6 Steps to an Effective Financial Statement Analysis

A financial statement analysis refers to the process of assessing a company’s financial performance.¹ External stakeholders use the financial analysis statement to gauge the organization's value. It is a sort of report card of a company’s financial health.

The financial accounting analysis involves a comprehensive examination of a company’s financial statements. By the end of the analysis, stakeholders can understand the company better and make more accurate decisions.²

This article will explore six steps to creating a valuable financial statement analysis.

One critical step to understanding effective financial statement analysis is gaining in-depth knowledge of the balance sheet, income statement, and cash flow statement. These three statements are utilized to calculate financial ratios that offer insights into the company’s financial performance. Each provides distinct information, yet they are all interconnected.

An income statement details the revenue a company generates and the expenses associated with its operating activities.³ The income statement provides a detailed account of a business’s revenues, expenses, gains, and losses, starting with total revenue and concluding with net income.

A company’s balance sheet provides insight into its overall value by summarizing its assets, liabilities, and shareholders’ equity at a specific date.⁴ For the balance sheet to balance, the total assets must equal the sum of liabilities and equity. Analysts interpret the difference between assets and liabilities as the company’s book value or equity.⁵

The cash flow statement presents the changes in cash over a given period and the opening and closing cash balances.6 It provides data on the amount of cash or cash equivalents moving through the company via various inflows and outflows—such as sales receipts, stock repurchases, or sales of assets—associated with operating activities, cash financing, and external investments.

Collect data on the company’s relevant historical financial information analysis (including the balance sheet, income statement, and cash flow statement), as well as its competitive stance, future directions, industry benchmarks, and competitor information.

Ensure that the data sticks to the four C’s of high-quality data: It must be current, correct, consistent, and complete. This helps to ensure the reliability of the data and increases credibility with external stakeholders.

Utilize apps, spreadsheets, databases, and accounting tools to collect, store, organize, and manage the data.

Ratio analysis of financial results comes in handy for assessing a company’s profitability, liquidity, and solvency over time. This analysis also enables comparisons of the company’s performance against other businesses in the same industry.^7,8 These are the key ratios to calculate:⁹

• Solvency or leverage ratios, such as debt-to-equity ratio and debt-to-assets ratio, compare a company’s debt levels to its assets, equity, and earnings to evaluate its long-term stability
• Liquidity ratios, such as the current ratio and working capital ratio, assess the company’s capacity to meet short-term liabilities
• Profitability ratios, such as profit margin ratio and gross margin ratio, measure the company’s ability to generate profits from its operations
• Turnover ratio, days sales in inventory, and other types of efficiency ratios analyze how effectively a company uses its assets and liabilities to generate sales and produce maximum profits
• Coverage ratios, such as the times interest earned ratio, indicate a company’s ability to pay interest and other debt-related obligations
• Market value ratios, including dividend yield ratio and price-to-earnings ratio, assess a company’s share price to provide insights into future performance and expected earnings

Known as time series analysis or trend analysis, the process of analyzing trends over time using financial analysis techniques involves examining financial data over a specified period to identify patterns, such as uptrends, downtrends, or stagnation, and gain insights into a company’s financial health. This approach is grounded in the concept that past financial behaviors offer indications of future performance.

Trend analysis generally considers short-term, medium-term, and long-term trends. It allows for an in-depth assessment of changes in specific line items within financial statements across time. This approach benefits investors as it points to how well-aligned the company is to prevailing trends.

Analyzing the progression of financial and performance metrics such as revenue, expenses, profits, and other key indicators ensures that financial analysts and stakeholders’ decision-making is informed by accurate historical data rather than speculation.

Evaluating a business’s performance relative to others in the same market will help you gain insight into its competitive positioning and risk profile. This comparative analysis helps gauge how the company ranks in terms of key performance indicators within its industry.

A comprehensive evaluation of the company’s competitiveness in the industry involves analyzing financial statements and other financial metrics, such as:¹⁰

• The current ratio: a measure of the company’s ability to pay off short-term liabilities due within a year
• Return on equity: how efficiently the company generates profit relative to the average shareholder equity it employs, expressed as a percentage
• Debt-to-equity ratio: the amount of debt the company is using to finance its assets, relative to the value of shareholders' equity
• Gross margin percentage: the remaining percentage of the company's revenue after the cost of producing or selling its goods or services has been subtracted

Regulatory filings are another reliable source of financial data. For instance, companies are required to file detailed financial information with the U.S. Securities and Exchange Commission (SEC). You can access these various financial reports and records through the publicly available Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database.¹¹

When writing the conclusion of the financial statement analysis, remember that you’re trying to show if the company can create value for shareholders and pay its creditors. The reader should be able to tell whether the company is performing well or poorly.

Present the information in a simple and direct way, preferably using presentation tools such as charts, graphs, or tables. Start with a concise summary of the company’s financial health by highlighting key indicators such as revenue growth, profitability margins, and cash flow trends.

Next, outline significant changes in the balance sheet and note any shifts in assets, liabilities, or equity positions. Emphasize fluctuations in working capital or debt levels. Include a focused analysis of the company's financial position and ratios related to liquidity, solvency, and efficiency.

Address any exceptional items or one-time events that may have influenced financial results and conclude with a summary of the company’s financial outlook concerning current trends and market conditions.

Finally, offer actionable recommendations based on your findings. For instance, you could recommend the company pursue new investments or adjust its financial strategy.

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