Defining financial analysis
Financial analysis is used to assess economic trends, establish financial guidelines, create long-term corporate activity plans, and pinpoint potential investment opportunities. This is accomplished by combining financial data with numbers. A financial analyst will carefully go over the income statement, balance sheet, and cash flow statement of a corporation. Both corporate finance and investment finance environments are suitable for conducting financial analysis.
Calculating ratios from the data in the financial statements to compare against those of other companies or against the company's own historical performance is one of the most popular methods for analyzing financial data.
The categories of financial analysis
Principal Analysis
To ascertain a company's value, fundamental analysis analyzes ratios derived from the information found in the financial statements, such as its profits per share (EPS). The analyst can determine the intrinsic value of the security by using ratio analysis along with a comprehensive investigation of the economic and financial circumstances around the company. The ultimate objective is to come up with a figure that an investor can use to determine whether an asset is undervalued or overvalued by contrasting it with its present price.
Technical Assessment
Moving averages and other statistical trends gleaned from trade activity are used in technical analysis (MA). Technical analysis focuses on the statistical examination of price movements since it essentially believes that the price of security already represents all information that is generally available. Instead of examining a security's intrinsic characteristics, technical analysis looks for patterns and trends in order to understand the market sentiment underlying price trends.
How do you do a financial analysis?
Both corporate finance and investment finance environments are suitable for conducting financial analysis. A financial analyst will carefully go over the income statement, balance sheet, and cash flow statement of a corporation. Calculating ratios from the data in the financial statements to compare against those of other companies or against the company's own historical performance is one of the most popular methods for analyzing financial data. Extrapolating a company's historical performance, such as net earnings or profit margin, into a projection of the company's future performance is a crucial component of corporate finance research.
Defining financial statement analysis
The process of examining a company's financial statements in order to make decisions is known as financial statement analysis. It is used by external stakeholders to assess an organization's general health as well as its financial performance and market value. It serves as a monitoring tool for handling finances for internal stakeholders.
How do you analyze financial statements?
Important financial information on every facet of a business's operations is documented in the financial statements of a corporation. They can therefore be assessed based on their past, present, and anticipated performance.
In the United States, generally accepted accounting standards (GAAP) serve as the foundation for financial statements. The balance sheet, the income statement, and the cash flow statement are the three primary financial statements that must be produced and maintained by a business in accordance with these principles. Standards for financial statement reporting are more stringent for publicly traded corporations. Accrual accounting is required by GAAP, which must be followed by public corporations. Private company has more freedom in how they prepare their financial statements and can choose between accrual and cash accounting.
Several methods are frequently applied in financial statement analysis. The three most crucial methods are ratio analysis, vertical analysis, and horizontal analysis. By comparing the values of line items over two or more years, a horizontal analysis compares data in a horizontal direction. The vertical analysis examines the proportions of the business as well as the vertical effects that line items have on other business areas. Ratio analysis creates statistical associations by using significant ratio measures.
The categories of financial statements
Businesses utilize the balance sheet, income statement, and cash flow statement to oversee daily operations and to be transparent with their stakeholders. Each of the three assertions is connected to the others and offers a unique perspective on the operations and performance of a business.
Balance Sheet
A company's financial worth in terms of book value is reported on the balance sheet. A company's assets, liabilities, and shareholders' equity are divided into three categories. Short-term assets like cash and accounts receivable can reveal a lot about a business' operational efficiency. Liabilities include the company's expense plans and the debt it is paying off. Shareholder's equity contains information on equity capital investments and retained earnings from periodic net income. Assets and liabilities must match up on the balance sheet to equal shareholder equity. This amount is regarded as a company's book value and acts as a significant performance gauge that changes with a company's financial activity.
Income Statement
The bottom line, or net profit or loss, is determined by comparing a company's revenue with its business expenses to produce an income statement. In order to analyze business efficiency at three separate points, the income statement is divided into three sections. To calculate gross profit, start with revenue and the direct expenses related to that revenue. The next step is operational profit, which deducts indirect expenditures like marketing, general, and depreciation. The net income is attained in the end after interest and taxes have been subtracted.
Calculating the operating profit margin, net profit margin, and gross profit margin—each of which divides profit by revenue—is a standard step in performing a basic examination of the income statement. The company's profit margin can be used to identify areas of operation where costs are moderate or excessive.
