Maintaining financial accounts such as balance sheets, income statements, and so on is critical for a business. It examines them in terms of internal and external stakeholders. This aids in determining a company’s financial health or performance in order to make decisions based on this information.
what is the definition of financial statement analysis?
The process of examining and interpreting a company’s financial statements is referred to as financial data analysis or financial statement review.
These are official documents that provide information about a company’s financial performance. The balance sheet, income statement, and cash flow statement are the statements used in the analysis.
businesses and financial analysis
Successful firms thoroughly examine their financial statements in order to assess performance across all dimensions. Financial management is vital to this achievement. Numerous options are available today to assist business owners with financial management.
how should financial statements be analyzed?
step 1: get the financial statements.
The first stage is to gather a company’s financial statements, which usually contain the balance sheet, income statement, and cash flow statement. These statements provide an overview of the company’s financial situation, profitability, and cash flow for a given time.
step 2: go over the balance sheet.
The balance sheet can be used to evaluate the company’s obligations, assets, and shareholders’ equity. Furthermore, it evaluates the company’s liquidity by examining its current assets (e.g., cash, accounts receivable) and current liabilities (e.g., short-term debt, accounts payable).
step 3: analyze the income statement
The income statement summarizes the company’s revenues, costs, and net income for the fiscal period. As a result, this stage entails assessing revenue trends, gross profit margin, operational profit margin, and net profit margin.
Finally, these results will be compared to industry benchmarks or historical data to determine the company’s profitability.
step 4: look at the cash flow statement.
In financial statement analysis, the cash flow statement summarizes the company’s cash inflows and outflows during a specific period. This phase requires you to seek sections on operating cash flow, investing cash flow, and financing cash flow.
Furthermore, it analyzes the company’s ability to generate cash from core operations and its investment and financing activities.
step 5: determine financial ratios.
Financial ratios provide insight into numerous areas of a company’s performance and can assist organizations in comparing their performance to that of their industry counterparts. Profitability ratios, leverage ratios, liquidity ratios, and others are all critical to calculate.
step 6: perform trend analysis
To find trends and patterns, compare financial statement data across multiple periods. Examine key measures such as revenue, profit margins, and ratios for a consistent increase or reduction. This examination can aid in comprehending the company’s financial trend.
the different types of financial statement
Below are the four basic financial statements you must know:
1. income statement
In financial statement analysis, the income statement summarizes a company’s sales, expenses, and resulting net income or net loss for a specified period. This is frequently a fiscal quarter or year.
It demonstrates the company’s potential to make profits by outlining the revenues earned and expenses incurred over the specified time.
parts of an income statement
- Sales Revenue
The top line is all the money that came into the business throughout the month before any expenses were deducted.
- Cost of Goods Sold (COGS)
It is the money Sara spends to earn her sales revenue. That is usually the wholesale cost of products for a retail shop like Sara’s.
- Gross Profit
Sara’s gross profit is her income after deducting COGS but before deducting general expenses.
- General Expenses
Sara’s monthly expenses include money she must spend to keep her business running and create sales. Some of these, such as rent, will be consistent from month to month. Others, such as utilities and office supplies, may change.
- Operating Earnings
Operating earnings (or EBITDA – Expenses Before Interest, Depreciation, Taxes, and Amortization) equal the total amount Sara receives after deducting expenses from revenue. Still, before deducting any taxes or loan interest, she must pay.
- Income Tax Expense
The cost of projected income tax paid or payable for the reporting period is referred to as an income Tax expense. This is part of the IT in EBITDA, along with interest payments (which Sara does not have).
- Net Profit
Net profit is the company’s entire amount after deducting all expenses, including taxes and interest.
explore more: top 7 things venture capitalists look for in a business plan
using financial ratios to analyze an income statement
You may assess your income statements using three essential financial ratios. They all compute different profit margins – the difference between income and expenses.
- Gross Profit Margin
Your gross profit margin is the amount your company makes per dollar produced after deducting COGS. This margin can be increased by lowering COGS (saving money on the wholesale cost of products and services) or boosting prices.
Use the following formula to calculate the gross profit margin:
Gross Profit Margin = (Sales Revenue – COGS) / Sales Revenue
Using the preceding example, we get:
Margin of Gross Profit = (9,000 – 4,000) / 9,000 = 0.55, or 55%
Sara’s gross profit margin is 55%, which means she keeps $0.55 of every dollar earned.
