Financial statement analysis

Financial statement analysis (or financial analysis) is the process of reviewing and analyzing
a company's financial statements to make better economic decisions. These statements include
the income statement, balance sheet, statement of cash flows, and a statement of changes in
equity. Financial statement analysis is a method or process involving specific techniques for
evaluating risks, performance, financial health, and future prospects of an organization.[1]
It is used by a variety of stakeholders, such as credit and equity investors, the government, the
public, and decision-makers within the organization. These stakeholders have different interests
and apply a variety of different techniques to meet their needs. For example, equity investors
are interested in the long-term earnings power of the organization and perhaps the sustainability
and growth of dividend payments. Creditors want to ensure the interest and principal is paid on
the organizations debt securities (e.g., bonds) when due.
Common methods of financial statement analysis include fundamental analysis, DuPont
analysis, horizontal and vertical analysis and the use of financial ratios. Historical information
combined with a series of assumptions and adjustments to the financial information may be
used to project future performance. The Chartered Financial Analyst designation is available for
professional financial analysts.

History
Benjamin Graham and David Dodd first published their influential book "Security Analysis" in
1934.[2] [3] A central premise of their book is that the market's pricing mechanism for financial
securities such as stocks and bonds is based upon faulty and irrational analytical processes
performed by many market participants. This results in the market price of a security only
occasionally coinciding with the intrinsic value around which the price tends to
fluctuate.[4] Investor Warren Buffett is a well-known supporter of Graham and Dodd's philosophy.
The Graham and Dodd approach is referred to as Fundamental analysis and includes: 1)
Economic analysis; 2) Industry analysis; and 3) Company analysis. The latter is the primary
realm of financial statement analysis. On the basis of these three analyses the intrinsic value of
the security is determined.[4]

Horizontal and vertical analysis

Horizontal analysis compares financial information over time, typically from past quarters or
years. Horizontal analysis is performed by comparing financial data from a past statement, such
as the income statement. When comparing this past information one will want to look for
variations such as higher or lower earnings.[5]
Vertical analysis is a percentage analysis of financial statements. Each line item listed in the
financial statement is listed as the percentage of another line item. For example, on an income
statement each line item will be listed as a percentage of gross sales. This technique is also
referred to as normalization[6] or common-sizing.[5]

Financial ratio analysis

Main article: Financial ratio

Financial ratios are very powerful tools to perform some quick analysis of financial statements.
There are four main categories of ratios: liquidity ratios, profitability ratios, activity ratios and
leverage ratios. These are typically analyzed over time and across competitors in an industry.
 Liquidity ratios are used to determine how quickly a company can turn its assets into cash if
it experiences financial difficulties or bankruptcy. It essentially is a measure of a company's
ability to remain in business. A few common liquidity ratios are the current ratio and the
liquidity index. The current ratio is current assets/current liabilities and measures how much
liquidity is available to pay for liabilities. The liquidity index shows how quickly a company
can turn assets into cash and is calculated by: (Trade receivables x Days to liquidate) +
(Inventory x Days to liquidate)/Trade Receivables + Inventory.
Profitability ratios are ratios that demonstrate how profitable a company is. A few popular
profitability ratios are the breakeven point and gross profit ratio. The breakeven point
calculates how much cash a company must generate to break even with their start up costs.
The gross profit ratio is equal to (revenue - the cost of goods sold)/revenue. This ratio
shows a quick snapshot of expected revenue.
Activity ratios are meant to show how well management is managing the company's
resources. Two common activity ratios are accounts payable turnover and accounts
receivable turnover. These ratios demonstrate how long it takes for a company to pay off its
accounts payable and how long it takes for a company to receive payments, respectively.
Leverage ratios depict how much a company relies upon its debt to fund operations. A very
common leverage ratio used for financial statement analysis is the debt-to-equity ratio. This
ratio shows the extent to which management is willing to use debt in order to fund
operations. This ratio is calculated as: (Long-term debt + Short-term debt + Leases)/
Equity.[7]
DuPont analysis uses several financial ratios that multiplied together equal return on equity, a
measure of how much income the firm earns divided by the amount of funds invested (equity).
A Dividend discount model (DDM) may also be used to value a company's stock price based on
the theory that its stock is worth the sum of all of its future dividend payments, discounted back
to their present value.[8] In other words, it is used to value stocks based on the net present
value of the future dividends.
Financial statement analyses are typically performed in spreadsheet software and summarized
in a variety of formats.

