Financial Statement Analysis
Financial statement analysis helps you better understand your company’s financial health. Our guide breaks down the process to get started today.
Unveiling the Secrets of Financial Statement Analysis: A Comprehensive Guide to Understanding and Utilizing Business Financials
One of the most important things you can do for your business is to review your finances – and the most proper way to do that is through financial statement analysis. With this process, you analyze your company’s financial statements to evaluate its health and business performance. Doing so also helps creditors, investors, regulatory authorities, and even yourself make better business decisions and develop stronger leadership.
The ultimate goals of financial statement analysis are to identify trends, weaknesses or risks associated with your finances to help improve performance. It’s also a great way to ensure you’re on your way to meeting key initiatives that progress your company forward. Essentially, this process is a must-do if you want to keep your business rocking. Below, we’ve provided a deep dive into all you need to know to undergo the process.
Types of Financial Statements
There are four types of financial statements that companies use as part of financial statement analysis, all of which are connected and yet provide different insights into business performance. For a more in-depth understanding of the financial statements, check out our blog reviewing the details of each statement.
First up is the balance sheet. This is a report that details three things about a company: its assets, liabilities and shareholder equity at a specific point in time. The assets cover what a business owns, including physical and non-physical property. Liabilities refer to money that a company owes to debtors. Finally, shareholder equity reflects money leftover from subtracting liabilities from assets, portraying a company’s overall net worth.
Next up is the income statement. An income statement shows how much revenue a company has earned over a specific period of time, usually by quarter or year. These statements are typically broken down by a few metrics, including company expenses, gains and losses. As a result, investors can better understand an organization’s net income.
Cash Flow Statement
We then have the cash flow statement. Here, companies will examine both cash inflow and outflow. More specifically, it shows the company’s operating, investing and financing activities as well as just how much cash the company has available. It’s a great way to see how a business is operating in both the short and long term.
Statement of Stockholders’ Equity
Last but not least, we have the statement of stockholders’ equity. This financial statement contains information on shared capital and retained earnings. In simple terms, it represents what a company’s net worth would be if its assets were liquidated and its liabilities paid.
Key Financial Ratios and Metrics
Metrics are the key to measuring the overall financial standing of your organization. The best metrics are financial ratios, which are numerical values taken straight from the financial statements mentioned above. They include:
These ratios measure the money available to a business to fulfill its short-term obligations. Liquidity ratios are split into several categories, including current ratio, quick ratio, cash coverage ratio and operating cash flow ratio.
- Current Ratio: The current ratio measures a company's ability to pay short-term and long-term obligations. It's calculated as current assets divided by current liabilities. For example, if a company has current assets of $100,000 and current liabilities of $50,000, its current ratio is 2.0. This means the company has twice as many current assets as current liabilities. In general, a higher current ratio indicates a company's better capability to meet its obligations. However, an excessively high ratio may suggest inefficiencies in using resources or assets.
- Quick Ratio: Also known as the acid-test ratio, the quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. It's calculated by subtracting inventories from current assets and then dividing by current liabilities. If a company has current assets of $100,000, inventories of $20,000, and current liabilities of $50,000, its quick ratio would be 1.6 (($100,000 - $20,000) / $50,000). This means it has 1.6 times the liquid assets to cover current liabilities. A quick ratio over 1.0 usually indicates that the company is in good financial health.
- Cash Coverage Ratio: This ratio is used to determine the cash a company has available to pay for its debt. It's calculated as earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by the company's total interest expense. For instance, if a company has an EBITDA of $400,000 and interest expenses of $100,000, its cash coverage ratio is 4.0 ($400,000 / $100,000). A cash coverage ratio over 1 indicates that the company can cover its interest expenses and thus is less risky to creditors and investors.
- Operating Cash Flow Ratio: This ratio measures a company’s short-term liquidity by comparing its operating cash flow to its total current liabilities. It's calculated by taking cash flow from operating activities and dividing it by current liabilities. If a company's operating cash flow is $150,000 and its current liabilities are $50,000, its operating cash flow ratio is 3.0 ($150,000 / $50,000). This means the company can cover its short-term liabilities 3 times over with the cash flow from its operations. A ratio greater than 1 is generally seen as satisfactory, as it means that the company can fully pay off its current liabilities with the cash generated from its operations.
On the other hand, solvency ratios measure a company’s ability to meet its long-term obligations. Examples of what this ratio covers include debt-to-equity ratio, interest cover ratio, debt-to-asset ratio and equity ratio.
- Debt-to-Equity Ratio (D/E): This ratio indicates the proportion of the company's funding that comes from creditors (debt) compared to what comes from investors (equity). It's calculated by dividing the company's total liabilities by its shareholder's equity. For example, if a company has total liabilities of $500,000 and shareholder's equity of $250,000, the D/E ratio is 2.0 ($500,000 / $250,000). A higher ratio suggests higher risk since it indicates that the company is heavily financed by debt.
