Understanding Financial Statement Analysis Techniques

What Is Financial Statement Analysis?

The procedure for determining an organisation’s fiscal viability and direction consists of evaluating the organisation’s financial data, specifically, the organisation’s income statements, balance sheets and cash flow statements to evaluate its overall health, profitability and operational efficiency. It enables investors, creditors and internal management to make informed decisions and guide strategic planning. Common focus of a project that includes financial statement analysis:

• Review of an organization’s Past performance, financial position and cash flow.
• Strengths and weaknesses of an organization
• Comparison of financial results with other organizations in the industry or market
• Common techniques include Horizontal, Vertical and Ratio analysis.
• Support for the organization’s forecasting and decision making processes

Core Financial Statements Used in Analysis

• Income Statement : An income statement indicates an organisation’s total income, expenses, and profit over a defined time. The income statement is broken into three parts that help to analyse business efficiency at three different points. Analysts analyse this information to determine:

• • • Analysis of Revenue Growth Trends
    • Evaluation of Cost Efficiency
    • Assessment of Operating Margin and Net Profit Margin

  Basic income statement analysis includes calculating Gross, Operating and Net Profit Margins, which divide profit by revenue. An increase in margins over a sustained period may indicate either increased pricing power due to increased demand for goods or services or greater efficiency from operating activities

• Balance Sheet : The balance sheet is a reporting tool that summarises assets, liabilities, and equity at a single point in time. The Balance sheet balances assets and liabilities to equal shareholder equity, representing the book value an important performance metric that changes with financial activities.  This statement provides the following:

• • • An Evaluation of Liquidity Position
    • An Evaluation of Capital Structure
    • An Evaluation of Financial Stability

  Maintaining a balanced asset or liability structure over a longer period, as an organisation continues, is critical to long-term survival.

• Cash Flow Statement : The cash flow statement shows the inflows and outflows of cash from operating, investing, and financing activities. Analysing cash flow is important because profits are not necessarily an indicator of liquidity. Research shows that a majority of all business failures are due to cash flow problems, even among those firms that are profitable.
  The companies and analysts also use Free Cash Flow statements and other valuation statements to analyse the value of a company. Free cash flow statements arrive at a net present by discounting the free cash flow that a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public.

Key Financial Statement Analysis Techniques

• Ratio Analysis : Financial ratio analysis has been used to report on a financial statement and analyse the financial information and assist project managers with their analysis and report writing. A summary of the most common categories of ratios:

• • • Liquidity Ratios
    • Profitability Ratios
    • Solvency Ratios
    • Efficiency Ratios

  Ratios allow for the analysis of data over time and allow for the analysis of the data of businesses within the same business sector.

• Horizontal Analysis : Analysis of horizontal financial data allows for the identification of growth trends and patterns in financial performance over multiple years.

• • • Advantages of horizontal financial data analysis.
    • Identify growth rates for revenue and expenses.
    • Identifying emerging cost pressures.

  Identifying future revenue growth, for example, a company with a consistent annual growth rate of 10% – 12% per year may have the potential for future growth in revenue.

• Vertical Analysis : Vertical analysis of the financial statements records the value of each line item as a percentage of the base value for that line item. Comparing a company’s line items on the income statement and using that value as a percentage of the base revenue value allows for the comparison of companies of different sizes in the same sector. This allows for the identification of cost structures that differ between companies.
• Cash Flow Analysis : Analysis of Cash Flows Uses Cash Flow Information to Assess:

• • • Operating cash flow adequacy
    • Generating Free Cash Flows
    • Repayment of Debt and Expansion Funding

  Many View Strong Operating Cash Flow V. Net Profit as a Sign of high-quality earnings

• Comparative and Benchmark Analysis : Benchmarking against:

• • • Industry averages
    • Competitors
    • Historical performance

  It provides the context needed to avoid confusion when reading numbers in isolation. Benchmarking will typically form the basis of the evaluation component of most company’s financial statement analysis projects.

Importance of Financial Statement Analysis

The following uses of financial statement analysis support.

• Making investment decisions
• Tracks Growth and trends by comparing financial reports across multiple periods, stakeholders can identify revenue patterns, growth trajectories and early warning signs of potential business failures.
• Evaluating borrower’s credit worthiness to determine lending decision by banks, credit unions, and other financial institutions
• Making corporate strategic plans and establishing budgets
• Identifying and managing risk

Because analysis of company financial statements focuses primarily on quantitative number analysis, educational institutions that offer degrees in commerce and finance place significant emphasis on these tools to assist students in building analytical and decision making capabilities.

Limitations of Financial Statement Analysis

Financial statement analysis is useful but also has many limitations.

• It is based on historical data.
• The analysis is final based on a determination made by management in both accounting policy and estimates.
• Qualitative factors such as quality of management and brand strength are not adequately addressed in any financial statement analysis.
• Assets and Liabilities are usually recorded at historical cost, ignoring Inflation and distorting true economic value.
• Management may artificially inflate figures around reporting deadlines to present a more favourable financial condition.
• Exclusion of Internally Generated Goodwill.

Regulatory Framework in India

• The Companies Act, 2013: Section 129 requires a company’s annual financial statements must be true & fair view of its financial affair and all companies registered in India to prepare Financial Statements for each Financial year. Section 134 governs the approval, signing and disclosures of a company’s Financial statements and the Board of Director’s Report.
• Securities and Exchange Board of India (SEBI): Companies listed on the stock exchange are required to submit and disclose quarterly and annual financial results under the SEBI Listing Obligations and Disclosure Requirements (LODR) Regulations.
• The Institute of Chartered Accountants of India (ICAI) and Indian Accounting Standards (Ind AS): ICAI prescribes accounting rules (Ind AS) that are followed while preparing financial statements.

Global Framework

• Generally Accepted Accounting Principles (GAAP): Provide a standardized framework for preparing Financial Statements. It ensures financial statements are Consistent, Transparent and Comparable, allowing stakeholders to evaluate a Company’s Health, Analyse Trends and Benchmark competitors effectively.
• International Financial Reporting Standards (IFRS): It is an International standard for financing reporting that ensures that financial statements are transparent and comparable across the world.