Financial statement analysis (FSA) means studying the financial statements of a company to get meaningful information for decision making. Apart from the management, external stakeholders also carry financial statement analysis for several purposes. There are several methods of financial statement analysis that management and external stakeholders use.
All these methods vary in calculation and factors used for the financial statement analysis. External stakeholders, including analysts, financial institutions, creditors, lenders, and more do FSA to understand the health of the company. Moreover, these methods provide a summary of data that helps to analyze and interpret financial data.
Methods of Financial Statement Analysis
Following are the most popular methods of financial statement analysis:
Horizontal and Vertical analysis
In horizontal analysis, the analysts compare the financial information of one period with the previous years. In this, we compare a line item with the same line item in another period (a year or quarter). The objective is to find any significant change in any line item. For instance, if the cost of goods sold (COGS) rises much more than the increase in sales or gross profit rises but net profit drops.
In the vertical analysis, every line item in the financial statement is calculated as a proportion of another prominent item. Usually, in the income statement, each line item is calculated as a proportion of revenue or sales. On the balance sheet, each line item is represented as a proportion of total assets. After the calculation of ratios, one can compare them with the past years to identify any usual happenings.
Comparative Financial Statements
This method is similar to the horizontal and vertical analysis. In this method, we prepare the income statement and balance sheet in a way to get a time perspective of the line items. Or, we can say, the financial statements show figures of two or more years in a single financial statement. It makes it easy to compare a line item with the previous years.
These figures could either be absolute, absolute increase or decrease from the past year, in terms of percentage, or comparison as ratios.
It is among the most popular methods of financial statement analysis. There are different types of ratios that help management and analysts to dig out meaningful information. There are four categories of ratios – profitability ratios, liquidity ratios, leverage ratios, and activity ratios. Some of the popular ratios are the current ratio, PE ratio, debt ratios, and more.
After analysts calculate a ratio (or ratios), they can compare it with the same ratio of previous years. Or, they can also compare it with the industry average or with the competitors. Also, one can compare the ratios with the set standards or the ideal ratio. For instance, the current ratio of 1 is excellent. However, the benchmark or ideal ratios vary from industry to industry.
This method of financial analysis is similar to the horizontal analysis. In this method, also we compare and review the financial statements of three or more years. Under this, the earliest year becomes the base year. The objective is to find any pattern in the financial numbers. These patterns could be rising (or falling) sales, any seasonal trend, fluctuations in expenses, and more. An analyst can also use ratios to identify trends (if any) in the financial numbers.
Other Methods of Financial Statement Analysis
Apart from the above popular methods, there are many more (but less popular) methods that help a business to make decisions. These methods do not precisely fall under financial statement analysis, yet they assist analysts, management, and other stakeholders in arriving at a decision. These methods are:
Cash Flow Analysis
This method helps to study the inflow and outflow of cash and bank balances. Under this method, we examine the movement of cash, rather than changes in the working capital. The study of cash flow tells the purpose – investing, operations, and more – for which the company is using its funds. Moreover, it also shows the source of those funds.
Statement of Changes in Working Capital
This method helps to study any rise or drop in the working capital. Working Capital is the difference between the current assets and the current liabilities. In other words, current liabilities get deducted from the existing assets to arrive at the value of working capital. However, this method fails to give the reason for the differences in the working capital.
Fund Flow Analysis
This method also helps to study the sources and uses of the funds for a given period. It tells where from the business is getting the funds and where it is spending them. Moreover, it also assists in highlighting changes (if any) in a company’s financial structure.
Cost Volume Profit Analysis
Such an analysis helps to establish a relationship between the sales, cost, and profit. For this analysis, we segregate costs into variable and fixed costs. After that, this method helps to define the relationship between sales and variable cost and with the fixed cost. Such a technique helps a business to find a break-even point and plan profit accordingly.
In the absence of the above methods of financial statement analysis, it could be challenging to carry a financial review. These methods make FSA easier by organizing the collection and evaluation of financial information. Banks, auditors, analyst firms, credit rating agencies, lenders, etc., use these methods to understand the health of a company.