What’s it: Financial statement analysis is a process to assess and evaluate the past performance and future prospects of the company. To do this, you need not only financial statements but also other relevant information. You need data such as operational data, industry, economic statistics as supporting information.
Why it matters: Financial analysis is a critical step in making economic decisions related to companies. Securities analysts do this to draft reports before recommending buying or selling shares. Creditors analyze financial statements before making a decision to offer a new credit facility.
Scope of analysis
Evaluating a company’s financial performance requires you to:
- Analyze financial ratios to assess profitability, solvency, working capital management, liquidity, and operating effectiveness.
- Compare current performance with historical conditions using trend analysis.
- Compare with peer companies or industry averages to find out how well companies are performing.
What do you need
You need supporting information in addition to financial statements. The annual report is the first in which management discusses essential aspects of the company’s operations and targets in this report. Other information you may need to collect is interim reports and company presentations. The press release is also essential because it provides current information about the company.
For public companies, you can find documents on the company or regulatory websites such as stock exchanges.
Next, you also need to gather information about the economic conditions, industry, and competitors. This information is useful to provide a more detailed understanding related to external factors that affect company performance.
What are the stages of financial statement analysis
In brief, the framework for financial statement analysis usually involves the following steps:
- Determine the purpose of the analysis. You need to determine what questions you want to answer through the study. The objective identifies the approach, tools, data sources, and format that you use to present the results.
- Collecting data. You then gather the necessary information. For example, to analyze a company’s historical performance, you might only need to use financial statements. When you want to examine more comprehensively, for example, valuing the company’s stock price, you need data such as economic and industry reports.
- Processing data. You need to convert financial data into useful statistics such as financial ratios or growth percentages. The more in-depth analysis may require not only descriptive statistics but also inferential statistics such as regression.
- Interpret statistics. To conclude, you might not only analyze historically but also compare with peer companies or industry averages.
What should you focus on
You can use two general approaches to analyze financial statements. First, you analyze several significant accounts and compare them from time to time. Second, you can use financial ratios.
You also need a comparison to answer the question: how well does the company perform. That will help you make a more objective opinion. To do this, you can take several company peers or industry averages.
Analysis usually focuses on performance dimensions, such as:
- Profitability, namely, the ability to generate profits from core business activities. You focus on accounts such as net income, EBIT, EBITDA, and operating income. You can also use several ratios such as gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE).
- Efficiency in generating profits and cash. You can assess it through indicators such as inventory turnover, accounts receivable turnover, accounts payable turnover, fixed asset turnover, and asset turnover.
- Ability to make cash. You might analyze trends like cash flow from operating activities, free cash flow, and EBITDA; comparing them from year to year and industry averages.
- Ability to meet short-term (liquidity) and long-term obligations (solvency). Some useful liquidity indicators are the current ratio, quick ratio, cash ratio, cash conversion cycle. Meanwhile, for solvency, you can use debt to equity ratio, debt to EBITDA, interest coverage, and debt to capital.
What to read next
- Financial Statement: Importance, Components, Users
- Financial Statement Analysis: Scope, Required Information, Steps, And Methods
- Financial Reporting: Importance, Effective Criteria
- Financial Reporting Framework: Meaning, Criteria