- Interest Coverage Ratio: This ratio measures a company's ability to pay interest on its outstanding debt. It's calculated by dividing earnings before interest and taxes (EBIT) by interest expenses. For instance, if a company has an EBIT of $200,000 and interest expenses of $50,000, its interest coverage ratio is 4.0 ($200,000 / $50,000). A higher ratio is better, as it means the company can comfortably meet its interest obligations.
- Debt-to-Asset Ratio: This ratio compares a company's total debt to its total assets, which can give an idea of the company's leverage. It's calculated by dividing the company's total debt by its total assets. If a company has total debt of $600,000 and total assets of $1,000,000, the debt-to-asset ratio is 0.6 ($600,000 / $1,000,000). A lower ratio is generally preferable as it indicates a lower risk to creditors and investors, as a smaller proportion of the company's assets are financed by debt.
- Equity Ratio: This ratio measures the proportion of the total assets that are financed by the owners, the shareholders. It's calculated by dividing the shareholder's equity by the total assets. For example, if a company has total assets of $2,000,000 and shareholder's equity of $1,000,000, the equity ratio is 0.5 ($1,000,000 / $2,000,000). This means that half of the company's assets are financed by equity. The higher the ratio, the less debt the company has and the less it relies on borrowed money.
As may be expected, profitability ratios measure how well a company generates profit. Some of the most common of these ratios consist of gross margin, net profit margin, return on assets and return on equity.
- Gross Margin: This ratio measures the proportion of money left over from revenues after accounting for the cost of goods sold (COGS). It's calculated by subtracting COGS from revenue, and then dividing the result by revenue. If a company has revenue of $500,000 and COGS of $300,000, its gross margin is 40% (($500,000 - $300,000) / $500,000). A higher gross margin percentage is generally better, indicating the company retains more on each dollar of sales to service its other costs and obligations.
- Net Profit Margin: This ratio is a key profitability metric for a company. It's calculated by taking net profit and dividing it by revenue. If a company has a net profit of $100,000 and revenue of $500,000, its net profit margin is 20% ($100,000 / $500,000). This means the company has a net income of 20 cents for each dollar of revenue generated. The higher the net profit margin, the more effective the company is at converting revenue into actual profit.
- Return on Assets (ROA): ROA is a measure of how efficiently a company can use its assets to generate earnings. It's calculated by dividing net income by total assets. For instance, if a company has net income of $200,000 and total assets of $1,000,000, its ROA is 20% ($200,000 / $1,000,000). This means that the company made 20 cents of profits for each dollar's worth of assets. A higher ROA indicates a company is more efficient at using its assets to generate profits.
- Return on Equity (ROE): ROE is a measure of financial performance, and it's calculated by dividing net income by shareholders' equity. If a company has net income of $100,000 and shareholder's equity of $500,000, its ROE is 20% ($100,000 / $500,000). This indicates how much profit the company generated for each dollar of shareholders' equity. A higher ROE indicates the company is more efficient at generating profits from each dollar of shareholder's equity.
Efficiency ratios, sometimes referred to as activity ratios, look at how efficiently a company is using its assets and resources. Companies can measure their efficiency through strategies like asset turnover ratio, inventory turnover, or days sales in inventory ratio.
- Asset Turnover Ratio: This ratio measures how effectively a company uses its assets to generate revenue. It's calculated by dividing the company's total sales or revenue by its average total assets. If a company has total sales of $2,000,000 and average total assets of $1,000,000, its asset turnover ratio is 2.0 ($2,000,000 / $1,000,000). This means that the company generates $2 of sales for every $1 of assets it owns. A higher ratio indicates a company is using its assets more efficiently to generate sales.
- Inventory Turnover Ratio: This ratio measures how often a company sells and replaces its inventory over a certain period, typically a year. It's calculated by dividing the cost of goods sold (COGS) by average inventory during the period. For example, if a company has COGS of $500,000 and average inventory of $100,000, its inventory turnover ratio is 5.0 ($500,000 / $100,000). This means the company turns over its inventory five times per year. A high ratio indicates efficient management of inventory, although the optimal ratio varies between industries.
- Days Sales in Inventory (DSI) Ratio: This ratio measures the average number of days a company holds inventory before selling it. It's calculated by dividing the number of days in the period (usually 365 days) by the inventory turnover ratio. Using the above inventory turnover ratio of 5.0, the DSI ratio would be 73 days (365 / 5). This means, on average, the company holds its inventory for 73 days before selling it. A lower DSI is typically preferable, indicating a shorter time to turn inventory into sales.
Market Value Ratios
Lastly, market value ratios assess a business’s overall market price to determine its value. Here, common ratios include earnings per share ratio, book value share ratio, and dividend yield ratio.
- Earnings Per Share (EPS) Ratio: EPS measures the profit allocated to each outstanding share of common stock. It's calculated by subtracting preferred dividends from net income, and then dividing by the weighted average number of common shares outstanding. If a company has net income of $500,000, preferred dividends of $50,000, and 200,000 shares outstanding, its EPS would be $2.25 (($500,000 - $50,000) / 200,000). A higher EPS often suggests better performance and profitability. However, EPS should not be viewed in isolation; it should be compared with other companies in the same industry and with the company's past EPS figures.
