Financial reporting is integral to a business.

Any organisation, big or small, is legally required

to compile comprehensive documentation of their financial activities.

With ever-evolving legislation presenting a constant challenge to public companies, getting the
stats right is essential. That’s where an analyst steps in – and as digital accounting and crypto
currencies become more commonplace, the demand for new financial talent is high.

Not only is financial reporting a matter of compliance, but tracking and analysing financial
performance equips business leaders and lenders with key intel to better assess the
company’s current standing, predict future financial outcomes and make informed economic
decisions regarding the management and direction of the organisation.

What is financial statement analysis?

Financial statement analysis is a component of accounting and key to understanding an

organisation’s financial condition. External stakeholders use it to understand the overall
performance and business value of an organisation, while internal constituents use it as a
monitoring tool for managing finances.

Acting as a company’s financial health ‘report card’, it comprises the review of three
significant financial statements that every company must maintain: the balance
sheet, income statement and cash flow statement.

 Balance sheet: summary of the assets, liabilities (debt) and equity of a business at the
end of an accounting period and a report of the company’s financial worth in terms of
book value.

 Income statement: a detailed account of a company’s revenue earning (also known as

the profit and loss statement).

 Cash flow statement: provides data on how much cash or cash equivalent circulates
the company via various inflows and outflows, spanning ongoing operational activities,
external investment sources and cash from financing.

As such, a financial statement analysis provides a comprehensive and unbiased overview of a

company’s profitability, value, creditworthiness and financial security.

What are the five methods of financial statement analysis?

GENERAL APPROACH TO FS ANALYSIS:

1.Horizontal analysis

Horizontal analysis compares historical data (such as ratios and line items) and is usually
depicted as a percentage growth over the same line item in the base year. This allows
financiers to easily spot trends and growth patterns and forecast future projections. This type
of analysis also lends insight into the operational results of an organisation and whether it is
operating efficiently and profitably, and makes it easier to compare growth rates amongst
sector competitors.
2.Vertical analysis

Vertical analysis is the proportional analysis of a financial statement, where each line item on a
financial statement is listed as a percentage of another item. For example, every line item on
an income statement is stated as a percentage of gross sales, while every line item on a
balance sheet is stated as a percentage of total assets. This gives analysts an understanding
of overall performance in terms of revenue and expenses.

3.Ratio analysis

Ratio analysis allows for meaningful comparison between the different elements of a financial
statement and is used to reveal a general upward or downward trend. It’s a quick method to
obtain an overview of a company’s financial health, but also more granular relationships
between data, such as debt and equity or price versus earnings, in addition to liability areas
such as staff turnover. Once a ratio has been calculated, it can be compared against the
previous period, which is crucial for setting performance targets.

4.Trend analysis

Trend analysis uses historical data (such as price movements and trade volume) to forecast
the long-term direction of market sentiment. It’s based on the idea that what has transpired in
the past will occur again in the future, which helps a business to better predict and prepare for
upward trends and reversals within particular market segments. Trend analysis is a useful
technique as moving with trends (and not against them) will result in profit for an investor.

5.Cost volume profit analysis

This analysis technique helps businesses better understand the relationship between sales,
costs, and business profit. It examines the fixed cost and variable cost and establishes the
relationship between sales and variable cost to help business leaders better plan and project
profit.

How does financial statement analysis help an organisation?

Financial statement analysis is not only crucial for complying with business laws and
regulations, but the data can serve the organisation in a multitude of ways.

Through financial statement analysis, business owners can identify and determine their
financial strengths and weaknesses, keep current on their debts and determine their profit
margins.

Financial statements are critical when seeking company partners and securing investment
capital. The data determines if a company is making money, but also helps investors identify a
reasonable cost per share. An unbiased financial profile is equally crucial when claiming funds
or applying for loans from lending institutions.

Analysing the financial statements from quarter to quarter and year to year help business
owners see trends in growth and formulate new strategies to consider any risks posed to the
wider market.
Furthermore, the analysis helps to measure a company’s financial performance against the
wider sector, giving business owners an understanding of how they compare to their top
competitors.

 Financial Ratios:

A set of calculations used to analyze a company's financial health by comparing different line
items from its financial statements, providing insights into its liquidity, efficiency, profitability,
and solvency.

 Liquidity Ratio:

A financial ratio that measures a company's ability to meet its short-term financial obligations
by assessing how readily it can convert assets into cash to pay current debts; a higher ratio
indicates better liquidity.

 Activity Ratio (or Efficiency Ratio):

A ratio that evaluates how effectively a company utilizes its assets to generate sales,
indicating operational efficiency in managing inventory, accounts receivable, and other
assets.

 Leverage Ratio (or Solvency Ratio):

A ratio that assesses a company's level of debt relative to its equity, indicating how much of
its assets are financed by borrowed funds.