- Operating Profit Margin
Your operational profit margin is similar to your gross profit margin but includes general expenses. This profit margin can be increased by boosting pricing, cutting COGS, or lowering operational expenses and overhead.
Use the following formula to calculate the operating profit margin:
Operating Profit Margin = EBITDA (Earnings Before Interest and Taxes) / Sales Revenue
That looks like this for Sara:
Operating Profit Margin = 2,750 / 9,000 = 0.31 (about 31%)
So, after deducting EBITDA, Sara earns $0.31 for every dollar she earns.
In order to earn more profit, you will typically focus on improving the operational profit margin. Interest and tax expenses are typically uncontrollable.
After all, Congress determines tax rates, while lenders determine loan rates. However, because your day-to-day activities determine EBITDA, your operating profit margin is the percentage you control most.
- Gross Profit Margin
The net profit margin is the link between your bottom line and your sales revenue; it is the total amount you keep after deducting all expenses.
Your net profit margin is calculated as follows:
Net profit margin = Net Income / Sales Revenue.
That looks like this for Sara:
Net profit margin = 1,850 / 9,000 = 0.21 (about 21%).
So Sara gets $0.21 for every dollar she makes.
- Balance Sheet
The balance sheet provides information about the company’s financial situation at the end of a fiscal quarter or year. It accurately represents a company’s liabilities, assets, and shareholders’ equity.
While assets are the company’s assets, liabilities are what the company owes. In contrast, shareholders’ equity indicates the owners’ residual interest in the company’s assets after deducting liabilities.
types of balance sheet
- Assets
Assets are all of the assets you own. Some of it is hard cash, such as the business bank account line item in the preceding example, which has $20,000.
Some of it, such as equipment or inventory, is less liquid. Accounts receivable, or money someone owes you, may not even be in your hands.
- Liabilities
Liabilities are expensive. Subtraction from your assets offers you an indication of how much worth your company has to work with.
In the preceding example, accounts payable—typically payments to vendors or contractors—could be regarded as a short-term liability; you’ll most likely pay them off each month. Other liabilities, such as business loan debt, last longer.
- Owner’s Equity
Owner’s equity is the sum of money you invested in the company. Capital refers to your first investment or the money you used to start. Retained earnings are the profits that your company has kept.
Drawing, also known as owner’s draw, is the money you earn from your firm. (You should not use your company’s retained earnings as a personal spending account for the sake of neat accounting and liability.)
explore more: annual budgeting guide for startups
using financial ratios to analyze a balance sheet
These three financial ratios allow you to perform a basic balance sheet analysis.
- The Current Ratio
The current ratio assesses your liquidity by determining how readily your current assets can be converted to cash to satisfy your short-term liabilities. Your assets will be more liquid if your ratio is higher.
Use the following formula to compute the current ratio:
Current Ratio = Current Assets / Current Liabilities
Using the preceding example, the calculation is as follows:
36,000 / 11,000 = 3.27 Current Ratio
Meaning of the ratio of 3.27:1. (liabilities: assets)
Your current ratio should not fall below 2:1; if it does, you don’t have enough current assets to cover your short-term commitments and are in trouble. The greater your ratio, the better your ability to cover liabilities.
- Rapid Ratio
The quick ratio (the acid test ratio) is similar to the current ratio in that it assesses how well your company can pay off its obligations. However, it only considers highly liquid assets such as cash or assets that can be rapidly converted to cash—that is, money that can be obtained immediately.
Use the following formula to compute the quick ratio:
Quick Ratio = (Cash and Cash Equivalents + Accounts Receivable + Marketable Securities) / Current Liabilities
In the above example, the total amount of cash equivalents and cash plus accounts receivable is $24,000. Nora’s Ceramics lacks marketable securities.
We don’t count the equipment line item in these assets because selling off equipment takes time.
So the formula is as follows:
24,000 / 11,000 = 2.18 Quick Ratio
Or a (quick assets: liabilities) ratio of 2.18:1
You’re doing well if your quick ratio is 1:1 or greater; you have enough liquid assets to cover your debts.
