company analysis, compares various metrics and financial ratios within an industry peer group of companies to determine value.
Advantages of Financial Statement Analysis
Regular financial statement analysis is a best practice for businesses of all types and sizes; many experts say it should be done monthly. Here are five of the many ways financial statement analysis can benefit a company. It allows business leaders to:
- Evaluate enhanced performance: Quantitative financial statement analysis allows a business to track progress against performance goals.
- Uncover competitive advantages: A more detailed understanding of revenue streams, profit drivers and operating efficiency can highlight potential areas for market share growth.
- Assess comprehensive financial health: Financial statement analysis monitors a company’s vital statistics and can provide early warnings of any deterioration.
- Improve decision-making: By establishing a set of key performance indicators and monitoring them regularly, decision-makers can rely on current, unbiased data to guide the business.
- Identify growth potential: With up-to-date analysis of revenue trends, asset utilization and available cash flow, business leaders can more quickly identify and act on growth opportunities.
Limitations of Financial Statement Analysis
Financial statement analysis is a valuable management and valuation tool, but there are a few limitations to keep in mind. Supplementing financial statement analysis with other types of analysis can help mitigate the primary drawbacks, which include:
- Requires available historical data: The availability, consistency and quality of historical data can make or break financial statement analysis. Inaccurate, outdated or missing data can render the analysis useless.
- Accounting policies can distort information: Changes in accounting policies, such as estimates for bad debt or inventory obsolescence, can create inconsistencies and variances that are not due to operational issues and can lead to incorrect conclusions.
- Does not consider qualitative factors: Financial statements are based on accounting transactions and, on a stand-alone basis, do not include other important, qualitative factors, such as brand reputation.
- May not be comparable across companies: Differences in company size, industry and accounting methods can limit the ability to analyze and compare financial statements in a meaningful way.
Practical Applications of Financial Statement Analysis
Financial statement analysis is used in many ways in day-to-day business. It is a cornerstone for assessing how a business performs, understanding the reasons underlying that performance, influencing decisions for the future and valuing companies. The four primary applications of financial statement analysis are investing, lending, valuation and strategy.
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Investment Decision-Making
Individual and institutional investors analyze financial statements to determine whether a company is a good investment. It’s typically one of the first methods they use to screen and compare multiple investment options. Investors’ analyses customarily focus on a company’s profitability and growth potential.
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Credit Analysis
Financial statement analysis is an objective way for lenders to assess the creditworthiness of a potential borrower. Lenders make money by extending credit, but they also want to minimize the risk of a borrower defaulting. Lenders use financial statement analysis to evaluate short-term liquidity and long-term solvency.
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Business Valuation
Mergers, acquisitions and partnerships are common in all industries and during different stages of a company’s life cycle. These transactions rely on business valuations, supported by financial statement analysis, to help set acquisition prices and to prepare pro forma financial statements for the newly combined companies.
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Corporate Finance and Strategy
Financial statement analysis is an integral part of corporate finance and strategic planning. It is used at the front end to identify opportunities and financial risks and on the back end to monitor progress against goals. Internal stakeholders at all levels in an organization rely on various aspects of financial statement analysis to provide insights to help them shape the future. Sales managers might focus on horizontal revenue trend analysis, while factory managers might focus on efficiency ratios. The financial and executive teams keep close tabs on profitability, liquidity, leverage and asset utilization.
Easily Manage and Analyze Financial Statements in NetSuite
The right technology can make financial statement analysis faster and easier, leaving more time for interpretation and action. NetSuite’s cloud-based financial management software automates the collection of accounting data and the preparation of financial statements. And, because the reporting is integrated with the accounting software, the statements are always current. Furthermore, since NetSuite financial management is part of the full NetSuite enterprise resource planning (ERP) system, data from operational and transactional modules integrates seamlessly with financial data, enriching financial statement analyses. In addition, a multidimensional analysis feature provides easy access to an even more granular level of information, which is useful when investigating the underlying reasons for observed changes or variances. Automated reports can be customized to display the ratios and other analyses that are most important to your business so you can stay on top of trends in real time.
Financial statement analysis provides next-level information that can help business managers run their operations better. It can also aid investors in evaluating their options and help lenders determine a business’s creditworthiness. Applying vertical, horizontal and ratio analyses to a business’s income statement, balance sheet, cash flow statement and other key financial statements uncovers information about profitability, efficiency, liquidity, valuation and debt. It also facilitates comparisons across fiscal periods and among peer companies. Financial statement analysis is a fundamental part of good fiscal hygiene that supports decision-making by identifying trends and highlighting a firm’s strengths and weaknesses. Regular execution of financial statement analysis is made easier with the right financial technology and skilled analysts.
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Financial Statement Analysis FAQs
Why is it important to analyze financial statements?
Financial statement analysis examines key items from the financial statements to gain insight into a company’s performance. It evaluates profitability, efficiency, liquidity, valuation and leverage, and then compares the results over time, with benchmarks or against competitors. This process is critical for assessing, quantifying and tracking a business’s financial well-being.
When analyzing financial statements, which part is most important?
Data quality is the most important part of financial statement analysis. It is crucial to use statements that are accurate and recent. When analyzing financial statements from multiple periods or different companies, it is also important to check for consistency in accounting methods and policies, as well as currency fluctuations.
What are the advantages and disadvantages of financial statement analysis?
Financial statement analysis is a widely used tool for evaluating a company’s performance and financial health. It has several advantages, such as its ability to measure progress toward goals, reveal opportunities to improve operating efficiency and competitive advantage, and uncover areas for potential growth. It enhances internal and external stakeholders’ decision-making with its unbiased quantitative measures. However, a key disadvantage is its reliance on historical data that may not be available, may use inconsistent accounting policies or may not be comparable across companies.
What are the 4 or 5 types, or methods, of financial statement analysis?
Five methods commonly used in financial statement analysis include horizontal, vertical, ratio, trend and cost-volume profit analyses. Vertical analysis examines the relationships between different items on the same financial statement for the same period. Horizontal financial analysis looks at a piece of financial information over various fiscal periods. Ratio analysis uses mathematical calculations that show the relationship between multiple data points. Trend analysis extrapolates past performance to project future activity. Cost-volume profit analysis looks at how changes in sales volume impact profitability.
How to do financial analysis?
The steps involved in doing financial analysis are fairly straightforward. The 10 steps in financial statement analysis are:
- Gather the appropriate financial statements.
- Perform an initial review.
- Conduct ratio analyses.
- Analyze trends and perform comparative analyses.
- Evaluate cash flows.
- Assess the quality of the company’s earnings.
- Understand management’s discussion and analysis (MD&A).
- Consider nonfinancial factors.
- Prepare future financial statement forecasts.
- Use business valuation techniques to estimate the company’s value.