In this article, we will be discussing analysis of financial statements in detail.
The analysis of financial statements involves gaining an understanding of the financial situation of an organization by reviewing the organization’s financial statements. You can use three key financial statements – Income statement, Balance sheet and statement of cash flows.
Analysis of these financial statements is often reported to the board of directors and senior management. They use this information as input in their decision-making process. External parties such as regulatory bodies and investors also use this analysis for gaining insight into the organization.
There are various users of the financial statement analysis. They include:
Note: It’s important to keep in mind that if you are using financial statements from more than one reporting period, each of the financial statements should be in a similar format so that you have all the relevant data in a comparable format to understand one period to other.
Each of the methods provided below gives visibility of variances, business trends, and also flags various issues. They raise questions about the company, which is required to be answered. Investigating the business, finding logical explanations for the variances and performing changes based on the positive or negative trends are the ultimate goals of the financial statement analysis.
There are various methods and techniques to perform Financial Statement Analysis. However, the most common methods of financial statement analysis include:
Horizontal Analysis: A horizontal analysis is a two-year comparison of analysis of the financial statements and its elements. It is also referred to as trend analysis, usually expressed in monetary terms and percentages.
This comparison provides analysts with insight into the aspects that could contribute significantly to the financial position or profitability of the organization.
For instance, in 2015, a company earned INR 4 lakhs more than its previous year. This increase in turnover appears to be a positive development.
However, examine closely, it reveals that the costs of the procuring goods and services increased by INR 4.5 lakhs. The wonderful picture of this additional turnover of INR 4 lakhs is now adjusted to the less positive picture.
Vertical Analysis: Vertical analysis is a financial statement analysis technique in which every line items of the financial statements are listed as percentages, based on a figure within the financial statement. The line items on the income statement could be stated as percentages of the gross sales, while the line items on the balance sheet could be stated as percentages of the total assets or liabilities.
And in case of cash flow, every inflow or outflow of cash could be stated as a percentage of total cash inflows. By doing this analysis, insight would be created about the changes in the allocation and distribution of the total assets.
This method of analysis of financial statement is also used for comparing one company to another in the form of benchmarking. Example, by representing the different items as a percentage of the total turnover, it’s easy to get insight into every division’s costs, expenditures and profit.
Ratio Analysis: A ratio between two quantities is used for representing the relationships between different figures on the profit and loss account, balance sheet, cash flow statement or such other accounting records. It is a form of Financial Statement Analysis, used for obtaining a quick indication of the organization’s financial performance in various key areas. Ratio Analysis as a financial analysis tool possesses many important features.
The data provided by the financial statements are available readily. The ratios enable the comparison of firms that differ in size as well as compare an organization’s financial performance with the industry averages.
Additionally, ratios could be used in the form of trend analysis for identifying the areas within an organization where performance has deteriorated or improved over time. Some of the key ratios include: