Financial Statement Analysis – A Complete Introduction

By  //  June 29, 2022

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Financial statements are essential to maintain financial health at a particular time in an organization, giving insight into its performance, operations, cash flow, and overall condition. Financial statement analysis requires analytical, problem-solving, and technical skills to bring short-term and long-term benefits to the business.

This post will give details about financial statement analysis and its importance in the growth of the business.

What is Financial Statement Analysis?

A financial statement is a document that helps to understand the financial position and cash flows. The documents include the balance sheet, cash flow statement, income statement, and supplementary notes. 

Financial Statement Analysis studies the relationship between the figures stated in financial statements and financial facts. It estimates the current and future financial positions after considering past financial positions and the results of an organization’s operation.

This approach determines the best possible prediction of future conditions. Financial statements are analyzed to determine a company’s strengths and weaknesses.

Why Do Firms Need to Analyze Financial Statements?

Analyzation of financial statements is essential due to following reasons:-

■ To assess the operational efficiency of a firm and its current profitability.

■ To understand the importance of components of the financial position of the firm.

■ It shows the significant facts regarding the efficiency of a firm and its managerial performance.

■ Identify the weakness and strengths of the firm in terms of financial position.

■ To make forecasts about the future aspects of the firm to make decisions related to operations and investments in the firm.

Process of Financial Statement Analysis

1. Restating Financial Statements: This is the procedure for presenting financial statements so that they can be more thoroughly analyzed and the company’s performance can be correctly interpreted.

2. Error correction: By correcting the mistakes, any noise or redundancy in the supplied data is eliminated. The reported accounting quality of numbers is improved as a result.

3. Financial Ratio Study: Adjusted financial statements are used for this analysis. Calculating different ratios is a necessary step in assessing the company’s success.

Types of Financial Statement Analysis

Financial analysts are responsible for financial statement analysis, and there are different methods to analyze financial statements. Let’s have a closer look at these methods.

■ Income Statement Analysis

There are two ways to analyze income statements: vertical and horizontal analysis. 

■ Vertical Analysis

In this method, the analysis takes place in vertical directions. To determine a percentage of revenue, analysts examine the statement line-by-line in this method. The following metrics are considered while analyzing the statement: 

The analysis takes place in the vertical direction while doing vertical analysis. Analysts look at the statement vertically to determine the revenue earned by the organization as a percentage. The following metrics are calculated while analyzing the statement vertically:

■ Interest 

■ Tax

■ Net earnings 

■ Gross profit Depreciation

■ Earnings Before Tax (EBT)  

■ Cost of Goods Sold (COGS) 

■ Selling General & Administrative (SG&A) 

Horizontal Analysis

Horizontal analysis is used to review financial statements over multiple periods in an organization. The financial analyst uses it to look at the income statement on a yearly basis (YoY) change in every line item.

■ Analysis of Cash flow statement

Analysis of cash flow statement is used to understand the cash flows and outflows over a specific period. Cash flow comprises funds from operations, borrowing, and investing. These three factors show how much money was spent during the evaluation, which is one of the most significant measures of how well the business is doing.

■ Analysis of Pyramid of Ratio

A pyramid of ratios can be used to display any business’s efficiency, profitability, and leverage. The pyramid of ratios determines the following insights: 

■ Dupont analysis

■ Return on equity ratio (ROE)

■ Rates of return and profitability analysis

■ Profitability, efficiency, and leverage ratios

■ Learn more about leverage in finance 

4. Analysis of Balance Sheet

Balance sheets are prepared to determine the efficiency of the business. Financial analysts compare the components of the income statement with the company’s capital assets on the balance sheet. Analysts can determine how efficiently the company generates revenue and sells its inventory by looking at different financial ratios on the balance sheet.

Skills Required to do Financial Statement Analysis

Financial statement analysis is crucial for every industry to determine growth and profitability. People with relevant skills and knowledge are in high demand in various industries. The skills required to do financial statement analysis depend on the industry in which you are employed.

Whether you are a student who wants to make a career in the financial domain or a working professional who has just joined the field of financial analysis, some of the common skills are required to do financial statement analysis. These skills are mentioned here.

■ Analysis skills

■ Communication skills

■ Financial modeling skills

■ Multitasking skills

■ Understanding financial law like the Sarbanes-Oxley Act

Conclusion

Financial statement analysis is a broad concept that provides a comprehensive knowledge of how to analyze financial statements to grow the financial position of a business. A brief sketch of the term financial statement is given in the post. Pursuing a financial analyst course is the best option for you if you are willing to upgrade your skills and knowledge to become a professional financial analyst. Hero Vired is a recognized institute started by the Hero Group to provide industry-relevant courses to interested students. The institute is also providing courses related to finance. To get the details, you can visit the official website of Hero Vired.