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Financial Statement Analysis: Concept and Methods

General understanding of financial statement analysis

Aiming to detect changes in company’s trends and relationships in order to make more successful economic decisions, the financial statement analysis (also referred as financial analysis of enterprise) is the process of analyzing and reviewing firm’s balance sheet (Statement of financial position), income statement (Profit and loss report) and other statements. It allows estimating company’s overall performance by calculating and comparing a complex of indicators, building the trend lines and making the conclusions on business health and sustainability. The users of financial statement analysis may be different: creditors, willing to find out more about the creditworthiness of firm; investors, who want to measure firm’s ability to issue dividends and company’s management.

Financial statement analysis methods

First of two key methods of the financial statement analysis is the use of horizontal and vertical analysis.

Horizontal financial statement analysis means the comparison of the information from the financial report of a company over some certain time periods. Both the financial information and the ratios derived from it can be compared. In other words, horizontal analysis (very often referred as trend analysis) is reviewing and comparing the dynamics of the same indicators and making conclusions on company’s performance over time. As said before, this analysis method may be applied the financial statement information itself and to ratios derived from it, so the horizontal analysis may include either absolute values comparison or percentage comparison. Ratios and indicators of a company can also be compared to average values in the economic sector or values of competitors.

Vertical analysis is a process of comparison of one item to the base item. Commonly, the vertical analysis is conducted for the financial statement of a single period (unlike the horizontal analysis, which is reviewing information over at least two different periods of time, or more). Also referred as common-size analysis, vertical analysis generally means usage of total assets or total liabilities or shareholders’ equity as base figures of the proportion. The main reason for performing the vertical analysis for one single period is seeing the relative proportions of different elements of assets and sources of finance. The second method of the financial statement analysis is ratios calculation and interpretation. Many ratios, showing the relative size of one number in relation to another exist, and being able to measure them and see their dynamics over time is extremely useful in terms of understanding firm’s performance and position.

The above-mentioned ratios may be grouped into several sets:

1. Liquidity ratios. The most important group of ratios in terms of firm’s debt paying ability. Includes the following ratios:

Current ratio, that indicates a firm's ability to pay its current liabilities from its current assets.

Quick ratio, measuring how well a company can meet its short-term obligations with its most liquid assets.

Cash ratio, showing how well a company can pay off its current liabilities with only cash and cash equivalents.

Liquidity index, measuring the amount of time required to convert assets into cash.

2. Activity ratios. These ratios are used to measure the efficiency of a company, describing how well it uses the assets, leverage or other balance sheet items of that kind:

Total asset turnover, measuring firm's ability to generate sales from its assets. Working capital turnover, measuring the amount of revenue, generated by the working capital.

Accounts receivable turnover, which measures how many times during a period the business can turn accounts receivable into cash.

Accounts collection period, that estimates the time needed to receive all the payments owed in terms of receivables.

Accounts payable turnover, that measures how many times during a period a company pays its suppliers.

Days payable outstanding, calculating the average number of days taking a company to pay its suppliers.

Inventory turnover (days inventory outstanding), indicating how many days it usually takes a firm to turn its inventory into sales.

3. Profitability ratios. This is a set of ratios, measuring the fundamental criteria of company’s performance – the ability of a company to earn a profit. Most commonly used are the following ratios:

Net profit margin, measuring net income generated by 1 dollar of sales.

Return on equity, that measures the ability of a firm to generate profits from the shareholders’ investments.

Return on assets, measuring the amount of income, generated by company’s assets during the period.

4. Financial sustainability ratios. A set of ratios indicating firm’s ability to pay its debt. The long-term debt-paying ability can be measured by the following ratios:

Times Interest Earned, measuring how many times a company could cover the interest expense with its income.

Debt Ratio, which indicates firm’s long-term debt-paying ability by comparing its total liabilities to total assets.

The Long-Term Debt to Total Capitalization Ratio, that is a measure of the company’s financial leverage. To calculate it the long-term debt should be divided by total capital available.

Debt to Equity Ratio, which compares the total debt of a company with the total shareholders’ equity.

Debt to Tangible Net Worth Ratio, measuring the physical cost of a company, excluding all the value derived from intangible assets.

Summary

The essence of the financial statement analysis of a company is the usage of different methods of emphasizing the comparative and relative importance of the data, presented in the financial report of a company in order to evaluate company’s performance and position. These methods include horizontal and vertical analysis, calculation of various ratios, studying and interpreting their values in order to make right conclusions on the business.

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