Financial Statement Analysis: 3 Ways to Analyze Financial Information

Financial statement analysis involves analyzing a company’s financial data to assess its performance. Company executives and in-house CPAs use financial statement analyses for decision-making and financial accounting. Shareholders and potential investors might use this data to measure a company’s ability to generate cash flow and pay dividends.

The relevant information for conducting financial statement analysis can be found mainly in four types of financial reports:

1. 1. Balance sheet: A balance sheet identifies a business’s present finances, including current assets and debts or liabilities owed. Organizations that deal with a significant amount of money, such as banks, usually prepare financial statements every day, while small businesses might prepare a quarterly statement or annual report. Finances appear in three categories on a balance sheet: assets, liabilities, and equity.
2. 2. Income statement: The income statement, sometimes called a profit and loss statement, illustrates profitability over a specific accounting period. In other words, it shows a company’s revenue, operating expenses, and gross profit. A common size income statement lists all line items in terms of percentages of total sales.
3. 3. Cash flow statement: Also called a statement of cash flows, this document shows cash and other earnings before interest, taxes, depreciation, and amortization. This document is essential for performing a cash flow analysis. The cash flow statement includes cash flow from operations, investing activities, financing activities such as bank loans, and revenue that a company has earned but has not yet received. (A related statement called a free cash flow statement looks at the cash flow left over after operations and capital expenditures are subtracted, and is useful for valuation purposes.)
4. 4. Shareholder’s equity statement: Companies use the statement on shareholder’s equity to reconcile the net income with the equity section on the balance sheet. Distributions, dividends, and capital injections are all recorded here, and the information is made available to shareholders and other stakeholders to assess the condition of their investment and get a more detailed picture of the company’s overall financial health.

To perform a financial statement analysis, consider the following methods:

1. 1. Horizontal analysis: A horizontal analysis, also known as a trend analysis, tracks performance changes over time. For an effective analysis, look at trends over different periods, usually with increments of a single year. Changes in dollar amounts and percentages show areas in need of improvement and where performance is on the right track.
2. 2. Vertical analysis: A vertical analysis compares different line items within the same statement. For instance, comparing total assets to cash would give the company or a potential investor a perspective on the liquidity of that company.
3. 3. Ratio analysis: Ratio analysis compares line items in a financial statement. Profitability ratios, leverage ratios, solvency ratios, and liquidity ratios can help assess a company’s financial position.

The following financial ratios are useful for assessing financial information:

1. 1. Liquidity ratio: The liquidity ratio is a financial ratio that reveals whether a company has enough working capital to pay down its short-term debt. Working capital comes from current assets—notably cash and cash equivalents (such as marketable securities that can be sold to create cash flow). The simplest way to calculate a company's liquidity ratio is to divide its current assets by its current liabilities. Often financial analysts focus squarely on short-term obligations; longer-term financial obligations are designed to be paid back over many years and do not necessarily reveal financial health.
2. 2. Current ratio: Calculating the current ratio of a company is the simplest and most common way of measuring liquidity. The current ratio looks at a company's total current assets—cash assets and otherwise—against their total current liabilities like debt obligations. The current ratio formula is: Current Ratio = Current Assets / Current Liabilities.
3. 3. Quick ratio: The quick ratio takes higher liquidity assets into account than the current ratio does. The quick ratio considers a company's cash and cash equivalents, short-term investments, and accounts payable against its current liabilities. Use this formula to calculate a party’s quick ratio: Quick Ratio = (Cash and Cash Equivalents, Accounts Payable, Short-Term Investments) / Current Liabilities.
4. 4. Debt-to-equity ratio: The debt-to-equity ratio is a profitability ratio that compares a company’s total liabilities with its shareholders' equity. Also abbreviated as a D/E ratio, it is calculated using the formula: Debt-to-Equity Ratio = Total Liabilities / Total Shareholders' Equity.
5. 5. Inventory turnover ratio: In a company's financial statements, the inventory turnover ratio is a metric that compares the cost of goods sold to the average value of inventory within an accounting period. The inventory turnover ratio formula is: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Value. The cost of goods sold (COGS) represents the expense of manufacturing a company’s products. COGS only includes direct costs like the price of the raw materials required to make the product and does not factor in indirect costs like those required to sell or market the product. The average inventory value represents the average cash value of the business's in-stock inventory in a period of time. An inventory turnover ratio can help business owners determine the number of times they turned, or sold out and replaced, their entire inventory in a given timeframe.
6. 6. Asset turnover ratio: The asset turnover ratio, also known as total asset turnover ratio, is an efficiency ratio that measures net sales revenue in relation to a company’s assets. Examples of assets include accounts receivable, cash, inventory, investments, equipment, and property. The asset turnover ratio is distinct from the return on assets (ROA), which is a profitability ratio that analyzes net income in relation to total assets. The asset turnover ratio formula is: Asset Turnover = Total Sales Revenue / Average Total Assets.
7. 7. Receivable turnover ratio: The accounts receivable turnover ratio (AR turnover ratio) is a bookkeeping metric that business owners use to compare total sales revenue to actual customer payments. When properly calculated over the course of an accounting period, an AR turnover ratio can show companies the average number of days their payment collections process takes. Companies measure AR turnover ratios because not all customers pay their bills on time. As a general rule, high-quality customers quickly pay invoices sent by an accounts receivable department. Other members of a customer base may be less reliable and not pay their bills for weeks or even months after invoicing. By monitoring an AR turnover ratio from one accounting period to the next, companies can predict how much working capital they’ll have on hand and help shield themselves from bad debt.

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