- Debt-Equity Ratio
The debt-to-equity ratio indicates how much your company relies on equity versus borrowed funds.
Use the following formula to establish your debt-to-equity ratio:
Debt to Equity Ratio = Total Debt / Owner or Shareholders’ Equity
In the preceding example, we include long-term debt but not accounts payable in the computation.
So our formula is as follows:
Debt-to-Equity Ratio = 10,000 / 25,000 = 0.4
(debt: equity) or a ratio of 0.4:1.
Nora is doing well in this scenario. A debt-to-equity ratio of 4:1 is deemed appropriate. Nora is able to run her firm entirely on her own money, thanks to all of her retained earnings.
- Cash Flows Statement
The cash flow statement details a company’s fund inflows and outflows over a fiscal year. It divides the cash flows into three categories:
- Operating activities (cash generated from core business operations), 2. Investing activities (cash used for asset investing)
- Financing activities (cash used to fund the company’s operations)
Generally, these financial statements are prepared in accordance with accounting rules and standards such as GAAP, Generally Accepted Accounting Rules, and IFRS, or International Financial Reporting Standards. The jurisdiction and the reporting requirements determine it.
parts of a cash flow statement
Keep in mind that the figures in brackets are currency subtractions—they can be read as negative amounts. Additions are numbers without brackets.
- Cash, Beginning of Period
Samy’s cash at the start of the period is the cash she has on hand at the start of the month.
- Net Income
Her net income is her total monthly income. Depending on how much of that income is in accounts receivable (unpaid) or the bank (paid), some or all of it may be deducted from the cash flow statement.
- Additions to Cash
Cash additions offset expenses recorded on the books but have not yet been paid out. Suraya, for example, owes $500 in accounts payable but hasn’t paid it.
For accounting purchases, the $200 depreciation is symbolic—she previously paid that $200 as part of the total cost of the object she’s depreciating.
- Subtraction from Cash
Subtraction from cash is used to reverse any transactions recorded as monthly revenue but never received. It’s $1,000 in accounts receivable in this scenario.
Samy’s net cash from operating operations is $700, which means she received $700 in cash during the month.
- Cash Flow from Investing Activities
Real estate, machinery, and stocks are among the assets that contribute to cash flow from investing operations. Samy invested $500 in a sewing machine this month.
This is documented as a $500 increase to her equipment account on the books. However, she paid $500 in cash for it. Therefore, the total amount must be deducted.
- Cash Flow from Financing Activities
Cash flow from finance activities includes money earned from loans, credit, and other debt interest. It may also include further capital inputs or draws from the business owner.
- Cash Flow for Month Ending
For the month ending March 31, 2020, cash flow is $200. Samy’s entire cash flow from operations ($700), less the cash she spent on equipment ($500), equals this figure. This month, she received $200 in cash for her business.
- Cash at the End of the Period
Ultimately, she has $2,200 in cash, which is the sum of the money she had at the start, plus the money she earned this month.
analyzing a cash flow statement with financial ratios
Financial cash flow ratios can tell you how much cash you have on hand to cover debt and how much of your income was in the form of cash during the month. Here are three formulas to assist you.
- Current Liability Coverage Ratio
The current obligation coverage ratio compares how much cash flow you have for a certain period to how much debt you must pay in the near future—typically, within a year.
To utilize this formula, you must first determine your current average obligation. Your current liabilities can change from month to month as you pay down the principal on a debt; calculating an average accounts for this so you can get a rough approximation.
Add all your current liabilities at the start of an accounting period and your current liabilities at the end, and divide them by two.
Assume Samy’s balance sheet displays $1,000 in total current liabilities at the start of March and $900 at the end.
(1,000 + 900) / 2 = 950
Her current average obligation is thus $950.
Here’s how to figure out your current average liability ratio:
Average Current Liabilities / Net Cash from Operating Activities = Current Average Liability Ratio
That would look like this for Samy:
Current Liability Ratio = 200/950 = 0.21, or 21%
A current liability coverage ratio of less than 1:1 indicates that the company isn’t earning enough cash to satisfy its immediate obligations. Samy’s business has the opportunity for improvement in this situation.
- Ratio of Cash Flow Coverage
The cash flow coverage ratio, like the current obligation coverage ratio, gauges how well you can pay off debt with cash. This ratio, on the other hand, considers all debt, including long- and short-term.