Cash Flow Statement
A summary of the company's cash flows from operating, investing, and financing activities is given in the cash flow statement. The top line item for operating activities on the cash flow statement is net income, which is carried over from the income statement. The cash flows related to firmwide investments are included in investing activities, as suggested by the name. Cash flow from debt and equity financing is included in the section on financing operations. How much cash a corporation has on hand is revealed in the bottom line.
Free Cash Flow and Other Valuation Statements
Companies and analysts examine a company's value using free cash flow figures in addition to other valuation statements. By discounting the expected future free cash flow of a company, free cash flow statements arrive at a net present value. In order to prepare for a prospective IPO, private enterprises may keep a value statement.
How to financially analyze a Balance Sheet:
A company's balance sheet is a crucial financial statement that provides significant information about its financial situation at a particular period.
A balance sheet analysis offers information on a company's financial situation at a particular period, including the worth of its assets and the amount of debt it owes. Analysts, investors, and decision-makers can use this data to estimate how profitable an investment in that company would be.
Checklist for the Balance Sheet
There are several significant factors to focus on while analyzing the assets, liabilities, and shareholders' equity sections of a balance sheet.
Assets
All of a company's economic resources are included in the assets section. Although the entire section is significant, the following specific points require additional attention:
Cash
A company's ability to make sales, receive payments, and control its purchases and debt commitments can be well-represented by its cash flow. How much cash a company has on hand might also indicate how well-equipped it is to weather a sudden downturn or pay off short-term obligations.
It's crucial to remember, though, that some companies choose to reinvest their earnings in order to boost their future earnings potential rather than relying heavily on cash to run their operations.
Accounts Receivable
Accounts receivable provide insight into a company’s capacity to collect the money it is owed. The company is probably doing a good job of collecting its money if sales remain constant or increase while accounts receivable decline annually (relative to prior years). On the other side, if accounts receivable rise annually, the business could not be effectively collecting its payments.
Inventory
A balance sheet's inventory column lists the raw materials, ongoing projects, and finished inventories for a business. Measurements of cost of goods sold (COGS), inventory turnover rate, days with unsold inventory, and other measures that assess operational effectiveness and profitability all require the utilization of this data. This part, however, only emphasizes the worth of a company's inventory without taking into account factors like obsolescence, spoiling, and shrinkage.
Liabilities
All of a company's debts to third parties are listed in the section on liabilities. Investors favor businesses with fewer liabilities than assets, but there are a few other critical factors to watch out for:
Accounts Payable
The amount of money a business owes to its suppliers or vendors is compiled in the accounts payable section. It consists of immediate financial obligations for goods or services supplied, including inventories, utility bills, and other invoices.
Because it enables them to comprehend how a firm balances credit and cash purchases, how long it takes to pay its bills, and how much money is set aside for its short-term debt obligations, accounts payable are crucial to analysts and investors.
Short-term Debt
The total amount of debt that a business must pay off within the next 12 months is listed in the short-term debt/current liabilities account. Accounts payable, unpaid wages, taxes, short-term loans, lease payments, and other obligations are included.
These debts, which are frequently referred to as operating debts, are accumulated in connection with a company's main business operations. Analysts, creditors, and investors should carefully analyze this section because it is used to assess a company's liquidity and capacity to pay short-term financial obligations.
Contingent Debt
The company's outstanding debts that are due in the next 12 months or more are listed in the long-term debt section. Loans, mortgages, bonds, lease commitments, and other things are included.
Long-term Debt
Long-term debts, often known as financing debt, are frequently accumulated through activities associated with capital raising. For analysts and investors, the long-term debt portion is crucial since it clarifies a company's capital structure, leverage, and long-term financial commitments.
Shareholders’ Equity
After all, debts have been settled, the total worth of the company that is available to shareholders is shown in the shareholders' Equity section. The assets less the liabilities of the company equal the value of shareholders' equity.
This part is crucial for analysts and investors since equity owners receive payouts after debt holders in the case of a liquidation.
Retained Earnings
The amount of accumulated money that is left over after paying dividends to shareholders is highlighted in the retained earnings section. The business keeps this cash and either invest it, holds it as cash, or uses it to pay off debt.
