Guide to analyzing financial statements for financial analysts
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One of the main tasks of an analyst is to perform an extensive analysis of financial statements. In this free guide, we will break down the most important types and techniques of financial statement analysis.
This guide is designed to be useful for both beginners and advanced finance professionals, with the main topics covering: (1) the income statement, (2) the balance sheet, (3) the cash flow statement, and (4) rates of return.
1. Income Statement Analysis
Most analysts start their financial statement analysis with the income statement. Intuitively, this is usually the first thing we think about with a business… we often ask questions such as, “How much revenue does it have?” “Is it profitable?” and “What are the margins like?”
In order to answer these questions, and much more, we will dive into the income statement to get started.
There are two main types of analysis we will perform: vertical analysis and horizontal analysis.
With this method of analysis, we will look up and down the income statement (hence, “vertical” analysis) to see how every line item compares to revenue, as a percentage.
For example, in the income statement shown below, we have the total dollar amounts and the percentages, which make up the vertical analysis.
As you see in the above example, we do a thorough analysis of the income statement by seeing each line item as a proportion of revenue.
One of the main tasks of a financial analyst is to perform an extensive analysis of a company’s financial statements. This usually begins with the income statement but also includes the balance sheet and cash flow statement.
The main goal of financial analysis is to measure a company’s financial performance over time and against its peers.
This analysis can then be used to forecast a company’s financial statements into the future.
Now it’s time to look at a different way to evaluate the income statement. With horizontal analysis, we look at the year-over-year (YoY) change in each line item.
In order to perform this exercise, you need to take the value in Period N and divide it by the value in Period N-1 and then subtract 1 from that number to get the percent change.
For the below example, revenue in Year 3 was $55,749, and in Year 2, it was $53,494. The YoY change in revenue is equal to $55,749 / $53,494 minus one, which equals 4.2%.
Let’s move on to the balance sheet. In this section of financial statement analysis, we will evaluate the operational efficiency of the business. We will take several items on the income statement and compare them to accounts on the balance sheet.
The balance sheet metrics can be divided into several categories, including liquidity, leverage, and operational efficiency.
Each of these three sections tells us a unique and important part of the company’s sources and uses of cash over a specific time period.
Many investors consider the cash flow statement the most important indicator of a company’s performance.
Today, investors quickly flip to this section to see if the company is actually making money or not and what its funding requirements are.
It’s important to understand how different ratios can be used to properly assess the operation of an organization from a cash management standpoint.
Below is an example of the cash flow statement and its three main components. Linking the 3 statements together in Excel is the building block of financial modeling. To learn more, please see our online courses to learn the process step by step.
4. Rates of Return and Profitability Analysis
In this part of our analysis of financial statements, we unlock the drivers of financial performance. By using a “pyramid” of ratios, we are able to demonstrate how you can determine the profitability, efficiency, and leverage drivers for any business.
This is the most advanced section of our financial analysis course, and we recommend that you watch a demonstration of how professionals perform this analysis.
The course includes a hands-on case study and Excel templates that can be used to calculate individual ratios and a pyramid of ratios from any set of financial statements.
The key insights to be derived from the pyramid of ratios include:
We hope this guide on the analysis of financial statements has been a valuable resource for you. If you’d like to keep learning with free CFI resources, we highly recommend these additional guides to improve your financial statement analysis:
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