A solid cash flow coverage ratio is vital for attracting investors, obtaining a loan, or selling your firm; it demonstrates that your company is financially healthy and capable of covering its debts.
Cash flow coverage is calculated on a yearly rather than monthly basis. Samy would then total the operating cash flow from her monthly cash flow statements for the year to calculate her annual cash flow.
For the sake of simplicity, we’ll assume Samy’s monthly cash flow from activities was exactly $700. Her overall cash flow for the year is, therefore, $8,400.
The formula is as follows:
Net Cash Flow from Operations / Total Debt = Cash Flow Coverage Ratio
Assume Samy has $5,000 remaining on a loan she took out to start her firm, in addition to her $1,200 credit card debt. Total debt is $6,200.
The equation for her would be 8,400 / 6,200 = 1.35
Experts generally advise keeping your cash flow coverage ratio above 1.0 to attract investors.
- Cash Flow Margins Ratios
The cash flow margin ratio indicates how much cash you earned for every sales dollar during the reporting period.
This formula is used to determine the cash flow margin ratio:
Net Cash from Operating Activities / Net Sales = Cash Flow Margin
Assume Samy earned $1,200 in net sales in March. Her cash flow margin ratio would be 700/1,200 = 0.58 or 58%.
So, for every dollar of sales revenue Samy generated in March, she received $0.58 in cash.
what advantages does financial statement analysis offer?
- Performance Assessment
Financial statement analysis aids in evaluating a company’s past and present financial performance. Stakeholders can examine profitability, liquidity, efficiency, and other aspects of the company’s operations by analyzing financial ratios, trends, and other indicators.
They can use this study to compare the company’s performance to industry benchmarks.
- Making Decisions
This study allows for more informed business decisions. By reviewing financial statements, stakeholders can assess the financial sustainability of possible investments, acquisitions, or partnerships.
It aids in planning the allocation of resources for future growth and profitability by assessing the risks and returns associated with these decisions.
- Financial Health Evaluation
The analysis of financial statements gives information about a company’s financial health and stability. It assists stakeholders in determining the company’s ability to meet financial obligations such as debt repayment and dividend payments.
what are the financial statement analysis methods?
- Horizontal Analysis
Horizontal analysis examines financial statement data over time to identify patterns and changes in important financial variables. It entails computing the percentage change in elements like revenue, expenses, and net income between periods.
Horizontal analysis aids in the identification of growth rates, patterns, and areas of progress or concern across time.
- Vertical Examination
Vertical analysis is the technique of calculating financial statement items as a percentage of a starting point. The income statement’s base figure is typically total revenue, while the balance sheet’s base figure is total assets or total liabilities and shareholders’ equity.
This aids in determining the composition and relative importance of various components in the financial statements.
- Analysis of Ratios
In financial statement analysis, ratio analysis entails calculating and understanding various financial ratios obtained from data in financial statements.
Financial ratios provide information on a company’s liquidity, profitability, solvency, efficiency, and other financial performance metrics.
Often employed Financial ratios include the current ratio, debt-to-equity ratio, gross profit margin, return on assets, and return on equity.
how does Countick assist businesses in making more informed financial decisions?
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Making financial decisions has gotten easier with access to a smart dashboard that shows the inflows and outflows of funds.
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The team committed to assisting with this service provides necessary advice on RBI laws and regulations about currency lending and other compliances.
FAQs
what is the point of analyzing financial statements every fiscal year?
The purpose of financial statement analysis is to evaluate a company’s financial health, profitability, liquidity, and stability.
By analyzing these statements, investors, analysts, and stakeholders can acquire insights into the company’s financial status, make educated decisions, and evaluate its performance compared to industry peers.
how does financial statement analysis determine a company’s financial performance?
Financial statement analysis is closely tied to evaluating a company’s financial performance. This financial performance report contains ratios, and by examining them, an analyst may estimate how efficiently the company can create profits and grow shareholder value.
what is a financial statement analysis example?
Analysts generally take note of several ratios and utilize them on the company’s income statement to determine its profit-earning capacity. For example, the analyst considers the gross profit margin, calculated by deducting the cost of products sold from the revenue.
An increase in this indicator indicates that the company’s financial performance is improving.
