How to harness the power of financial statement analysis?

What is financial statement analysis?

Financial statement analysis is the process of examining a company’s financial statements in order to better inform decision-making, strategies and policies. This type of analysis may be conducted by external stakeholders looking to grasp the overall financial health of a company, to assess performance, calculate the impact of bad debts, and to inform decisions about future collaboration or investment.

It may also be conducted by external authorities such as government agencies or auditors to ensure compliance with relevant regulations.

Finally, it can be carried out in-house, to help internal stakeholders track the company’s performance, identify and compensate for any weaknesses, and inform decisions on the future growth of the company.

Generally, financial statements are published according to the company’s accounting cycle in its annual report, covering the fiscal year, although a financial analyst can prepare them at any time if a snapshot of the financial health of the company is needed.

Types of financial statements

Companies generally have a number of different financial records which record the business’s activities and its financial performance. These range from daily journal entries through to the published financial reports. Such documents are often required for regulatory purposes and may be audited by government agencies and auditors for tax purposes, by banks and investors for funding and investment purposes, and by external or internal accountants and advisors for the purposes of guiding the future of the company.

Depending on their size and the regulations binding upon them, different companies will prepare different types of financial statements, all of which can provide vital information on company performance.

The main types of financial statements are the company’s balance sheet, its cash flow statement and its income statement.

The balance sheet

The main information presented in a company’s balance sheet are its assets, liabilities, working capital and capital employed.

In simple terms, a company’s assets are the things it owns, while its liabilities are the things it owes.

Assets can be divided into current assets and fixed assets. Current assets are things that the company “owns” in the short term (usually defined as less than a year), and includes such things as stocks, cash, raw materials. Fixed assets are long-term (generally over a year) assets, such as property, equipment, and vehicles. These assets are affected by depreciation over time, which is also recorded in the balance sheet.

Liabilities can also be current or long-term. Current liabilities include repayments such as business loans, credits, overdrafts, while long-term liabilities include debts such as mortgages and longer-term loans.

The cash-flow statement

The second main type of financial statement is the cash-flow statement, which summarises movements of cash (and cash equivalents) entering and exiting the company.

Analysis of the cash-flow statement can provide an instant picture of exactly how healthy the company is, identifying exactly how much operating cash flow (OCF) is available. This is also known as the company’s “liquidity”. External stakeholders find this information crucial as it can reassure them as to whether the company is breaking even.

The main elements which appear in the cash-flow statement are operating cash flow (OCF), cash flow from investing activities, and cash flow from financing activities.

Cash flow from operations includes cash generated and incurred by the business through such things as the sale of goods and services, interest payments, rent payments, payments of salaries and wages to employees, payments to suppliers, income tax payments.

Cash flow from investing activities include transactions relating to loans and investments, the sale or purchase of assets, and payments relating to any mergers or acquisitions.

Cash flow from financing activities covers cash from investors or banks in the form of dividends, repayment of loans and so on.

Without going into too much detail, there are two main methods of calculating cash flow: the direct method and the indirect methods. The most appropriate formula for your business will largely depend on the accounting method you use.

The income statement

Income statements (also sometimes referred to as “profit and loss statements”) provide invaluable information on corporate performance. In contrast to the balance sheet, which records assets and liabilities, the income sheet records income and expenses.

Income statements include such information as revenue, expenses, cost of goods sold, gross profit, operating income, net income, depreciation and EBITDA. Each of these categories is often broken down into further sub-categories to provide detailed information.

How to analyse a financial statement

Analysis of a company’s financial statements in the form of its balance sheet and its income statement is usually undertaken by a financial analyst. However, it is possible to understand the basics of financial statement analysis without being a specialist.

There are three main types of financial statement analysis, known as “horizontal analysis”, “vertical analysis” and “ratio analysis”. All three can give insight into a company’s performance and, generally speaking, they are all used to provide a comprehensive picture of the financial health of the business. 

Horizontal analysis

Horizontal analysis involves comparing balance sheets and income statements over different periods of time. For example, you could compare a company’s balance sheet in 2010 to its balance sheet in 2015 to see whether it grew over that period. This year-by-year analysis may, for example, compare gross profit in Year 1, Year 2 and Year 3 to see whether the company is heading in the right direction.

Vertical analysis

Vertical analysis involves comparing different elements within a single statement to one another in the form of percentages. For example, vertical analysis can help identify the proportion of revenue generated from sales. The key aspects that financial analysts look at when conducting a vertical analysis are the cost of goods sold, gross profit, depreciation, selling general and administrative, interest, earnings before tax, tax and net earnings, all as a percentage of the company’s revenue.

Ratio analysis

The third type of financial statement analysis is known as “ratio analysis”. This involves analysing various components of the balance sheet, income statement and cash flow statement to identify trends (i.e. upwards or downwards) and to compare the company with other, similar or competing companies. This helps analysts understand the position of the company within its market and can help identify gaps in the market, unique selling points and other competitive advantages.

Harnessing the power of financial statement analysis

This preliminary exploration of financial statement analysis demonstrates the importance of maintaining meticulous financial records so that the wealth of information they contain can be used to promote the future performance of your company.

Introducing integrated spend management solutions and tailor-made accounting software helps you harness information about your daily activities, while leaving you free to focus on your core business.

Find out more by contacting Mooncard today for a demonstration of exactly how our solutions can help you build upon the solid foundations of financial statement analysis.