What is Financial Statement Analysis
Financial statement analysis evaluates a company’s value through its historical data in the three basic financial statements. These are the balance sheet, income statement, and cash flow statement. It entails the interpretation and study of financial data. This financial assessment presents the company’s profitability, operational efficiency, cash flow cycle, working capital requirements, capital expenditures/expansion requirements, and debt servicing capacity. Such information is critical to effectively run the day-to-day operations and build long-term plans.
What are the Common Types of Financial Statement Analysis
Ratio Analysis. Ratio Analysis evaluates the financial information related to other information in the same financial reports. These consist of the following.
- Profitability Ratios assess how well a company is generating profits from its operations.
- Liquidity Ratios determine a company’s ability to meet its short-term obligations.
- Solvency Ratios measure a company’s level of debt and how much a company relies on debt financing to finance operations or investments.
- Activity Ratios appraise a company’s operational efficiency or how well it uses its assets to generate revenue.
Vertical Analysis. Vertical analysis involves comparing the items in the financial statements as a percentage of a common base.
Horizontal Analysis. Horizontal analysis entails comparing financial data from multiple periods to identify changes or trends.
What is Needed to Conduct Financial Statement Analysis
To prepare for financial statement analysis, a company must have complete records of its revenues, expenses, payments, deposits, purchases, invoices, and all other business transactions to generate reliable financial statements.
The three primary financial statements are the balance sheet, income statement, and cash flow statement. Balance Sheet is a list of the company’s resources (assets) and who funded these assets, which are either through loans (liabilities) or owner’s investment (equity). The income statement reports how much profit/money the business is generating. The Cash Flow Statement tells us how cash moved in the business during a specific period. It shows the beginning cash balance, how much money went in and out of the company, and the ending cash balance.
A review of these statements will help assess the business’s financial health, including margins generated, efficiency in capital utilization, and availability of cash to cover the company’s obligations.
How to Maximize the Use of Financial Statement Analysis
- Accuracy. The reliability of financial statements in business decisions depends on the accuracy of the data used in building these financial statements. A financial analysis based on incorrect data will result in decisions based on false assumptions that may be costly.
- Timeliness. Information should be current and relevant. Outdated financial statements may reflect something other than the financial situation when a decision must be made.
- Consistency. Financial reports must be prepared to show the same information periodically. This allows management to see progress, trends, or unusual incidents and promptly act on them as needed. This will also enable them to make quick decisions if required.
What are the Limitations of Using Financial Statement Analysis
- Reliance on Historical Data. Financial analysis based solely on financial statements will be limited to historical data. While this information reflects past financial performance, it does not provide insights into current or future circumstances.
- Limited Scope. In making business decisions, assessment should not depend solely on financial analysis. Other non-financial factors such as industry trends, technological advancement, consumer behavior, competitive positioning, and market conditions must likewise be considered.
Why a Business Owner Must Know How to Interpret Financial Statements
A Business Owner must understand the company’s financial performance well, as this will guide him in making critical business decisions. Tracking the movement of the financial data provides information as to the stability and profitability of the business. It also provides triggers in case there is an abrupt change in the numbers or trends, which can be immediately reviewed and acted upon.
What Are Possible Business Decisions That Will Rely on Financial Statement Analysis?
- To invest or not. Prospective investors will look at financial analysis reports to help them decide whether to put in capital and for how much in a business opportunity.
- To hold share or exit. An existing shareholder will look at financial analysis reports if he needs to decide whether to hold on to his investment or if it is time to sell.
- To pursue business plans. The company’s management must evaluate financial performance through financial analysis reports to formulate plans and policies.
- To assess debt management. Management will look at the financial analysis reports to determine if there is a need to avail of loans and their capacity to repay them. If the company has an existing loan, financial analysis reports will help management understand its position in meeting its obligations and complying with loan covenants.
- To pursue expansion or diversification. Management may identify opportunities to expand its market or diversify its products. The financial analysis reports will provide information that may be used to weigh the benefits or challenges of such a decision in the company’s financial standing at a given time.
- To take immediate action as needed. Consistent and periodic review of financial statement analysis reports will enable management to make prompt business decisions in various areas of operations. They can identify the trends worth pursuing, areas needing more control and monitoring, expense accounts that can be subject to cost-cutting measures, or abrupt changes that need further review or investigation.
Why is Financial Statement Analysis Important
While most businesses prepare financial statements, business owners must fully utilize this information to thoroughly understand their financial situation and how they can be more competitive in today’s economy.
Every company’s activity, action, and decision are linked to finances. As such, financial statement analysis will inform the Business Owner about which activities will generate more profit, which will affect cash flow, which will provide stability for its day-to-day operations, and which should be pursued for long-term benefits.
For financial statement analysis to be relevant as a guide in making business decisions and taking appropriate action to ensure continued growth and profitability, these financial statements must be based on the timely recording and reporting of accurate and complete transactions.