- Book Value Per Share (BVPS) Ratio: This ratio compares a company's book value (total assets - total liabilities) to the number of shares outstanding. If a company has a book value of $1,000,000 and 200,000 shares outstanding, its BVPS is $5 ($1,000,000 / 200,000). A higher BVPS could mean that the company is undervalued, but this ratio needs to be compared to the market price to provide insight into a company's valuation. Also, as with all ratios, it's important to compare BVPS across companies in the same industry.
- Dividend Yield Ratio: This ratio measures how much a company pays out in dividends each year relative to its stock price. It's calculated by dividing the annual dividend payment by the market price per share. If a company pays annual dividends of $1 per share and its stock price is $50, its dividend yield ratio is 2% ($1 / $50). Investors who prioritize income over capital growth might prefer companies with high dividend yield ratios. However, an excessively high dividend yield can also signal financial instability, as companies can sometimes push up the dividend yield to maintain their appeal to investors despite underlying problems.
Analyzing Financial Statements: A Step-by-Step Guide
By now, you know all about the different types of financial statements and ratios. The question then becomes: how can you perform a financial statement analysis? There are several techniques you can utilize:
1. Vertical Analysis
With a vertical analysis, each line item on a financial statement is listed as a percentage of another line item, comparing them over a single period of time. In doing so, it is easier to understand the relative sizes of all the different accounts on a financial statement.
2. Horizontal Analysis
By contrast, horizontal analysis is used to compare historical financial data over different accounting periods. This is done to see if there are any trends or changes in finances and gives insight into past business performance.
3. Ratio Analysis
The ratios mentioned above are a part of ratio analysis, which compares line items in financial statements. This type of analysis helps companies analyze profitability, efficiency, liquidity and solvency.
4. Common Size Analysis
A common size analysis is another term for a vertical analysis, allowing you to see any particularly large or drastic changes in your finances. Doing so allows you to even compare finances between companies.
The Role of Financial Statement Analysis in Decision-Making
Undergoing a financial statement analysis gives you and your investors a better (and bigger) picture of your company’s overall financial health. This is especially important during volatile times in the economy when smart decision-making is essential to survival. The following are some other ways this process can help you make better business decisions.
Identifying Financial Strengths and Weaknesses
Being aware of your financial strengths ensures you can continue making good decisions – and lean into those strategies even further. On the other hand, knowing your weaknesses will show you where you can improve financially, including when to save money and when to spend it.
Evaluating Business Performance
By analyzing your business performance, you can optimize both your day-to-day operations and your long-term decision-making. Moreover, you’ll be better suited to recognize opportunities when they appear and know what risks you could face in the future.
Facilitating Strategic Planning
No business is successful without a strategic plan in place, and that includes your finances. By compiling and analyzing the necessary financial statements, you will have stronger financial plans in place to present to investors or other financial institutions.
Enhancing Stakeholder Communication
Good stakeholder communication ensures all necessary parties are up to date on your finances and leads to more interconnected business decision-making. Should there be any financial issues, stakeholders can help you navigate your financial journey more smoothly and effectively.
Undergoing Cost-Cutting Initiatives
With detailed financial information available and a good understanding of the business performance, these reports can help guide the way to a successful cost-cutting strategy. Without the understanding of the financial performance, it becomes more more difficult to cut costs in a way that will positively impact the company.
Limitations and Challenges of Financial Statement Analysis
There’s no doubting the power of a proper financial statement analysis. However, it comes with its limitations and challenges. Recognizing them will help deepen your understanding of this process and help you paint a better picture of where you stand.
Financial Statement Manipulation
Some companies will, unfortunately, perform financial statement manipulation in hopes of paving their financial health in a better light. This includes tricks like recording false revenue, changing the timeline of expenses or failing to state liabilities. One of the most famous examples would be looking at Enron and the way they handled transactions to overstate revenue and hide expenses through other entities.
Financial statement analysis is all about gathering and analyzing quantitative information, which, while very helpful in regard to finances, leaves out qualitative factors. As a result, you may not get a comprehensive overview of your organization’s health.
Changes in Accounting Standards
Accounting standards can vary greatly from company to company. Moreover, accounting standards, policies, and methods as a whole can change over time, making some analyses lose their value.
Comparability and Industry Benchmarks
Lastly, comparability can be an issue, particularly if companies use different processes in how they handle transactions. Moreover, industry benchmarks have a habit of changing as well, such as which ratios to use or how to use them.
Ready for the Analysis You Deserve?
And there we have it – everything you need to know about financial statement analysis. As you can see, there are a lot of moving parts in this process, and it comes with its limitations. However, undergoing this analysis is incredibly useful in keeping up with your financial health and helps you make more informed business decisions that lead to greater money-making success.
To ensure you’re up to par, it’s best to perform a regular financial statement analysis, whether that’s quarterly or annually. Decimal provides accounting services that help you save time and headaches while increasing your financial efficiency. Get in touch today to receive a free consultation, and get on the right financial footing.