 Profitability Ratio:

A ratio that measures how well a company generates profit from its operations, often
expressed as a percentage of sales, revealing its overall earnings performance.

Key points to remember:

 Liquidity Ratios:

Key examples include the current ratio and quick ratio, which compare current assets to
current liabilities.

 Activity Ratios:

Common examples include inventory turnover ratio, accounts receivable turnover ratio, and
asset turnover ratio.

 Leverage Ratios:

Important examples include debt-to-equity ratio and debt-to-asset ratio.

 Profitability Ratios:
Key ratios include gross profit margin, operating profit margin, net profit margin, and return on
equity (ROE).

What are Financial Ratios?

Financial ratios are created with the use of numerical values taken from financial
statements to gain meaningful information about a company. The numbers found on a
company’s financial statements – balance sheet, income statement, and cash flow statement –
are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth,
margins, profitability, rates of return, valuation, and more.

Financial ratios are grouped into the following categories:

 Liquidity ratios

 Leverage ratios

 Efficiency ratios

 Profitability ratios

 Market value ratios

Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:

1. Track company performance

Determining individual financial ratios per period and tracking the change in their values over
time is done to spot trends that may be developing in a company. For example, an increasing
debt-to-asset ratio may indicate that a company is overburdened with debt and may
eventually be facing default risk.

2. Make comparative judgments regarding company performance

Comparing financial ratios with that of major competitors is done to identify whether a
company is performing better or worse than the industry average. For example, comparing the
return on assets between companies helps an analyst or investor to determine which company
is making the most efficient use of its assets.

Users of financial ratios include parties external and internal to the company:

 External users: Financial analysts, retail investors, creditors, competitors, tax

authorities, regulatory authorities, and industry observers

 Internal users: Management team, employees, and owners

Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and
long-term obligations. Common liquidity ratios include the following:

The current ratio measures a company’s ability to pay off short-term liabilities with current
assets:

Current ratio = Current assets / Current liabilities

The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick
assets:

Acid-test ratio = Current assets – Inventories / Current liabilities

The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash
equivalents:

Cash ratio = Cash and Cash equivalents / Current Liabilities

The operating cash flow ratio is a measure of the number of times a company can pay off
current liabilities with the cash generated in a given period:

Operating cash flow ratio = Operating cash flow / Current liabilities

Leverage Financial Ratios

Leverage ratios measure the amount of capital that comes from debt. In other words, leverage
financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include
the following:

The debt ratio measures the relative amount of a company’s assets that are provided from
debt:

Debt ratio = Total liabilities / Total assets

The debt to equity ratio calculates the weight of total debt and financial liabilities against
shareholders’ equity:

Debt to equity ratio = Total liabilities / Shareholder’s equity

The interest coverage ratio shows how easily a company can pay its interest expenses:

Interest coverage ratio = Operating income / Interest expenses

The debt service coverage ratio reveals how easily a company can pay its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

Efficiency Ratios
Efficiency ratios, also known as activity financial ratios, are used to measure how well a
company is utilizing its assets and resources. Common efficiency ratios include:

The asset turnover ratio measures a company’s ability to generate sales from assets:

Asset turnover ratio = Net sales / Average total assets

The inventory turnover ratio measures how many times a company’s inventory is sold and
replaced over a given period:

Inventory turnover ratio = Cost of goods sold / Average inventory

The accounts receivable turnover ratio measures how many times a company can turn
receivables into cash over a given period:

Receivables turnover ratio = Net credit sales / Average accounts receivable

The days sales in inventory ratio measures the average number of days that a company holds
on to inventory before selling it to customers:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Profitability Ratios

Profitability ratios measure a company’s ability to generate income relative to revenue,

balance sheet assets, operating costs, and equity. Common profitability financial ratios include
the following:

The gross margin ratio compares the gross profit of a company to its net sales to show how
much profit a company makes after paying its cost of goods sold:

Gross margin ratio = Gross profit / Net sales

The operating margin ratio, sometimes known as the return on sales ratio, compares the
operating income of a company to its net sales to determine operating efficiency:

Operating margin ratio = Operating income / Net sales

The return on assets ratio measures how efficiently a company is using its assets to generate
profit:

Return on assets ratio = Net income / Total assets

The return on equity ratio measures how efficiently a company is using its equity to generate
profit:

Return on equity ratio = Net income / Shareholder’s equity

Learn more about the different profitability ratios in the following video:

Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock. Common
market value ratios include the following:

The book value per share ratio calculates the per-share value of a company based on the
equity available to shareholders:

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total
common shares outstanding

The dividend yield ratio measures the amount of dividends attributed to shareholders relative
to the market value per share:

Dividend yield ratio = Dividend per share / Share price

The earnings per share ratio measures the amount of net income earned for each share
outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

The price-earnings ratio compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share