Recasting financial statements

Investors typically are attempting to understand how much cash the company will generate in
the future and its rate of profit growth, relative to the amount of capital deployed. Analysts may
modify ("recast") the financial statements by adjusting the underlying assumptions to aid in this
computation. For example, operating leases (treated like a rental transaction) may be recast as
capital leases (indicating ownership), adding assets and liabilities to the balance sheet. This
affects the financial statement ratios.[1]
Recasting financial statements requires a solid understanding of accounting theory. Once the
cash flow in future years is projected, a discount rate or interest rate will be applied to measure
the value of the company and its stock or debt.[1]}

Certifications
Financial analysts typically have finance and accounting education at the undergraduate or
graduate level. Persons may earn the Chartered Financial Analyst (CFA) designation through a
series of challenging examinations.
 Financial statement analysis
Overview of Financial Statement Analysis

Financial statement analysis involves gaining an understanding of an organization's financial

situation by reviewing its financial statements. This review involves identifying the following items
for a company's financial statements over a series of reporting periods:

Trends. Create trend lines for key items in the financial statements over multiple time periods, to
see how the company is performing. Typical trend lines are for revenues, the gross margin, net
profits, cash, accounts receivable, and debt.
Proportion analysis.An array of ratios are available for discerning the relationship between the size
of various accounts in the financial statements. For example, one can calculate a company's quick
ratio to estimate its ability to pay its immediate liabilities, or its debt to equity ratio to see if it has
taken on too much debt. These analyses are frequently between the revenues and expenses listed on
the income statement and the assets, liabilities, and equity accounts listed on the balance sheet.

Financial statement analysis is an exceptionally powerful tool for a variety of users of financial
statements, each having different objectives in learning about the financial circumstances of the
entity.

Users of Financial Statement Analysis

There are a number of users of financial statement analysis. They are:

Creditors.Anyone who has lent funds to a company is interested in its ability to pay back the debt,
and so will focus on various cash flowmeasures.
Investors. Both current and prospective investors examine financial statements to learn about a
company's ability to continue issuing dividends, or to generate cash flow, or to continue growing at
its historical rate (depending upon their investment philosophies).
Management. The company controller prepares an ongoing analysis of the company's financial
results, particularly in relation to a number of operational metrics that are not seen by outside
entities (such as the cost per delivery, cost per distribution channel, profit by product, and so forth).
Regulatory authorities. If a company is publicly held, its financial statements are examined by
the Securities and Exchange Commission (if the company files in the United States) to see if its
statements conform to the various accounting standards and the rules of the SEC.
 Methods of Financial Statement Analysis
There are two key methods for analyzing financial statements. The first method is the use of
horizontal and vertical analysis. Horizontal analysisis the comparison of financial
information over a series of reporting periods, while vertical analysis is the proportional
analysis of a financial statement, where each line item on a financial statement is listed as a
percentage of another item. Typically, this means that every line item on an in come
statement is stated as a percentage of gross sales, while every line item on a balance sheet is
stated as a percentage of total assets. Thus, horizontal analysis is the revi ew of the results of
multiple time periods, while vertical analysis is the review of the proportion of accounts to
each other within a single period.
The second method for analyzing financial statements is the use of many kinds of ratios.
Ratios are used to calculate the relative size of one number in relation to another. After a
ratio is calculated, you can then compare it to the same ratio calculated for a prior period, or
that is based on an industry average, to see if the company is performing in accordance with
expectations. In a typical financial statement analysis, most ratios will be within
expectations, while a small number will flag potential problems that will attract the att ention
of the reviewer.
There are several general categories of ratios, each designed to examine a different aspect of
a company's performance. The general groups of ratios are:

Liquidity ratios. This is the most fundamentally important set of ratios, because they
measure the ability of a company to remain in business. Click the following links for a
thorough review of each ratio.
o Cash coverage ratio.Shows the amount of cash available to pay interest.
o Current ratio.Measures the amount of liquidity available to pay for current liabilities.
o Quick ratio. The same as the current ratio, but does not include inventory.
o Liquidity index. Measures the amount of time required to convert assets into cash.
Activity ratios. These ratios are a strong indicator of the quality of management, since they
reveal how well management is utilizing company resources. Click the following links for a
thorough review of each ratio.
o Accounts payable turnover ratio. Measures the speed with which a company pays its
suppliers.
 o Accounts receivable turnover ratio.Measures a company's ability to collect accounts
receivable.
o Fixed asset turnover ratio.Measures a company's ability to generate sales from a
certain base of fixed assets.
o Inventory turnover ratio. Measures the amount of inventory needed to support a
given level of sales.
o Sales to working capital ratio. Shows the amount of working capital required to
support a given amount of sales.
o Working capital turnover ratio.Measures a company's ability to generate sales from a
certain base of working capital.
Leverage ratios. These ratios reveal the extent to which a company is relying upon debt to
fund its operations, and its ability to pay back the debt. Click the following links for a
thorough review of each ratio.
o Debt to equity ratio. Shows the extent to which management is willing to fund
operations with debt, rather than equity.
o Debt service coverage ratio. Reveals the ability of a company to pay its debt
obligations.
o Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.
Profitability ratios. These ratios measure how well a company performs in generating a
profit. Click the following links for a thorough review of each ratio.
o Breakeven point. Reveals the sales level at which a company breaks even.
o Contribution margin ratio. Shows the profits left after variable costs are subtracted
from sales.
o Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of
sales.
o Margin of safety. Calculates the amount by which sales must drop before a company
reaches its break even point.
o Net profit ratio. Calculates the amount of profit after taxes and all expenses have
been deducted from net sales.
o Return on equity. Shows company profit as a percentage of equity.
o Return on net assets. Shows company profits as a percentage of fixed assets and
working capital.
o Return on operating assets. Shows company profit as percentage of assets utilized.
 Problems with Financial Statement Analysis

