Would you rather own a loss-making company with £10 million in revenue? Or a highly profitable £2 million revenue one?
At first glance, the highly profitable company seems like a no-brainer. But the answer isn’t as clear-cut as it seems.
This is where financial statements analysis shines brightest. It’s central to decision-making, helping investors, managers, and lenders go beyond just the figures to understand the story they are trying to tell.
What Is Financial Statements Analysis?
Financial statements analysis is the evaluation of a company’s historical financial statements to assess its performance over time. It aids in decision-making by putting meaning to the figures. Investors (and other users of financial information) can then determine the health, profitability and viability of businesses.
Financial statements analysis is a core component for:
- Investors who assess and value companies before buying shares.
- Lenders who determine creditworthiness before approving loans.
- Managers who use financial insights to make strategic corporate decisions.
- Regulators who ensure compliance with financial conduct and reporting standards.
The 3 Primary Financial Statements
Companies use the income statement, balance sheet and cash flow statement to summarise and present their quarterly and yearly results, providing transparency and insight into company operations.
Income Statement
The income statement shows a company’s financial performance by presenting its revenues, expenses and profit over a particular period. Beyond how much a company makes, spends, and keeps, this statement provides key insights into operational efficiency.
Key Income Statement Components
- Revenue: the total income received from selling goods and services.
- Cost of Sales: the direct costs of producing those goods and services.
- Gross Profit: revenue minus the cost of sales.
- Operating Expenses: costs incurred to run the business (wages, rent, etc.)
- Operating Profit: gross profit minus operating expenses.
- Net Profit: the final profit after all expenses are accounted for.
Balance Sheet
The balance sheet provides a snapshot of a company’s financial position at a point in time and is structured around this fundamental equation:
Assets = Liabilities + Equity
This equation (the accounting equation) governs every balance sheet, ensuring they stay…balanced. Understanding this statement is crucial for assessing short-term and long-term financial stability.
Key Balance Sheet Components
- Assets: what the company owns (cash, buildings, equipment).
- Liabilities: what the company owes (loans and other forms of borrowing).
- Equity: shareholder investments and retained earnings.
Cash Flow Statement
The cash flow statement shows how cash moves in and out of every company – how it generates and spends it. The statement groups and presents cash inflows and outflows in three sections.
Key Cash Flow Statement Components
- Operating Activities: all the cash generated from and spent on core business activities.
- Investing Activities: all the cash spent on or received from investments.
- Financing Activities: all the cash raised from and spent on debt and equity financing.
Methods of Analysis
Financial statements analysis describes what investors do when they’re examining financial statements. But it doesn’t explain how.
So, here are the five primary ways financial statement analysis is conducted.
Horizontal Analysis
Horizontal analysis compares company data across periods. It deals primarily with growth rates and is often used to highlight and compare growth over:
- Quarters (Q1 2024 vs Q1 2023)
- Years (2024 vs 2023)
- Several years (compounded annual growth rates)
Vertical Analysis
Vertical analysis expresses financial line items as a percentage of a base figure. This type of analysis occurs predominantly in the income statement but can also be used in the other two statements.
The primary example of vertical analysis is profit margins, which are calculated by dividing the company’s profit (e.g., gross profit) by revenue. Revenue is the base figure.
Ratio Analysis
Ratio analysis involves calculating financial ratios and metrics to evaluate a company’s performance. It is commonly used in stock valuation (when calculating terminal value) because it provides the historical basis for making future assumptions.
Ratio analysis is also handy in establishing a company’s expensiveness relative to its history. If a company trades at a 30x PE ratio when its 10-year average is 20x, it can be considered relatively expensive (or overvalued).
Comparative Analysis
Comparative analysis is similar to ratio analysis – the only difference is the comparison criteria. Here, a company’s metrics are compared to its industry peers.
This type of analysis helps identify competitive advantages and weaknesses, potentially leading the analyst or investor to change the company being studied and potentially invested in.
Decomposition Analysis
This entails breaking down metrics into their singular components. This allows for a better understanding of what’s driving company performance.
The best example is the decomposition of Return on Equity (ROE) using the DuPont Analysis. Using its distinct components:
ROE = Net Profit Margin * Asset Turnover * Financial Leverage Ratio
This breakdown helps investors and analysts identify whether a high ROE is due to operational efficiency (a higher net profit margin and asset turnover) or excessive leverage (a higher financial leverage ratio).
Limitations of Financial Statements Analysis
While beneficial in several ways, financial statement analysis has its drawbacks.
Historical Data Bias
While historical data provides a basis for future assumptions, past performance doesn’t guarantee future results. Not because a company grew its revenue by 20% in each of the past five years mean it will do so for the next five.
Accounting Adjustments
Sometimes, companies adjust figures to give investors and analysts a ‘truer’ representation of their performance. While perfectly legal, these adjusted figures often exclude key figures (like stock-based compensation) to improve items like profit and cash flow.
External Economic Factors
When prices start falling, even good companies are at the mercy of paranoid investors. No matter how well-run a company is, it isn’t immune to an economic downturn.
The key is to trust your research and analysis and not follow the herd. Remember:
Be fearful when others are greedy and greedy when others are fearful.
Warren Buffett
Non-Financial Factors
Brand reputation, management quality and alignment, and innovation also matter. Financials only tell half the story…but depending on the company, they’re all you need. Understanding the depth and significance of a company’s qualitative traits completes the research process.
Rounding It Up!
Financial statement analysis is essential for understanding a company and its operations and helping investors, analysts, managers, and lenders make well-informed decisions.
However, while financial ratios and analytical methods offer valuable insights, they should be used alongside qualitative factors and a broader economic perspective for a more complete company assessment.
