This article explains the Financial statement analysis or (financial analysis) in a practical way. After reading you will understand the basics of this powerful financial management tool.
Financial Statement Analysis (FSA) or financial analysis refers to the process of analysing the feasibility, stability and profitability of an organization, business unit or project.
It identifies the financial strengths and weaknesses of an organization by establishing the relationship between the items of the balance sheet and the profit and loss account.
Financial Statement Analysis
Financial statement analysis is often reported to senior management and the board of directors. They use this information of the financial statement analysis as input in the decision-making process.
The financial statement analysis is also used by external parties, such as investors and supervisory bodies to gain insight into organizations. There are several financial statement analysis methods and techniques that can be used to analyse a balance sheet and a profit and loss account. The two most common types of financial statement analysis are:
- Horizontal & Vertical analysis
- Ratio analysis
Horizontal & Vertical analysis
A horizontal analysis consists of a two-year comparison of financial data with other years. This analysis is also known as trend analysis. The horizontal analysis is often expressed in monetary terms (currency) and percentages.
Comparisons of currency amounts provide analysts with an insight into aspects that might contribute significantly to the profitability or the financial position of the organization. An example of a horizontal analysis in currency: In 2011, an organization turned over two million more than in the previous year.
This increased turnover appears to be a very positive development. This is true, however, when the analysis is examined more closely, it shows that the procurement costs of goods and services have increased by 2.5 million. The wonderful picture of an additional turnover of 2 million is at once adjusted to a less positive picture.
A horizontal analysis expressed as a percentage, provides more insight and feeling about the significance of an increase or decrease. An example of a horizontal analysis expressed as a percentage is a representation of an increase in turnover of 1 million on revenues of 2 million in the previous year.
This is an increase of 50%, which is a remarkable growth in turnover for an organization. However, if the increase is compared with a turnover of 20 million in the previous year, then the increase will amount to 5%, which represents a normal growth of an organization.
Expressing an analysis as a percentage provides a much better insight into the increase than when expressed as a currency.
A vertical analysis consists of a representation of standard headings on a financial statement that are expressed as percentage of those headings. In a vertical analysis both the assets and liabilities are considered equal to 100%.
Some examples of headings are: equity, short-term and long-term liabilities. These are expressed as a percentage of the total assets. By doing this every year, insight will be created into the change in the distribution of total assets.
A vertical analysis is also often used to compare companies with one another in the form of benchmarking. Because the headings occur in any given organization, this makes it easy to compare organizations. For example borrowed capital compared to the total assets.
A vertical analysis can also be applied to the profit and loss accounts. By representing the standard heading as a percentage of the total turnover of that year, it is easy to obtain insight into the division of each currency with the different costs, expenditures and profit.
This makes it possible to compare the successive years to identify certain trends.
Ratios, a ratio between two quantities, are used to represent relationships between various figures on a balance sheet, profit and loss account or other accounting records. Ratios always represent a ratio of one figure related to another. The four most common ratios are:
Profitability ratio & profitability
Profitability ratio & profitability measure the results of an organization’s day-to-day management or overall performance and effectiveness of management. Some of the most commonly used profitability ratios are: gross profit ratio, net profit ratio, operating ratio and return on equity capital, return on capital employed ratio, dividends yield ratio and earnings per share ratio.
Liquidity ratios evaluate the current solvency of an organization’s financial position. These ratios are calculated to find out whether an organization has the ability to meet its current obligations. Two common liquidity ratios are the current ratio and the quick ratio.
Efficiency ratios measure the effectiveness of the means that are deployed in an organization. Another name for this ratio is turnover ratio. Many common aspects with which the turnover ratio is calculated are: working capital turnover ratio, fixed assets turnover ratio and debtors’ turnover ratio.
Solvency ratios measure an organization’s ability to meet their long-term interest expenses and repayment obligations. Common ratios are debt-to-equity ratio, equity ratio and interest coverage ratio.
Advantages of Financial Statement Analysis
Financial Statement Analysis is a useful tool that has many advantages. Firstly, it provides investors with information about deciding to invest their funds in an organization. Secondly, governments and regulatory authorities will be provided with an insight into whether the organization meets the accounting principles.
Finally, government agencies can analyse what the organization’s tax liabilities are.
It’s Your Turn
What do you think? How do you apply the financial statement analysis in today’s business? Are the ratios, mentioned in the post, common for you or do you use other or more ratios? If so, which one do you use and why? Please share your experience and knowledge in the comments box below.
- Will, I., Subramanyam, K. R., & Robert, F. H. (2001). Financial statement analysis. McGraw-Hill Internation.
- Stickney, C. P. (1993). Financial statement analysis. Fort Worth, TX: Dryden.
- Lev, B. (1974). Financial statement analysis: a new approach. Englewood Cliffs, NJ: Prentice-Hall.
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