While financial statement analysis is an excellent tool, there are several issues to be aware of that
can interfere with your interpretation of the analysis results. These issues are:

Comparability between periods. The company preparing the financial statements may have changed
the accounts in which it stores financial information, so that results may differ from period to
period. For example, an expense may appear in the cost of goods sold in one period, and in
administrative expenses in another period.
Comparability between companies. An analyst frequently compares the financial ratios of different
companies in order to see how they match up against each other. However, each company may
aggregate financial information differently, so that the results of their ratios are not really
comparable. This can lead an analyst to draw incorrect conclusions about the results of a company
in comparison to its competitors.
Operational information. Financial analysis only reviews a company's financial information, not its
operational information, so you cannot see a variety of key indicators of future performance, such as
the size of the order backlog, or changes in warranty claims. Thus, financial analysis only presents
part of the total picture.

Similar Terms
Horizontal analysis is also known as trend analysis.

6 Steps to an Effective Financial Statement Analysis

By Prof. Dubos J. Masson, Ph.D., CTP, FP&A

Published: 2/19/2016

For any financial professional, it is important to know how to effectively analyze the financial
statements of a firm. This requires an understanding of three key areas:

1. The structure of the financial statements

2. The economic characteristics of the industry in which the firm operates and
3. The strategies the firm pursues to differentiate itself from its competitors.
There are generally six steps to developing an effective analysis of financial statements.

1. Identify the industry economic characteristics.

First, determine a value chain analysis for the industrythe chain of activities involved in the
creation, manufacture and distribution of the firms products and/or services. Techniques such
as Porters Five Forces or analysis of economic attributes are typically used in this step.

2. Identify company strategies.

Next, look at the nature of the product/service being offered by the firm, including the
uniqueness of product, level of profit margins, creation of brand loyalty and control of costs.
Additionally, factors such as supply chain integration, geographic diversification and industry
diversification should be considered.

3. Assess the quality of the firms financial statements.

Review the key financial statements within the context of the relevant accounting standards. In
examining balance sheet accounts, issues such as recognition, valuation and classification are
keys to proper evaluation. The main question should be whether this balance sheet is a
complete representation of the firms economic position. When evaluating the income
statement, the main point is to properly assess the quality of earnings as a complete
representation of the firms economic performance. Evaluation of the statement of cash flows
helps in understanding the impact of the firms liquidity position from its operations, investments
and financial activities over the periodin essence, where funds came from, where they went,
and how the overall liquidity of the firm was affected.

4. Analyze current profitability and risk.

This is the step where financial professionals can really add value in the evaluation of the firm
and its financial statements. The most common analysis tools are key financial statement ratios
relating to liquidity, asset management, profitability, debt management/coverage and risk/market
valuation. With respect to profitability, there are two broad questions to be asked: how profitable
are the operations of the firm relative to its assetsindependent of how the firm finances those
assetsand how profitable is the firm from the perspective of the equity shareholders. It is also
important to learn how to disaggregate return measures into primary impact factors. Lastly, it is
critical to analyze any financial statement ratios in a comparative manner, looking at the current
ratios in relation to those from earlier periods or relative to other firms or industry averages.

5. Prepare forecasted financial statements.

Although often challenging, financial professionals must make reasonable assumptions about
the future of the firm (and its industry) and determine how these assumptions will impact both
the cash flows and the funding. This often takes the form of pro-forma financial statements,
based on techniques such as the percent of sales approach.

6. Value the firm.

While there are many valuation approaches, the most common is a type of discounted cash flow
methodology. These cash flows could be in the form of projected dividends, or more detailed
techniques such as free cash flows to either the equity holders or on enterprise basis. Other
approaches may include using relative valuation or accounting-based measures such as
economic value added.

The next steps

Once the analysis of the firm and its financial statements are completed, there are further
questions that must be answered. One of the most critical is: Can we really trust the numbers
that are being provided? There are many reported instances of accounting irregularities.
Whether it is called aggressive accounting, earnings management, or outright fraudulent
financial reporting, it is important for the financial professional to understand how these types of
manipulations are perpetrated and more importantly, how to detect them.