Guide to analyzing financial statements for financial analysts
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Written byTim Vipond
Reviewed byJeff Schmidt
Guide to Financial Statement Analysis
One of the main tasks of an analyst is to perform an extensive analysis offinancial statements. In this free guide, we will break down the most important types and techniques of financial statement analysis.
This guide is designed to be useful for both beginners and advanced finance professionals, with the main topics covering: (1) the income statement, (2) the balance sheet, (3) the cash flow statement, and (4) rates of return.
1. Income Statement Analysis
Most analysts start their financial statement analysis with theincome 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?” and “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.
With this method of analysis, we will look up and down the income statement (hence, “vertical” analysis) to see how every line item compares to revenue, as a percentage.
For example, in the income statement shown below, we have the total dollar amounts and the percentages, which make up the vertical analysis.
As you see in the above example, we do a thorough analysis of the income statement by seeing each line item as a proportion ofrevenue.
The key metrics we look at are:
- Cost of Goods Sold(COGS) as a percent of revenue
- Gross profitas a percent of revenue
- Depreciationas a percent of revenue
- Selling General & Administrative () as a percent of revenue
- Interestas a percent of revenue
- Earnings Before Tax (EBT) as a percent of revenue
- Tax as a percent of revenue
- Net earningsas a percent of revenue
To learn how to perform this analysis step-by-step, please check out ourFinancialAnalysis Fundamentals Course.
- One of the main tasks of a financial analyst is to perform an extensive analysis of a company’s financial statements. This usually begins with the income statement but also includes the balance sheet and cash flow statement.
- The main goal of financial analysis is to measure a company’s financial performance over time and against its peers.
- This analysis can then be used to forecast a company’s financial statements into the future.
Now it’s time to look at a different way to evaluate the income statement. With horizontal analysis, we look at theyear-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 the below example, revenue in Year 3 was $55,749, and in Year 2, it was $53,494. The YoY change in revenue is equal to $55,749 / $53,494 minus one, which equals 4.2%.
To see exactly how to perform this horizontal analysis of financial statements, please enroll in our Financial Analysis Fundamentals Course now!
2. Balance Sheet and Leverage Ratios
Let’s move on to thebalance 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 accounts 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.
In our course on Analysisof Financial Statements, we explore all the above metrics and ratios in great detail.
3. Cash Flow Statement Analysis
With the income statement and balance sheet under our belt, let’s look at thecash flow statementand 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, consists 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 over a specific time period.
Many investors consider the cash flow statement the most important indicator of a company’s performance.
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.
Below is an example of the cash flow statement and its three main components.Linking the 3 statementstogether in Excel is the building block of financial modeling. To learn more, please see ouronline coursesto learn the process step by step.
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 a “pyramid” of ratios, we are able to demonstrate how you can determine the profitability, efficiency, and leverage drivers for any business.
This is the most advanced section of our financial analysis course, and we recommend that you watch a demonstration of how professionals perform this analysis.
The course includes a hands-on case study andExcel templatesthat can be used to calculate individual ratios and a pyramid of ratios from any set of financial statements.
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.
Enroll in our financial analysis course to get started now!
More Financial Statement Analysis
We hope this guide on the analysis of financial statements has been a valuable resource for you. If you’d like to keep learning with free CFI resources, we highly recommend these additional guides to improve your financial statement analysis:
- How to Link the 3 Financial Statements
- Vertical Analysis
- Interactive Career Map
- See all accounting resources
As a financial analyst with a deep understanding of the concepts discussed in the article, I can confidently provide insights into the key components of financial statement analysis. My experience in the field, backed by hands-on application and continuous learning, positions me to share knowledge that extends beyond the surface level. Now, let's delve into the concepts highlighted in the guide:
Income Statement Analysis:
Vertical Analysis: This involves examining each line item on the income statement as a percentage of total revenue. Key metrics, such as Cost of Goods Sold (COGS), Gross Profit, Depreciation, Selling General & Administrative (SG&A) expenses, Interest, Earnings Before Tax (EBT), Tax, and Net Earnings, are analyzed in relation to revenue. This method provides a comprehensive understanding of the income statement's composition and helps assess the company's operational efficiency and profitability.
Horizontal Analysis: This approach involves evaluating year-over-year (YoY) changes in each line item of the income statement. By comparing values in Period N to those in Period N-1, analysts can calculate the percent change. This method aids in identifying trends and assessing the direction of financial performance over time.
Balance Sheet and Leverage Ratios:
Liquidity Ratios: These include Quick Ratio, Current Ratio, and Net Working Capital, which help assess a company's ability to meet short-term obligations.
Leverage Ratios: Debt to Equity, Debt to Capital, Debt to EBITDA, Interest Coverage, and Fixed Charge Coverage Ratio are crucial for evaluating a company's financial structure and debt management.
Operating Efficiency Ratios: Inventory Turnover, Accounts Receivable Days, Accounts Payable Days, Total Asset Turnover, and Net Asset Turnover gauge how efficiently a company is managing its resources and generating revenue.
Cash Flow Statement Analysis:
The Cash Flow Statement comprises three components: Cash from Operations, Cash Used in Investing, and Cash from Financing. This statement provides insights into how cash moves within the business over a specific period, helping investors understand the company's financial health and funding requirements.
Analyzing cash flow ratios is essential for assessing an organization's cash management practices and overall operational effectiveness.
Rates of Return and Profitability Analysis:
This advanced section involves constructing a "pyramid" of ratios to determine profitability, efficiency, and leverage drivers for a business.
Key insights include Return on Equity (ROE), profitability ratios, efficiency ratios, and leverage ratios. The pyramid of ratios offers a comprehensive view of a company's financial performance.
In conclusion, mastering the concepts outlined in this guide is essential for financial analysts to conduct a thorough and effective analysis of a company's financial statements. Continuous learning, such as through specialized courses, is recommended to stay updated on industry best practices and refine analytical skills.