In business, financial statements offer critical information about a company's operations. They provide insight into overall performance, operating cash flow, and profitability. Business leaders use these financial metrics to guide decisions and manage growth. Shareholders and investors use information from financial statements to determine whether a company is a good investment.
Understanding how to analyze financial documents can also help you evaluate potential business partners or vendors, develop departmental budgets, or make investment decisions.
Read on to learn more about financial statements and performance metrics and how to analyze them.
What is financial statement analysis?
Financial statement analysis is the process of assessing a company’s key financial documents to understand its performance. Companies use financial statement analysis to guide business decisions, set budgets, and plan for the future. Investors use this information to decide whether or not to fund a company.
Financial metrics are key performance indicators (KPIs) that offer insight into a company's operations and identify significant relationships between items in the financial statement. Organizations use these metrics to analyze the financial status of a company. For example, profit margin, one of several financial metrics to be discussed later in this post, is the ratio of its profit (sales minus expenses) divided by its revenue.1 This metric can indicate how well-managed the company is.
Understanding Financial Statements
As a manager, the statements you will see most often include the following four reports:
- Balance sheet: lists resources (assets) and funding sources (equity and liabilities and/or debt)2
- Income statement: highlights profits and losses over a specific time period
- Statement of shareholders’ equity: shows the difference between total assets and total liabilities, indicating how much a company must pay its shareholders3
- Cash flow statement: measures how a company spends its cash or cash equivalents and has separate sections for money spent on operating expenses, investing, and financing activities, such as money spent issuing debt or paying portions of revenue to shareholders
Key Financial Ratios and Metrics
Financial statements provide the information required to assess a company’s fiscal health, and financial ratios are tools that summarize financial statements. Depending on the information needed, analysts calculate different types of ratios. Some common ratios and metrics include:
- Liquidity ratios: help financial analysts understand a company’s ability to pay its debts4
- Profitability ratios: indicate how a company can earn profits; calculated by dividing gross profit margin by net revenue and multiplying the result by 1005
- Efficiency ratios: calculate expenses as a portion of revenue to see how much money a company spends to make money6
- Solvency ratios: determine if a company has enough cash flow to meet its obligations
- Market value ratios: help benchmark a company against its competitors by comparing stock prices
Analyzing Financial Statements
Financial statements are used for multiple purposes, and there are many ways to analyze them. Horizontal analysis compares historical data over multiple periods.7 If a company wants to prove its stability to a potential investor, it may provide three years of financial statements for a horizontal analysis. Conversely, the vertical approach analyzes relationships between numbers in a single accounting period. A company may use this method to discover why profit margins are lower in a quarter.8
Other financial performance analysis methods include ratio, trends, and comparative analysis. Ratio analysis assesses operational stability, liquidity, and profitability. Trends analysis evaluates financial patterns over time. Comparative analysis evaluates and compares statements from different accounting periods. Each of these methods offers insight into a company’s financial performance and can be used to detect financial anomalies, such as an expensive product launch, that could affect the bottom line.
Interpreting Performance Metrics
As an analyst, you will need various performance metrics to understand your company’s fiscal activity. Depending on your company’s financial goals, some possible work scenarios might include:
- Looking at the return on investment (ROI) for certain products by dividing total sales by the cost to develop and launch the product
- Calculating return on equity to determine the company’s return on its assets
- Creating annual reports for shareholders and calculating the earnings per share (net income divided by the total number of shares)
- Determining the cost to provide your products to customers by subtracting the cost of goods sold from net sales and dividing this number by revenue to get the gross margin9
- Finding a way to cut costs by calculating the operating margin to see the impact of overhead costs
Common Size Analysis
Common size analysis is a tool financial analysts use to compare percentages between two or more years. It displays each line item of your financial statement as a percentage of a base figure to help you determine how your company is performing year after year and how it compares to competitors. This type of analysis makes it easier to compare various metrics over time, and you can use it to assess balance sheets, income statements, and cash flow statements. To create a common size assessment, you must calculate each line of your profit and loss statement as a percentage of the company’s net revenue.
