Analysts apply several methods in judging the financial stability of a company to decide its valuation in the stock market. Analysing financial statements is one of them. At the core, financial statements are the health report card that helps investors predict the company’s performance in the long run.
Financial statement analysis is a process of analysing financial conditions for decision-making purposes. It allows external stakeholders to evaluate the financial performance of the company and its business value.
Types of Financial Statements
There are three significant financial statements that every company needs to maintain. – Balance Sheet, Income Statement, and Cash Flow Statement. Let us discuss them one by one.
- Balance Sheet: It is a report card that reveals a company’s worth in terms of book value at the end of a specific year. It consists of three main parts, namely, assets, liabilities (debt), and shareholder’s equity. The most straightforward formula to arrive at book value or shareholder’s equity is to subtract debt from assets. The book value is an important performance metric, which rises or falls with increased or decreased financial activities of the company.
- Income Statement: It is a detailed account of the company’s revenue earnings and expenses in a particular past period, such as a financial year. Also known as the profit and loss statement, it provides the bottom line for decision-making, whether the company is making profit or loss.
- Cash Flow Statement: It is an account of how much liquid cash or cash equivalent circulates in the company. It is a report card that shows how well a company manages its cash position. A cash flow statement is an important document to evaluate a company’s financial health and compliments the balance sheet and income statement.
Methods of Financial Statement Analysis
There are several techniques used by analysts to develop a fair understanding of a company’s financial performance over a period. The three most commonly practised methods of financial analysis are – horizontal analysis, vertical analysis, and ratio and trend analysis.
- Horizontal Analysis: The performance of two or more periods is compared to understand the company’s progress over a period. Each component of a ledger is compared with the previous period to gather a general understanding of trends. For example, if the cost of final goods rises by 20 per cent in a year, but it is not reflected in the revenue earned, then there may be some components which are costing the company more.
- Vertical Analysis: Vertical analysis helps to establish a correlation between different line items in a ledger. It gives analysts an understanding of overall performance in terms of revenue and expenses. The results are reviewed as a ratio.
- Ratio analysis: Ratio methods of financial analysis are used to compare one financial component against another and reveal a general upward or downward trend. Once the ratio is calculated, it can be compared against the previous period to analyse if the company’s performance is in accord with set expectations. It helps management highlight any deviation from set expectations and take corrective measures.
- Trend analysis: It helps to analyse trends over three or more periods. It takes into account incremental change patterns, considering the earliest year as the base period. A change in a financial statement will either reveal a positive or negative trend.
Conclusion
Understanding financial statement analysis is vital for successful stock market investments. Financial statements serve as a company’s health report card, aiding investors in predicting its long-term performance. To analyse a company’s financial health, analysts employ four primary methods. These techniques empower investors and stakeholders to make informed decisions about a company’s financial stability and its value in the stock market. Successful investors employ these methods to navigate the complex world of finance and achieve their investment goals.
FAQs
Financial statement analysis is the process of evaluating a company’s financial statements to assess its financial health and performance. It is essential for investors, creditors, and management to make informed decisions about investing, lending, or managing a business. The three primary types of financial statements are the Balance Sheet, Income Statement, and Cash Flow Statement. The Balance Sheet provides a snapshot of a company’s assets, liabilities, and equity at a specific point in time. The Income Statement shows revenue, expenses, and profits over a period. The Cash Flow Statement details cash inflows and outflows. Ratio analysis involves comparing different financial metrics to assess a company’s performance. It helps in understanding the relationships between various financial variables, such as profitability, liquidity, and leverage. Ratio analysis provides insights into a company’s strengths and weaknesses and helps in benchmarking against industry standards. Trend analysis involves studying financial data over multiple periods to identify patterns and trends. You can use it by selecting a base year and comparing subsequent years to it. Positive trends indicate improvement, while negative trends may signal issues that need attention. Trend analysis helps in assessing the direction and consistency of a company’s financial performance. Horizontal analysis compares financial data over different time periods, such as comparing this year’s revenue to last year’s. It focuses on changes in financial figures over time. In contrast, vertical analysis looks at the proportion of each line item on the financial statements relative to total revenue or assets. It helps in understanding the composition of financial statements.
