A company's financial statement analyzes a company's finances over time. A country’s law requires companies to keep records of their economic activity to track their finances and prevent financial mismanagement.
Financial Statement Analysis
Financial statement analysis involves analysing a company's financial statements to make business decisions. External investors and stakeholders use it to understand the overall health of an organisation and to evaluate its financial performance. Internal constituents use it to monitor company finances.
Analysing Financial Statements
The financial statements of a company record critical financial data of a business, and they can be evaluated based on past, current, and projected performance.
In general, financial statements made according to Generally Accepted Accounting Principles (GAAP). These principles require a business to create three primary financial statements: A balance sheet, An income statement, and a notice of cash flow. Usually, public companies have strict standards for reporting financial information, and they must follow GAAP standards which require accrual accounting.
Private companies have more flexibility to prepare their financial statements and also have the option to use either accrual or cash for their business accounting.
A financial statement analysis of a company uses several techniques. Three of the essential methods are horizontal analysis, vertical analysis, and ratio analysis.
Horizontal Analysis
The horizontal study compares data horizontally by analysing the values of line items across two or more years. The use of Horizontal analysis is to analyse financial statements to compare historical data, such as ratios, or line items, over several accounting periods. Horizontal analysis can either use absolute comparisons of percentage comparisons, where the numbers in each subsequent period are calculated as a percentage of the amount in the baseline year, with the baseline amount being listed as 100% and is known as base-year analysing.
How Horizontal Analysis Is Used
Generally Accepted Accounting Principles (GAAP) use consistency and comparability of financial statements.
Consistency
Consistency is the skill to accurately review one company's financial statements over some time as accounting methods and tools remain standard.
Comparability
Comparability is the technique used by financial analysers to review side-by-side two or more different companies' financials. The horizontal analysis not only improves the review of a company's consistency over time directly, but it also enhances the comparability of growth in a company to that of its competitors.
The horizontal analysis helps investors and analysts to see all the factors driving a company's financial performance over many years, and is useful to spot trends and growth patterns. It enables analysts to assess changes in overtime and project them into the future of the company. By analysing a company's income statement, balance sheet, and cash flow statement over time, an analyst can create a complete picture of a business' operational results.
Factors
The analysis of critical measures of a business like profit, sales, returns, and detect emerging issues.
Vertical Analysis
Financial statements that include vertical analysis that show line item percentages separately. Several companies are using these types of financial statements that include detailed vertical analysis to provide greater detail on a company's finances.
Common-size financial statements often incorporate comparative financial statements that include columns comparing each line item to a previously reported period. The vertical analysis helps to gain a picture of whether businesses’ performance metrics are improving or deteriorating.
Ratio Analysis
Ratio analysis is a method to gain insight into a company's liquidity, operational efficiency, and profits by studying its financial statements like the balance sheet and income statements.
Investors and financial analysts employ ratio analysis to evaluate the financial health of companies by scrutinising financial statements. Comparative data demonstrates how a company performs over time and is used to estimate likely future performance. This data can also compare a company's financial standing with industry averages and its competition.
Ratios act as points of comparison for companies. They use these ratios to evaluate stocks within a particular industry.
In most cases, it is also essential to understand the variables driving ratios as a company's management has the flexibility to alter its strategy to make it's stock and company ratios more attractive. Generally, utilising ratios, in combination with other ratio analyses, is a recommended strategy to using them in isolation.
Having a comprehensive understanding of ratios in each department of a company gives an analyst a comprehensive overview of the company from several different angles and helps them spot potential red flags.
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