The resulting value, which reflects how the business handled its profits, may be good or negative. Because it sheds light on the company's financial stability, how it will handle future growth, and how it will manage its cash flow, it is crucial for analysts, investors, and lenders.
Paid-in Capital
The amount of money a firm makes from selling stock directly to investors is summed up in the paid-in capital portion. It includes money obtained from the direct selling of preferred or ordinary stock. Exchanges between investors on the secondary market are excluded.
Additional paid-in capital is included in this section as well (which is the number of money investors paid for stock beyond its par value). For analysts and investors, a high level of paid-in capital is a good signal since it shows a considerable amount of interest or confidence in the company.
How to financially analyze an Income Statement:
The sales, costs, profits, and losses incurred by a corporation over a specific time are detailed in the income statement. Investors and analysts will find this information very helpful since it allows them to monitor a company's performance, profitability, efficiency, and other factors.
A couple of sections, in particular, deserve further attention:
Net Income
One of the most significant lines on the income statement is net income, often known as net earnings. This displays the amount of profit or loss the business made within the given time frame. For analysts and investors, it is one of the indications of a company's profitability that is most frequently used. Earnings per share, net profit margin, and retained earnings are a few other computations that may be made using net income.
One of the most crucial pieces of information on an income statement is net income, also known as "the bottom line," which shows how much a business makes after deducting expenses. It is, in other words, the profit or loss realized over a certain time frame.
The last line of the income statement will always show net income, however, you can also calculate net income by using the formula below:
Operating Expenses
All expenditures associated with routine business operations, including rent, wages, inventory costs, marketing, and administrative fees, are listed in the operating expenses section. It draws attention to the sum of money needed to run the business.
The operating expenses component, which is also used to determine operating income, has a direct impact on the company's bottom line. Additionally, it offers information on profitability and cost-effectiveness, which is crucial for analysts and investors.
Gross Profit
The gross profit demonstrates the volume of sales revenue (minus the costs incurred to achieve those sales). In other words, it demonstrates the amount of profit a business makes after deducting the cost of products sold.
The gross profit represents revenues before deducting operating expenses like marketing costs, administrative fees, and shipping costs. It does not include charges for supplies, labor, transaction fees, equipment, or shipping. This part is crucial to analysts and investors because it assesses how effectively a business turns production inputs (such as labor and materials) into completed goods (e.g. goods, and services).
How to financially analyze a Cash Flow Statement:
The cash flow statement gives important details about a company's three types of cash inflows and outflows. Observe the following:
Operating Activities
All cash inflows and outflows stemming from routine business operations are summarized in the operating activities section. It is sometimes seen as the most significant part of the cash flow statement because it is typically the main source of a company's cash. A positive cash flow from operating operations (inflows greater than outflows) can be a sign of a financially sound business.
Investing Activities
The section on investing operations includes all cash inflows and outflows coming from a company's investments, including payments for business acquisitions, the selling of assets, loans made and repaid, and the purchase or leasing of assets.
Since money is being spent to buy investments, this part typically only includes cash outflows, but there may be cash inflows when the company sells investments and gets money in the process.
Because every business manages investing operations differently, it is challenging to assess financial health just based on this area. However, investments in machinery, real estate, and other assets are typically a sign that a business is stable enough to make investments in expansion.
Financial Activities
Any monetary inflows or outflows involving debt, stock, or dividends are considered financing operations. In other words, it provides an overview of all business funding-related transactions. It draws attention to the flow of money between the business and its shareholders, financiers, lenders, and creditors and sheds light on how borrowing affects the company's cash flow.
A corporation that has a positive cash flow from financing activities has received money (for instance, by issuing shares), whereas one that has a negative cash flow has spent money (for example, making dividend payments).
Audit and Regulations to consider
A public company's financial statements should typically be audited for investment, financing, and tax reasons, though local regulations may differ. These are frequently undertaken by independent accountants or auditing firms. An audit report that either offer an unqualified opinion on the financial accounts or qualifications as to their fairness and accuracy summarizes the audit's findings. Typically, the annual report contains the audit opinion on the financial statements.
