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Financial Statement Analysis

The financial statement analysis process provides a systematic approach for extracting and evaluating the accounting information needed for a specific business purpose. Although every analysis is different, the process used is likely to be similar.

The financial statement analysis process includes establishing the goal or goals that the analysis is supposed to achieve which helps draw the analyst’s attention to the most relevant information. Typical general goals include screening, diagnosis, forecasting, and reconstruction. A full review of the financial statements and the notes produces a rounded view of the company and may call attention to specific areas that should be analyzed in detail. The selection of techniques to generate the information required depends on the goal of the analysis .As well as ratios, common techniques include common-size statements, vertical analysis, and horizontal analysis. The application of appropriate techniques is often a mechanical process, although care should be taken that differences in ratio calculation, accounting policies, asset valuation, and so on are understood so that a valid comparison between companies can be made. Finally, interpretation of the results requires putting the results in context- for example, by comparing results with industry benchmarks.

One technique used for analyzing financial statements is vertical analysis. It can be difficult to see even basic financial relationships when looking at the numerical values in a company’s financial statements. Therefore, it is helpful to construct common-size statements and perform a vertical analysis in order to look for any unusual percentages in the common-size statements that identify items that have an excessively large or small value when considered relative to other values reported in the same accounting period. Both single period and multiple period vertical analyses can be used.

Another technique used for analyzing financial statements is horizontal analysis. It involves making comparisons across two or more years of financial statements data. Although horizontal analysis techniques can be applied to the balance sheet to quantify the changes in current or total assets over time, this type of analysis is usually focused on quantifying the changes in a company’s profitability over time.

Both vertical and horizontal analyses are excellent tools for comparing items that appear on financial statements such as the income statement or the balance sheet, whether for one year or over several years. However, for a more in-depth analysis of the relationships between these items, an analyst needs to examine certain commonly used financial ratios.

Ratios examine relationships rather than amounts. Therefore, a company of one size can be directly compared with a second company, or companies, that are of a different size or that operate in a different business. If analysts compare published ratios rather than self-calculated ratios, it is important for them to be aware of how published ratios have been calculated because not all analysts calculate ratios in exactly the same way. In addition, analysts should look into not only ratios that are below expectations, but also ratios that are significantly better than expected. Exceptional ratios may be a result of decisions that sacrifice long-term profitability and growth for short-term profitability. Ratios are grouped into the following broad categories for analyzing financial statements: profitability, efficiency, liquidity and leverage.

A company’s ability to operate profitably is crucial to its survival as a going concern. Commonly used GAAP-based profitability ratios are net profit margin, return on assets, return on equity, and the DuPont identity.

Efficiency ratios concentrate on how well the company manages and uses its assets. The DuPont identity shows that one efficiency ratio-asset turnover- is a component of both ROA and ROE. Two additional turnover ratios, the accounts receivable ratio and the inventory turnover ratio, are typically used in the GAAP-based efficiency analysis.

Liquidity refers to a company’s ability to convert assets into cash in order to satisfy its obligations. The ability to meet current obligations on time is important to all companies. It can be measured using working capital, the current ratio and the acid test ratio.

One of the most commonly used measures of financial leverage in financial statement analyses is the debt-to-equity ratio. Another view of how a company has financed its assets is provided by the company’s debt-to-assets ratio.

The financial statements provide the information necessary for the company to manage its working capital.

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