Common size analysis uses percentages to help you gain a better understanding of your company, assess its profitability, and compare it to the competition. For example, if you only look at your company’s total income, you might think your competitor is more successful; however, if you calculate total income as a percentage of the company’s net revenue, you might discover that you align more closely with your competitor.
Financial Statement Forecasting
Financial analysis often focuses on past performance, but that data can also be used to make future projections. Some financial statement forecasting tools include the straight-line method, which uses past trends to predict future scenarios. In addition, a moving average looks at previous patterns to predict financial health in the future. This method can account for other variables, such as seasonal shifts in sales. Other forecasting methods involve complex statistical analysis, such as multiple linear regression. This statistical method uses two or more independent variables to predict the outcome of a dependent variable. For example, you might assess how reducing various product costs will impact your overall revenue.10
Evaluating Financial Health and Performance
Whatever your future position, knowing how to analyze financial data and use financial statements will be valuable skills. As you rise through a company, you can use financial statements to direct strategic decisions and financial planning. For example, you may decide it’s too financially risky to develop a new product. You can also help your company with cost-saving strategies to help maximize future profitability.
Financial Statement Disclosures and Notes
When analyzing a company’s financial statements, read the disclosures. Each company includes supplementary information in the introduction and footnotes that can clarify its finances. If, for example, a company’s corporate office was destroyed in a natural disaster, it will take a financial hit. Footnotes help tell the story so you can better understand the data.
As a financial analyst, you should also review the company’s accounting policies and estimates. This will show whether the statements are based on actual or projected income.
Limitations and Challenges in Financial Statement Analysis
Financial analysis does have its limitations. For one, there is no way to interpret non-financial factors. If a new CEO comes into a company and changes its accounting practices, that could change financial reporting. Additionally, if the company's financial statements are unaudited, there is always a chance that an unscrupulous businessperson could be manipulating the data.
Finally, when making future projections, there is simply no way to account for external factors such as inflation, supply chain delays, technological advancements, regulatory changes, and socio-political influences. External factors often shape the environment in which your company operates and can influence its overall success.
Case Studies and Practical Examples
Financial analysis can vary depending on the company. Public companies (traded on the stock market) are required to make their financial statements public. You can look at the EDGAR database from the United States Securities and Exchanges Commission (SEC) to find reports for companies including Apple, Amazon, and many others on the stock exchange.11
If you’re a professional evaluating a startup, many of the numbers will likely be based on forecasts. The company may have starting capital, but there is no accurate way to predict how it will perform when the product hits the market. In this case, you may want to run multiple scenarios for your analysis.
If you’re working for a large company, you might use ratio analysis, as discussed above, as a key performance indicator to measure progress. Your boss, for instance, may set a goal to reduce debt by 20%. Ratio analysis can help you see how you have done.
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1. Retrieved on November 28, 2023, from brex.com/journal/what-is-a-good-profit-margin
2. Retrieved on November 28, 2023, from investopedia.com/terms/b/balancesheet.asp
3. Retrieved on November 28, 2023, from business.com/articles/statement-of-shareholder-equity/
4. Retrieved on November 28, 2023, from corporatefinanceinstitute.com/resources/accounting/liquidity-ratio/
5. Retrieved on November 28, 2023, from bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/glossary/gross-profit-margin-ratio
6. Retrieved on November 28, 2023, from wallstreetmojo.com/efficiency-ratios-formula/
7. Retrieved on November 28, 2023, from investopedia.com/terms/h/horizontalanalysis.asp
8. Retrieved on November 28, 2023, from fool.com/the-ascent/small-business/accounting/articles/vertical-analysis/
9. Retrieved on November 28, 2023, from bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/glossary/gross-margin
10. Retrieved on November 28, 2023, from corporatefinanceinstitute.com/resources/financial-modeling/forecasting-methods/
11. Retrieved on November 28, 2023, from sec.gov/edgar