How to Analyze a Company’s Financial Statements

Only by financial statement analysis can one know how healthy a company is and therefore make proper investment or management decisions. To stakeholders such as investors, accountants, and commerce students, the value of financial statement analysis lies in the depth of insight it provides into the profitability, liquidity, and general financial stability of a company. This guide explains what financial statements are, the different types, and how to analyze each comprehensively. The above skills would be very helpful for the students of India who would consider ACCA courses, CMA, or similar ones.

What is a Financial Statement?

The financial statements of a firm over an accounted period, therefore, provide a statutory record of its assets, liabilities, equity, revenues, and expenses as well as the inflows and outflows of cash characterizing the financial situation of the firm.

Importance of Financial Statements

Financial statements are critical for multiple reasons:

1. Decision-Making Tool: They provide investors, managers, and creditors with the ability to make informed decisions.
2. Compliance with Regulations: Financial statements comply with the Companies Act and other regulatory bodies as per the legal obligations.
3. Performance Measurement: The firms measure their performance in operations and finances period after period against the standards of the industry.
4. Educational Insight: For CA, CFA, ACCA course students, and CMA, financial statements form a significant portion of their study material and therefore would benefit students in qualifying requirements for advanced finance roles under eligibility criteria.

Types of Financial Statements

To analyze the performance of a company, one should understand the four types of financial statements. Each of the financial statements is unique in its own way and fulfills a different purpose regarding the reflection of the health of a company.

Balance Sheet

The balance sheet provides a snapshot of all of a firm’s assets, liabilities, and equity at some point in time. It is arranged according to the fundamental accounting equation:

Assets=Liabilities+Equity

• Assets: Cash, inventory, property, and equipment possessed by the company.
• Liabilities: That is, debts and obligations, such as loans and accounts payable.
• Equity: Residual interest in the assets minus liabilities; this would represent the ownership of the company in the business.

Balance Sheet Components	Description
Assets	Resources owned by the company.
Liabilities	Obligations the company owes to others.
Equity	The net worth or ownership value of the company.

The balance sheet is a tool used to determine the short-term and long-term capacity of a company to satisfy its obligations, thus assessing a company’s liquidity and financial soundness.

Income Statement

The income statement is also known as the Profit & Loss statement. The statement presents revenues and expenses in terms of profit over a specific period; thus, it summarizes the profits made by a company for a given time period, hence showing its profitability to various stakeholders.

• Revenue: All revenues from sales as well as services.
• Cost: Expense incurred in generating revenues. They are the costs of inventories used, administrative costs, and taxes.
• Net Income: Net Income is income minus expenses left after deductions of all expenses from revenues.

It is one of the key financial statements to analyze a company’s profitability and holds information regarding revenue generation and expense management.

Cash Flow Statement

The cash flow statement is a summary of the inflows and outflows of cash over an accounting period and can be broken into three primary activities:

• Operating Activities: Cash flows from the company’s regular businesses.
• Investment Activities: Cash that is used for or generated by investments, including acquisitions or sales of assets.
• Financing Activities: Cash flows from raising or repayment of capital, like the issue of shares or the repayment of loans.

It helps ensure a company has enough cash to fulfill obligations because the cash flow statement evaluates companies’ cash management skills.

Statement of Changes in Equity

This is a statement reflecting the manner in which, due to profits, dividends, and additional capital invested in the business, shareholders’ equity evolves with time.

• Retained earnings: The total profits accumulated which have not been distributed to owners.
• Dividends: Those portions paid in the form of return on investment into shareholders.
• The new issue of shares: The issues of new shares help firms raise more capital.

The statement of changes in equity is quite helpful in showing profit reinvestment and the general structure of equity in the corporation.

How to Analyze Financial Statements

Effective analysis requires checking each financial statement using different techniques and ratios. Let’s see specific methods for analyzing every one of these statements in detail.

