Financial Statement Analysis?

The main task of an analyst is to perform an extensive analysis of?financial statements.?In this article, we will break down the most important methods, types, and approaches to financial analysis.

This article is designed to be useful for both beginners and advanced finance professionals, with the main topics covering: (1) income statement, (2) balance sheet, (3) cash flow, and (4) rates of return.

#1 Income statement analysis

Most analysts start their analysis of financial statements with the?income statement.?Intuitively, this is usually the first thing we think about with a business…we often ask questions such as, “how much revenue does it have, is it profitable, what are the margins like?”

In order to answer these questions, and much more, we will dive into the income statement to get started.

There are two main types of analysis we will perform: vertical analysis and horizontal analysis.

?Vertical analysis

With this method of analysis of financial statements, we will look up and down the income statement (hence, “vertical” analysis) to see how every line item compares to revenue, as a percentage.

The key metrics we look at are:

• Cost of Goods Sold?(COGS) as a percent of revenue
• Gross profit?as a percent of revenue
• Depreciation?as a percent of revenue
• Selling General & Administrative (SG&A) as a percent of revenue
• Interest?as a percent of revenue
• Earnings Before Tax (EBT) as a percent of revenue
• Tax as a percent of revenue
• Net earnings?as a percent of revenue

Horizontal Analysis

Now it’s time to look at a different way to evaluate the income statement.?With horizontal analysis, we look across the income statement at the?year-over-year?(YoY) change in each line item.

In order to perform this exercise, you need to take the value in Period N and divide it by the value in Period N-1 and then subtract 1 from that number to get the percent change.

For example, revenue in 2017 was $4,000 and in 2016 it was $3,000.?The YoY change in revenue is equal to $4,000 / $3,000 minus one, which equals 33%.

#2 Balance sheet and leverage ratios

Let’s move on to the?balance sheet.?In this section of financial statement analysis, we will evaluate the operational efficiency of the business.?We will take several items on the income statement, and compare them to the company’s capital assets on the balance sheet.

The balance sheet metrics can be divided into several categories, including liquidity, leverage, and operational efficiency.

?The main liquidity ratios for a business are:

• Quick ratio
• Current ratio
• Net working capital

?The main leverage ratios are:

• Debt to equity
• Debt to capital
• Debt to EBITDA
• Interest coverage
• Fixed-charge coverage ratio

?The main operating efficiency ratios are:

• Inventory turnover
• Accounts receivable days
• Accounts payable days
• Total asset turnover
• Net asset turnover

Using the above financial ratios, we can determine how efficiently a company is generating revenue and how quickly it’s selling inventory.

Using the financial ratios derived from the balance sheet and comparing them historically versus industry averages or competitors will help you assess the solvency and leverage of a business.

#3 Cash flow statement analysis

With the income statement and balance sheet under our belt, let’s look at the?cash flow statement?and all the insights it tells us about the business.

The cash flow statement will help us understand the inflows and outflows of cash over the time period we’re looking at.

?Cash flow statement overview

The cash flow statement, or statement of cash flow, consist of three components:

• Cash from operations
• Cash used in investing
• Cash from financing

Each of these three sections tells us a unique and important part of the company’s sources and uses of cash during the time period being evaluated.

Many investors consider the cash flow statement the most important indicator of a company’s performance and it’s hard to imagine that until only recently companies didn’t even have to file a cash flow statement.

Today, investors quickly flip to this section to see if the company is actually making money or not, and what its funding requirements are.

It’s important to understand how different ratios can be used to properly assess the operation of an organization from a cash management standpoint.

#4 Rates of return and profitability analysis

In this part of our analysis of financial statements, we unlock the drivers of financial performance. By using the pyramid of ratios, we are able to demonstrate how you can determine the profitability, efficiency, and leverage drivers for any business.

The key insights to be derived from the pyramid of ratios include:

• Return on equity ratio?(ROE)
• Profitability, efficiency, and leverage ratios
• Primary, secondary, and tertiary ratios
• Dupont analysis

?By constructing the pyramid of ratios, you will gain an extremely solid understanding of the business and its financial statements.