The subject of an auditor's legal liability has generated a lot of discussions. It is often believed that they have a legal duty of care to the existing shareholders because audit reports are frequently directed to them. But based on common law precedence, this might not be the case. In Canada, auditors are liable only to investors utilizing a prospectus to acquire shares in the primary market. When the auditor was aware of the possible investor and how they would utilize the information in the financial accounts, they have been held accountable in the United Kingdom to potential investors. Today's auditors frequently insert liability-restricting language in their reports to prevent anyone other than the report's addressees from relying on it. Responsibility is a significant problem; for instance, auditors in the UK are subject to unlimited liability.
In addition to this, there has been a great deal of worry in the US, especially in the post-Enron age, over the veracity of financial accounts. The chief executive officer (CEO) and chief financial officer (CFO), who are corporate officers, are individually liable for honest financial reporting that gives readers of the report an accurate understanding of the company.
Over time, various nations formed their own accounting standards, which makes it challenging to compare businesses internationally. A set of norms and criteria are utilized to assure consistency and comparability between financial statements presented by various companies. Generally Accepted Accounting Principles (GAAP), as they are more commonly known, serve as the foundation for the creation of financial statements, while many businesses voluntarily reveal data that is not required to be disclosed.
The International Accounting Standards Board has recently undertaken efforts to standardize accounting regulations ("IASB"). International Financial Reporting Standards (IFRS) are created by the IASB and are currently being considered by South Africa, Australia, Canada, and the European Union (for publicly traded firms only). The U.S. Financial Accounting Standards Board has pledged to harmonize the U.S. Over time, GAAP, and IFRS.
To sum it all up
Despite the fact that each financial statement is covered separately in this article, keep in mind that they are all interconnected. The income statement's revenues and expenses, which determine the company's earnings or losses, are also influenced by changes in the balance sheet's assets and liabilities. Cash flows are connected to net income reported on the income statement, but they are not the same thing. Cash flows give more details about the cash assets listed on a balance sheet. so forth. A single financial statement cannot tell the whole story. But when taken as a whole, they offer investors a wealth of information. And when it comes to making good investments, information is the investor's best tool.
FAQ
What are the advantages of a financial statement analysis?
Financial statement analysis analyzes a company's balance sheet, income statement, or statement of cash flows to assess its performance or value. Investors may create a more complex picture of a company's financial profile by utilizing a variety of methodologies, such as horizontal, vertical, or ratio analysis.
What are the different types of financial statement analysis?
Three major strategies are most frequently used by analysts to examine the financial statements of a corporation. Comparing historical data is the first step in horizontal analysis. Horizontal analysis is frequently used to identify growth trends throughout a range of time periods. The vertical analysis also evaluates how different financial statement items relate to one another. For illustration, a cost item might be stated as a percentage of revenue generated by the business. Finally, line-item data are compared using ratio analysis, a key component of fundamental equity analysis. Examples of ratio analysis include price-to-earnings ratios, earnings per share, and dividend yield.
What is an example of financial statement analysis?
To ascertain how effectively a company produces profits and shareholder value, an analyst may first examine a number of ratios on its income statement. The difference between revenues and the cost of goods sold, for instance, will be displayed by the gross profit margin. It may be a good sign for the business if the company has a higher gross profit margin than its rivals. Applying a horizontal analysis to the operating trends of the company, the analyst may also notice that the gross profit margin has been rising over the past nine fiscal quarters.
What is the importance of financial reporting and analysis?
Making decisions based on financial facts requires thorough financial reporting and analysis. A recommendation, such as sanctioning a loan or allocating money to an investment, is what financial reporting and analysis are for.
How do you create a financial analysis report?
The purpose of the report and any relevant rules and regulations serve as the guiding principles for creating a financial analysis report.
- Objective: The report's objective provides direction for the formality and length of the document.
For instance, a lender weighing whether to approve or deny 20 loans on average per day may search for a one-paragraph report outlining three important financial ratios. As an alternative, a very long and thorough report might be required if a financial expert is recommending giving a $1 million investment to a portfolio manager.
- Laws and regulations: Specific financial analysis reports may need to follow strictly predetermined formatting requirements as per the relevant laws and regulations.
Depending on the type of study you're seeking to conduct, there are various financial analysis template types accessible. Many of them are available for free online.