What is financial statement analysis?

Analysing a company’s financial statements is key to the decision-making process and the company’s performance in the future. Financial statement analysis also provides crucial information for shareholders and investors. The analysis helps break down the figures to create a full picture of a company’s financial health in one document. Financial statements tend to appear in annual reports, but they can be drawn up at any time by a financial analyst to show the financial health of a company.

IFRS (International Financial Reporting Standards) is the common global financial reporting language. The IFRS Foundation is a not-for-profit that develops this single set of globally understood and accepted accounting standards. In the UK, accounting standards are published by the Financial Reporting Council. UK GAAP (Generally Accepted Accounting Practice) is the formal title of the body of accounting standards and other guidance which apply in the United Kingdom. 

How to analyse a financial statement

There are two main financial statements that are assessed and used for valuation methods: the income statement and the statement of financial position (also known as the balance sheet). From these, net and gross profit margins can be attained which allow stakeholders to understand financial performance for any particular period of time. The statement of shareholders’ equity is a document issued as part of the statement of financial position and is of particular interest to shareholders as it highlights the business activities that contribute to whether the value of their equity goes up or down.

The income statement is key amongst the financial reports because it shows financial performance based on income usually over a 12-month period. This includes revenue, cost of sales (and any other expenses), plus gross and net profit. A statement of cash flow is slightly different but no less useful as it shows the amount of cash and cash equivalents entering and leaving the company. It can show a much truer reflection of financial health as it is not as easily manipulated by the timing of non-cash transactions.

The statement of financial position collates vital information about where money is coming in from and how it is being spent, creating a balance sheet. The main elements that make up a balance sheet are assets, liabilities, working capital (net current assets), and capital employed.

Generally speaking, assets are things that the company owns, while liabilities are things that the company owes.

Assets fall into two categories:

• Current assets: These are short-term and so will be owned or last for less than a year e.g. stock, raw materials, cash.

• Fixed assets: These are (non-current) assets which are long-term, meaning they will be owned or last for longer than a year such as vehicles, computer equipment, and buildings. These assets are subject to depreciation.

Likewise, liabilities are grouped into two categories:

• Current liabilities: These are short-term debts that a company would need to pay back within a year e.g. an overdraft, trade credit, short-term business loan.

• Long-term liabilities: These are also known as non-current liabilities and consist of borrowed money to be paid back over more than a year, such as mortgages or a long-term bank loan.

Other line items that appear on a balance sheet include:

• Net current assets: These are the same as working capital. The figure is calculated by subtracting current liabilities from current assets. It represents the money available for the running and operation of a business, such as paying salaries and buying stock.

• Net assets: This figure represents what the business is worth. It’s calculated by adding fixed assets and net current assets (working capital) together. It can also be found through the difference between total assets and total liabilities.

• Capital employed: Found by adding any equity and reserves, such as shareholder funds, to the long-term liabilities, this figure should always match the net assets figure, to make the sheet balance.

Both horizontal analysis and vertical analysis give insights into financial statements. Horizontal analysis compares account balances and ratios over different time periods. You could compare a company’s sales in 2019 to its sales in 2020 for example, to show the effect of the pandemic. Vertical analysis on the other hand, would restate each amount in the income statement as a percentage of sales. This analysis would give a heads up if the cost of goods sold or any other expense appeared to be too high when compared to sales, for instance.

The importance of ratio analysis

Ratios that can be derived from financial statements provide the basis for financial analysis. Ratios help put all the available financial information into context so that it’s easily digestible for potential investors, shareholders, and stakeholders alike. There are five basic financial ratio groups that offer different metrics:

• Profitability ratios: These measure a company’s use of assets and its control of expenses to generate a good rate of return.

• Liquidity ratios: These measure how much cash is available to pay off debt such as the current ratio which is found by dividing total current assets by total current liabilities.

• Activity ratios: Also referred to as efficiency ratios, these measure the effectiveness of a company’s use of assets. 

• Debt ratios: Also known as leverage ratios, these measure a company’s ability to pay long-term debt.

• Market ratios: These are primarily for shareholders as they measure the cost of issuing stock. They also demonstrate the relationship between return and the value of an investment in the company’s shares.

There are numerous ratios that can be used to measure almost any metric that an analyst chooses to look at. Some are more commonly used than others depending on the information that can be gleaned. Below are just a handful of ratios which offer a snapshot of how robust a company’s finances are.

The accounts receivable turnover ratio is derived by dividing your net credit sales by your average accounts receivable. The ratio is used to measure how effective a company is at extending credits and collecting debts. A higher number means that your customers pay on time and your company does well at collecting debts. The accounts receivable turnover ratio is an efficiency ratio as is the asset turnover ratio, inventory ratio, fixed assets turnover ratio, working capital turnover ratio, and accounts payable turnover ratio.

The quick ratio indicates a company’s short-term liquidity and measures the company’s ability to meet its short-term obligations with its most liquid assets. Despite being called “quick” it takes into account multiple factors like current assets, inventory, prepaid expenses, and current liabilities. The higher the ratio, the better a company’s liquidity and financial health; the lower the ratio, the more likely the company will struggle with paying debts. At the other end of the spectrum, solvency measures the company’s ability to meet its long-term debts, which is an indicator of its ability for long-term growth and expansion. The debt-to-equity ratio can be used when considering solvency. This is not the same as a coverage ratio which is usually employed to identify if a company is potentially in a troubling financial situation or to compare competitors in the field.

Return on equity (ROE) is a ratio calculated by dividing a company’s net income by its shareholders’ equity. The resulting figure provides a measure of how efficient a company is in generating profits, which is a valuable piece of financial data for potential investors.

Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. It represents the reserve money that’s available to company management for reinvesting back into the business. When expressed as a percentage of total earnings, it is also called the retention ratio. 

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If you’re looking to expand your knowledge in all aspects of financing activities including preparing financial statements and running the financial affairs of a small business, the MBA Finance is a gateway to refreshing or launching your career.