Analyzing the Balance Sheet

To analyze the balance sheet, focus on liquidity, solvency, and asset utilization ratios:

1. Liquidity Ratios: Measure the company’s ability to meet short-term obligations.
   1. Current Ratio = Current Assets / Current Liabilities
   2. Quick Ratio = (Current Assets – Inventory) / Current Liabilities
2. Solvency Ratios: Evaluate long-term financial stability and debt levels.
   1. Debt-to-Equity Ratio = Total Debt / Total Equity
   2. Equity Ratio = Total Equity / Total Assets
3. Asset Utilization Ratios: Assess how effectively a company uses its assets.
   1. Return on Assets (ROA) = Net Income / Total Assets
   2. Inventory Turnover = Cost of Goods Sold / Average Inventory

These ratios allow you to evaluate whether the firm is utilizing its assets productively and whether it maintains a comfortable level of debt relative to equity.

Analyzing the Income Statement

The income statement analysis centers around profitability and expense control:

1. Profitability Ratios:
   1. Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
   2. Net Profit Margin = Net Income / Revenue
2. Expense Ratios:
   1. Operating Expense Ratio = Operating Expenses / Revenue
   2. Tax-to-Sales Ratio = Tax Expense / Revenue
3. Growth Ratios:
   1. Revenue Growth Rate = (Current Period Revenue – Previous Period Revenue) / Previous Period Revenue
   2. Expense Growth Rate = (Current Period Expenses – Previous Period Expenses) / Previous Period Expenses

Profitability ratios inform if the company is using income to make profits efficiently and effectively, while growth ratios inform revenue and expenditure trends over time.

Analyzing the Cash Flow Statement

The cash flow statement is crucial for understanding liquidity and cash management:

1. Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities
   1. This ratio shows the company’s ability to cover short-term liabilities with cash from operations.
2. Free Cash Flow = Cash from Operating Activities – Capital Expenditures
   1. Free cash flow indicates the cash available for expansion, dividend payments, and reducing debt.
3. Cash Flow Coverage Ratios = Cash Flow from Operations / Interest Payments
   1. This ratio shows how well a company can meet its interest obligations with cash generated from operations.

Analyzing these ratios helps determine whether a company is generating enough cash to sustain its operations and fund growth.

Analyzing the Statement of Changes in Equity

The statement of changes in equity is also useful in assessing the capital structure of a company as well as the returns to the shareholders.

1. Retained Earnings Growth Rate:
   1. This shows how much of the profit is being retained for future growth versus distributed to shareholders.
2. Dividend Payout Ratio = Dividends / Net Income
   1. This ratio reflects the portion of net income distributed to shareholders, indicating the company’s dividend policy.
3. Equity to Asset Ratio = Total Equity / Total Assets
   1. The ratio provides insights into how much of the company’s assets are financed by equity.

From the concept of changes in equity, one can determine how the profits are being reinvested or the value being passed back to the shareholders.

Ratio Analysis

Ratio analysis is the procedure by which one can measure the company’s financial soundness and efficiency. The most important financial ratios include:

1. Liquidity Ratios: Measure short-term solvency.
2. Solvency Ratios: These measures reflect the firm’s ability to meet long-term obligations.
3. Efficiency Ratios: Showing the business’s efficiency in its use of assets.
4. Profitability Ratios: It measure profit generation and cost control.

Horizontal & Vertical Analysis

• Horizontal Analysis: It compares financials across different periods indicating trends in increase or decrease. In other words, if I compare income for the past three years, I will determine the level of growth that has existed.
• Vertical Analysis: A direct comparison of every line as a percentage of an arbitrary base figure, preferably revenue. This helps the analyst understand the cost structure and how revenue is comprised at a point in time.

Conclusion

This helps in the analysis of the performance, growth, and financial health of the company. Several analysis techniques, such as ratio analysis or horizontal and vertical analysis, are applied for the evaluation of the viability of a company. In most cases, financial statement analysis skills are also important in most programs, such as ACCA courses or CMA, by equipping students with advanced analysis techniques. Moreover, achieving eligibility for ACCA and being aware of the ACCA syllabus will lead to further opportunities in international finance and accounting careers.