Guide to Financial Statement Analysis
The main task of an analyst is to perform an extensive analysis of financial statements. In this free guide, we will break down the most important methods, types, and approaches to financial analysis.
This guide is designed to be useful for both beginners and advanced finance professionals, with the main topics covering: (1) income statement, (2) balance sheet, (3) cash flow, and (4) rates of return.
Image: Example financial analysis template.
#1 Income statement analysis
Most analysts start their analysis of financial statements 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, 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 of financial statements, 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.
The key metrics we look at are:
- Cost of Goods Sold (COGS) as a percent of revenue
- Gross profit as a percent of revenue
- Depreciation as a percent of revenue
- Selling General & Administrative (SG&A) as a percent of revenue
- Interest as a percent of revenue
- Earnings Before Tax (EBT) as a percent of revenue
- Tax as a percent of revenue
- Net earnings as a percent of revenue
To learn how to perform this analysis step-by-step please check out our Financial Analysis Fundamentals Course.
Now it’s time to look at a different way to evaluate the income statement. With horizontal analysis, we look across the income statement 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 example, revenue in 2017 was $4,000 and in 2016 it was $3,000. The YoY change in revenue is equal to $4,000 / $3,000 minus one, which equals 33%.
To see exactly how to perform this horizontal analysis of financial statements please enroll in our Financial Analysis Fundamentals Course now!
#2 Balance sheet and leverage ratios
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 the company’s capital assets on the balance sheet.
The balance sheet metrics can be divided into several categories, including liquidity, leverage, and operational efficiency.
The main liquidity ratios for a business are:
- Quick ratio
- Current ratio
- Net working capital
The main leverage ratios are:
- Debt to equity
- Debt to capital
- Debt to EBITDA
- Interest coverage
- Fixed charge coverage ratio
The main operating efficiency ratios are:
- Inventory turnover
- Accounts receivable days
- Accounts payable days
- Total asset turnover
- Net asset turnover
Using the above financial ratios, we can determine how efficiently a company is generating revenue and how quickly it’s selling inventory.
Using the financial ratios derived from the balance sheet and comparing them historically versus industry averages or competitors will help you assess the solvency and leverage of a business.
In our course on analysis of financial statements, we explore all the above metrics and ratios in great detail.
#3 Cash flow statement analysis
With the income statement and balance sheet under our belt, let’s look at the cash flow statement and all the insights it tells us about the business.
The cash flow statement will help us understand the inflows and outflows of cash over the time period we’re looking at.
Cash flow statement overview
The cash flow statement, or statement of cash flow, consist of three components:
- Cash from operations
- Cash used in investing
- Cash from financing
Each of these three sections tells us a unique and important part of the company’s sources and uses of cash during the time period being evaluated.
Many investors consider the cash flow statement the most important indicator of a company’s performance and it’s hard to imagine that until only recently companies didn’t even have to file a cash flow statement.
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 the 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, 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:
- Return on equity ratio (ROE)
- Profitability, efficiency, and leverage ratios
- Primary, secondary, and tertiary ratios
- Dupont analysis
By constructing the pyramid of ratios, you will gain an extremely solid understanding of the business and its financial statements.
Enroll in our financial analysis course to get started now!
More analysis of financial statements
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: