Techniques of Financial Statement Analysis

Financial statement analysis is an essential tool for value investing to evaluate a company’s financial performance and identify areas for improvement. 

Types of Financial Statements

You can analyze the financial statements to compare the company’s performance and growth aspects.  

You can analyze mainly three financial statements:

#1. Income Statement

The income statement, also known as a profit and loss statement, provides information about a company’s revenue, expenses, net income, EPS (earning per share), and dividend payout. 

You can use the income statement to assess a company’s profitability, growth potential, and efficiency in managing costs. 

For example, in the Income statement of ITC, you can see the company’s sale is increasing year-on-year basis whereas, the operating profit is decreased in the last 2 financial years. ITC pays a regular dividend every year to the shareholders. It’s crucial information if you want to invest in dividend-paying companies in India. 

Income Statement

#2. Balance Sheet

The balance sheet provides an overview of a company’s share capital, reserves for growth,  fixed & currency assets, and current liabilities. You can analyze the balance sheet to assess a company’s liquidity, solvency, and financial stability. 

You can use balance sheet data to evaluate a company’s ability to assess the value of the company’s assets and liabilities.

You can calculate important ratios like the current ratio, debt-to-equity ratio, solvency ratio, return on equity and return on assets through the balance sheet. 

In the balance sheet of ITC, you can see the company’s borrowings have increased since 2020 which can be a negative sign. 

balance sheet

#3. Cash Flow Statement

The cash flow statement provides a record of a company’s inflows and outflows of cash. You can analyze how cash is generated and used in the operations, investments, and financing activities of the company. 

In the image, you can see the ITC’s cash from operating activities is increasing year on year basis which has a direct relation with the sales. 

Cash Flow Statement

On the other hand, the negative balance in the ‘cash from financing activities’ is increasing year on year basis. 

If you expand the details, you will find that the company is paying more dividends every year to its shareholders. 

cash flow

Techniques of Financial Statement Analysis

You can use financial statement analysis techniques to identify trends, patterns, & anomalies in financial statements, and assess a company’s financial health. The primary techniques of financial statement analysis are:

#1. Horizontal Analysis

You can use the Horizontal analysis or trend analysis technique to compare financial data for year on year basis to identify trends and patterns in a company’s financial performance. You can compare revenue, expenses, and net income for the previous years to know whether the company’s business is growing or declining. 

For example, a company’s revenue has been increasing but its net income has been declining. There is a possibility that the company is experiencing a decline in profitability despite an increase in revenue.

#2. Vertical Analysis

You can use Vertical analysis or common-size analysis to compare different aspects to a base amount, like sales or total assets. It helps you to understand how profitable a company is compared to its size. 

For example, if a company has total assets of Rs. 10 crore and total liabilities of Rs. 4 crores, the debt-to-assets ratio is 40%. This means 40% of the company’s assets are financed by debt. You can compare this ratio with other companies in the same industry to understand the financially stability of the company.

#3. Trend Analysis

Trend analysis technique analyze the financial data over an extended period of five to ten years. You can use trend analysis to identify long-term trends and patterns in a company’s financial position.

For example, if a company’s revenue has been declining over the past five years, it can be a indication of lack of innovation, increased competition, or a shrinking market. 

#4. Ratio Analysis

Ration analysis is the most common technique to do the financial statement analysis. You can use ratio analysis  to assess a company’s financial performance, liquidity, solvency, and efficiency. 

Some of the most common ratios used in financial statement analysis include

A. Current Ratio

The current ratio measures a company’s ability to pay its short-term liabilities using its short-term assets. It is calculated by dividing current assets by current liabilities.

Current Ratio = Current Assets / Current Liabilities

B. Debt-to-Equity Ratio 

The debt-to-equity ratio measures a company’s financial leverage by comparing its total liabilities to its shareholders’ equity. It is calculated by dividing total liabilities by shareholders’ equity.

Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity

C. Debt-to-Asset Ratio

The debt-to-asset ratio measures the percentage of a company’s assets that are financed by debt. It is calculated by dividing total liabilities by total assets.

Debt-to-Asset Ratio = Total Liabilities / Total Assets

D. Net Profit Margin

The net profit margin measures a company’s profitability by comparing its net profit to its total revenue. It is calculated by dividing net profit by total revenue.

Net Profit Margin = Net Profit / Total Revenue

E. Return on Equity (ROE)

The return on equity measures a company’s profitability by comparing its net income to its shareholders’ equity. It is calculated by dividing net income by shareholders’ equity.

Return on Equity (ROE) = Net Income / Shareholders’ Equity

F. PE Ratio

Price-to-Earnings ratio measures the company’s stock valuation based on earring per share. It is calculated by divided current stock price by earnings per share (EPS) of the company.

PE Ratio = Market Price per Share / Earnings per Share (EPS)

#5. Cash Flow Analysis

Cash flow analysis is used to evaluate the inflows and outflows of cash in a business. It helps to identify how much cash a company is generating or spending over a period of time. 

You can evaluate three types of cash flows in cash flow analysis:

A. Operating Cash Flow: cash generates or uses in its day-to-day operations, such as sales revenue and expenses.

B. Investing Cash Flow: cash spends or receives when investing in assets, such as property, equipment, or investments.

C. Financing Cash Flow: cash generates or uses when financing its operations, such as taking out loans or issuing stocks.

How to Perform Financial Statement Analysis

Step #1. Collecting financial statements

Collect the income statement, balance sheet, and cash flow statement to perform the financial statement. You can use screener to get the financial statements. 

Step #2. Reviewing financial statements

Make sure that the financial statements are accurate and complete. It involves checking for errors, inconsistencies, and omissions.

Step #3. Identifying trends and pattern

You should identify trends and patterns in the financial statements using techniques such as horizontal analysis, vertical analysis, trend analysis, ratio analysis, and cash flow analysis. These techniques help you to identify significant changes and patterns in financial statemtents. 

Step #4. Calculating financial ratios

Use the financial ratios to assess a company’s financial performance, liquidity, solvency, and efficiency.

Step #5. Interpreting financial data

Interpret the financial data and draw conclusions based on the analysis. It involves assessing a company’s financial health, identifying areas for improvement, and making informed decisions.

Final Words

​​You can use  financial statement analysis  in evaluating a company’s financial health, but it’s important to conduct additional research before making any stock purchases.

About Rajan Dhawan

Rajan has covered personal finance and investing for over 5 years. Previously, he was in the IT field for 8 years after completing his MCA but his deep interest in personal finance led him to become an investing expert. He is passionate about investing, stocks, startups, and cryptos.

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