Financial statement analysis is a topic that is isn’t difficult, but is plagued with hard to read articles and content.
As always here at FinanceFluent.com, we will to explain the concepts in simple terms that everyone can understand.
After reading this page you will be able to understand the annual report of a company, profitability ratios, leverage & liquidity ratios and activity ratios.
The annual report of a company forms the basis of financial statement analysis and all key information you will need is contained therein.
In order to analyze and compare financial developments over time, we will need at least three years of data and ideally five years of data.
Purpose of financial analysis
Financial analysis is used to determine the overall financial health of a company and how this has developed over the last few years. This enables better decision making for both the owners, debtholders and other stakeholders. For example, an employee could do his own financial analysis of a company to evaluate the attractiveness of one company over another. In other words, financial analysis of a company is relevant for all stakeholders.
Income statement analysis
The income statement shows how much a firm has earned over a pre-determined period of time. This will usually be a year (i.e. the annual report). The income statement contains the revenue of a company, subtracts the expenses and the end results is literally net profit for the year. In the simplest form, the income statement is:
= Profit for the year
The income statement is set up following a top-down structure. You start at the top with revenue and subtract the expenses line by line. The expenses “closest to revenue” will be variable expenses which varies directly with sales, followed by general expenses which are not directly associated with sales such as administration and marketing. The last expense item on the income statement (excluding taxes) is interest expenses, or in other words, the items that varies the least with revenue and thus are of fixed nature. The general outline of an income statement thus is:
– Cost of goods sold
= Gross profit
– Selling, general and administrative expenses (SG&A)
= Operating income
+/- Other income and expenses
+/- Interest income and expenses
= Pretax income
= Profit for the year
Balance statement analysis
A company’s financial position at a specific point in time is summarized on the balance sheet. The balance sheet is a representation of all the firm’s investments to the date (the assets) and how the acquisition of these assets have been financed (liabilities and shareholders’ equity). In the simplest form, the balance sheet is:
= Shareholders’ equity
As mentioned, the assets compose all of the firm’s investment to date. These investments are broken into current assets and non-current assets. Current assets represent the value of all assets that follow one or more of the criteria below:
- To be sold, realized or consumed within a normal operating period (usually 12 months)
- Primary purpose is to be traded (i.e. inventory is thus current assets)
- Is expected to be realized within 12 months after reporting date
- Is a cash or cash equivalent
As stated, if one or more of these criteria are met, the asset will be a current asset. If none of the criteria are met, it is a non-current asset. As an example of non-current asset a production plant satisfies none of the criteria above and will thus be a non-current asset.
Liabilities are set up in the same way as assets with a current and non-current part. The defining criteria are very similar to current and non-current assets. Current liabilities follow one or more of the criteria below:
- Settlement expected within a normal operation cycle
- Primary purpose is to be traded
- Is expected to be settled within 12 months after the reporting date (e.g. portion of long-term debt to be settled within the next 12 months)
If none of these criteria are met, the liability is a non-current liability. An example of a non-current liability is long-term debt to be settled in five years.
Shareholders’ equity is the amount that would be returned to shareholders if all the company’s assets were sold and all debt repaid or as we saw above:
= Shareholders’ equity
This is the indirect way of calculating shareholders’ equity. The direct way can be found directly on the balance sheet or in the notes and is defined as:
+ Retained earnings
– Treasury shares
= Shareholders’ Equity
Naturally, Shareholders’ Equity should be the same whichever method is used.
Cash flow statement analysis
The income statement, shows how much money a company has earned over a given period of time. However, this is not equal to the amount of cash the company has made. On the income statement, there are items (most notably depreciation), that has no cash effect and on the balance sheet, there are items that has a large cash effect but is not present on the income statement (most notably dividends paid and new loans obtained). Further, if products are sold on a 90-day credit, revenue will be recognized when the sale was made, but the cash inflow is only due in 90 day’s time.
Cash is king, and making a sale with the payment due in 100 years (an extreme example), might look nice on the income statement, but in reality, it will likely not have a positive effect which will be easily visible on the cash flow statement.
The cash flow statement is broken up into operating activities, investing activities and financing activities. In the simplest form the cash flow statement is the following:
Profit for the year
+/- cash flow from operating activities (ideally this is a positive number)
+/- cash flow from investing activities (this will usually be a negative number)
+/- cash flow from financing activities
= Net change in cash
As on the balance sheet there is also another way to get the net change in cash, which is very simple:
Cash and cash equivalents, end of period
– Cash and cash equivalents, beginning of period
= Net change in cash
And, as was the case on the balance sheet, these two measures should be equal whichever method is used.
All cash flows directly related to operating activities are presented here. Current assets and liabilities will usually be represented here, as they are directly tied to the operations of a company (e.g. inventory is very much a part of operations). Further, there are also other non-cash items on the income statement, that does not have any cash affect, most notably depreciations and secondarily, a write-off of an asset will also impact the income statement but not the cash flow statement.
Is usually represented by cash outflows to buy new production facilities, equipment or marketable securities. If a company divests an asset, it will show as a net cash inflow.
Financing activities covers changes to debt, loans and dividends. For example, if a company issues a new loan, it will result in a cash inflow and when interest is paid on the loan, it represents a cash outflow. Likewise, dividends paid to equity holders will also be a cash outflow.
Limitations of financial statement analysis
Knowing financial statement analysis is a great ability to have. Part of having this knowledge is also to know that limitations of that knowledge. The most important of these limitations/problems are in the following order:
Issues in comparing different periods: Companies often change accounting practices. Two examples of this are:
- An item that is part of cost of goods sold one year, can be part of administrative expenses the next year
- If assets or subsidiaries are sold earlier financial statements should be corrected for this effect, otherwise you are basically comparing two different companies
Issues with comparing companies: Two different companies in the same industry might have different accounting practices. The most common examples are:
- One company might activate development costs on the balance sheet and depreciate it over a number of years, while another chooses for it to show up as expenses. While in theory, it should be the same between two companies there is a lot of room for interpretation. The company putting the development costs on the balance sheet will have a higher net income compared to the other company expensing it
- The issues in comparing different periods also applies for comparing two companies. If two companies don’t have the same internal principles regarding their financial statements, one should be cautious of this when interpreting data
Lack of forward looking information: Two companies with the same financial history might have a very different outlook although their financial statements are similar. The most common examples are:
- Order backlog in the two companies could be very different. The company with the larger order backlog is naturally the better one, all else equal
These are the most important issues to remember. There will of course be other issues on a case-by-case basis, however, the one’s covered in this article will be sufficient in the majority of cases.