Mastering Techniques and Methods of Financial Statement Analysis

Using financial data isn’t just optional today–it’s critical for making informed, strategic decisions. Companies, governments, and investors all rely on financial analysis to make sound business decisions. Through analysis of a company's income statements, balance sheets, and cash flow statements, financial analysts can assess risk and provide advice on financial policies.¹

What methods can you use to analyze a company’s financial statements? Read on to explore the basics of financial analysis methods, key techniques, tools for analysis, and common pitfalls to avoid.

Understanding Financial Statement Analysis

Financial statement analysis is the process of assessing a company’s financial health and performance by reviewing its financial statements.² The analysis benefits stakeholders when making decisions.

Investors

Analyzing a company’s finances helps investors evaluate a business’s financial health and performance to help them decide whether to buy, hold, or sell stocks.³ Typically, investors focus on metrics that maximize their returns, such as the following:

• Profitability
• Growth potential
• Return on investment

Managers

Reliable financial analysis helps managers assess operational efficiency, allocate resources, set strategic goals, and ensure legal and regulatory compliance.^4,5 With the right data, managers can customize their financial modeling to address areas in need of improvement and enhance organizational performance.

Creditors

Creditors, on the other end, use financial analysis to evaluate a company’s ability to repay loans and meet credit obligations.⁶ They focus on liquidity, solvency, and cash flow metrics to minimize default risk.

Key Techniques for Financial Statement Analysis

There are three key types of financial analysis techniques:

• Horizontal
• Vertical
• Ratio

Each type involves several techniques, and you can use them independently or in conjunction with others. However, you can use all three types of financial analytical techniques in all financial statements.

Horizontal Analysis

Horizontal analysis, also known as trend analysis, compares financial data over different accounting periods.⁷ This technique of financial statement analysis allows you to see trends and evaluate performance changes in a company. For example, comparing a company’s income statement for each quarter in a year would show whether the company is experiencing consistent growth, seasonal fluctuations, or any concerning revenue decline.

Vertical Analysis

Vertical analysis is the process of expressing each item in a financial statement as a percentage of the base amount.⁸ It assesses the relationships between different components of financial statements for the same period, making it an important corporate finance planning and analysis tool. With vertical analysis, in an income statement for example, you list all items as a percentage of total revenue. In a balance sheet, you express items as a percentage of total assets or total liabilities and equity.

Ratio Analysis

Ratio analysis is the calculation and interpretation of key financial ratios to learn about a company’s liquidity, profitability, solvency, and efficiency.⁹ You can use ratios to evaluate how a company is performing or how it compares with another business in the same industry. For instance, the quick ratio–calculated as quick assets divided by current liabilities–reveals how quickly a business can generate cash to cover its short-term obligations during cash flow problems.

Advanced Methods for Financial Statement Analysis

Beyond the three key techniques of financial statement analysis, you can tap into advanced methods to get deeper insights into a company's financial performance.

Trend Analysis and Forecasting Future Performance

Trend analysis is a technique for evaluating historical financial data to uncover patterns that may inform a company's decision. For instance, you can analyze a company's five-year revenue growth to check if its income is steadily increasing, experiencing fluctuations, or showing signs of decline. Based on the insights you collect, you can forecast the business’ future performance, advise clients on expected growth or potential downturns, and guide their’ strategic decisions.

Common-Size Analysis for Benchmarking Across Companies

Another method you can use is common-size analysis. With this technique, you can convert financial statement items of several companies into percentages of a common base, such as total revenue or assets. These percentages make it easier to compare financial performance across companies of different sizes, providing valuable benchmarking insight.

DuPont Analysis for Detailed Profitability Insights

DuPont analysis is a financial performance framework that breaks down return on equity into key drivers–profit margin, asset turnover, and leverage–to better understand profitability factors.¹⁰ This method of financial analysis assesses which specific factors are impacting a company’s profitability, allowing you to offer more targeted financial recommendations.

Tools and Resources for Financial Statement Analysis

To analyze financial statements, you need tools for collecting, calculating, benchmarking, and forecasting data. Two widely used tools for financial analysis are Microsoft Excel and Google Sheets. These tools have advanced features like pivot tables and financial functions, which make them ideal for the following:

• Calculating financial ratios
• Creating financial models
• Performing trend analysis

If you’re looking for pre-built solutions, you can choose dedicated platforms like Bloomberg Terminal or S&P Capital IQ. Such platforms offer comprehensive solutions for conducting thorough analyses and making informed decisions.

For data comparison analysis, you can use industry benchmarks and standards as reference points to assess a company’s financial performance relative to its peers. For instance, you can compare metrics like profitability to industry averages to identify areas where a company excels or needs improvement.

Common Pitfalls and Challenges

During analysis, you’re likely to face challenges, some of which can undermine the accuracy and effectiveness of the process:

• Misinterpreting financial data: Data misinterpretation can lead to faulty decisions and misguided strategies.
• Over-relying on historical data: Depending too much on past data may cause you to miss emerging trends or future risks that could affect the company’s financial outlook.
• Ignoring qualitative factors: Overlooking non-quantitative factors such as management expertise or industry shift can underestimate key factors of a company's performance.

Master Financial Statement Analysis Techniques

SCU’s Online Master of Science (MS) in Finance and Analytics program is designed to equip professionals with the skills to lead data-driven financial initiatives and uncover valuable insights from financial statements. Through a dynamic curriculum focused on financial modeling, data analysis, and strategic decision-making, you’ll sharpen your analytical thinking and become a solution-oriented leader in the field. Plus, with our flexible online format, you can build your career without putting the rest of your life on hold — no commuting, no rigid schedules, just a learning experience that fits seamlessly around your work, family, and hobbies.

To learn how this program meets your professional needs in the evolving field of financial reporting, connect with an admissions outreach advisor today.