Financial statement analysis requires a combination of analytical, problem-solving and technical skills. Accountants have the ability to bring short- and long-term benefits to business by providing detailed statement analysis.
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What Is Financial Statement Analysis?
According to Accounting Tools, financial statement analysis involves reviewing the financial statements of an organization to gain an understanding of its financial situation.
Financial statements usually include a balance sheet, income statement, statement of cash flows and supplementary notes.
An internal analysis is conducted by employees, executives, government agencies or other individuals with access to a business firm’s internal accounting records. In contrast, an external analysis is conducted by outsiders with access to published financial statements. These outsiders may include creditors, investors, credit agencies, government agencies or the general public.
Either a short- or long-term analysis can be conducted. While a short-term analysis considers a firm’s ability to pay short-term debts, or liquidity, a long-term analysis considers a firm’s ability to pay long-term debts, or solvency.
Tools and techniques used in financial analysis include cash flow analysis, common-size statement analysis, comparative statement analysis, cost-volume-profit analysis, fund flow analysis, networking capital analysis and trend analysis.
Methods of Financial Statement Analysis
Financial statement analysis can be conducted using either horizontal and vertical analysis, or analysis that uses ratios.
Horizontal analysis involves comparing financial information over a series of reported periods, with a base year being chosen as a starting point for future comparison.
Vertical analysis involves a proportional analysis of a financial statement. Every line item is listed as a percentage of another line item, with a base year being chosen to compare figures of the same year’s statement. Instead of being used as an alternative to horizontal analysis, vertical analysis is used alongside it.
Analysis using ratios is used to calculate the relative size of one figure in relation to another, which can then be compared to the ratio for a prior period. This method of conducting financial statement analysis includes the following categories of ratios:
- Liquidity ratios: These measure a company’s ability to continue doing business. Examples of liquidity ratios include the cash coverage ratio, current ratio, quick ratio and liquidity index.
- Activity ratios: These measure management’s quality and performance. Examples of activity ratios include the accounts payable turnover ratio, accounts receivable turnover ratio, fixed asset turnover ratio, inventory turnover ratio, sales-to-working capital ratio and working capital turnover ratio.
- Leverage ratios: These measure a company’s reliance on debt to finance operations. Examples of leverage ratios include the debt service coverage ratio, debt-to-equity ratio and fixed charge coverage.
- Profitability ratios: These measure a company’s ability to generate profit. Examples of profitability ratios include the contribution margin ratio, gross profit ratio, net profit ratio, break-even point, margin of safety, return on equity, return on net assets and return on operating assets.
Benefits of Accurate Financial Statement Analysis
Financial statement analysis is crucial for complying with business laws and regulations, while also meeting the needs of stakeholders and various other parties. But in order to conduct accurate financial statement analysis, developing skills and intuition is as important as following best accounting practices.
Financial statement analysis can benefit organizations in numerous ways. It provides internal and external stakeholders with the opportunity to make informed decisions regarding investing. Financial statement analysis also provides lending institutions with an unbiased view of a business’s financial health, which is helpful for making lending decisions. And as top executives and others in management rely on accounting to provide an accurate depiction of the effects of their decisions, financial statement analysis helps with matters of corporate governance as well.
Follow these tips for conducting accurate financial statement analysis:
- Maintain objectivity by knowing that decisions should be based on more than numbers listed on financial statements. Accountants should consider intangible variables as well. For example, employee satisfaction should be considered when planning for future financial expenditures.
- Avoid developing a false sense of security. While financial statements can be used to show whether a business is stable and profitable, accountants should also use real-time observations of business activities. For example, a dwindling inventory that cannot be replaced easily could cause big issues eventually.
- Stay focused on relevance. Recent trends should be taken into consideration when analyzing financial information. For example, while a trend that favors a company’s product may show higher sales, it won’t necessarily provide a precise comparison with the company’s competition.
- Trust intuition, as the decision to invest in a product should be based on more than numbers alone. For example, past success anticipating trends should be taken into consideration when making future investments.
Business growth depends on the accurate and timely analysis of financial statements. While the rapid pace of business today is placing more importance on insights gathered by accountants, developing knowledge is still an essential aspect of growing a business. For professionals interested in a career that can make a significant impact on businesses, investors and consumers, pursuing a master’s degree in accounting could be an especially worthwhile endeavor.