Financial Statement Analysis Overview: Techniques, Components, and Applications

Financial statement Analysis refers to the process of examining a company financial record to make well-informed business decisions. Since financial statements vary between companies, each document is designed to provide insight into the organization financial health. These records are crucial for tracking performance over time and assessing progress toward key strategic goal.

As per IAS 1, (Presentation of Financial Statements) the required financial statements for a complete set of financial reporting are five:

Types of Financial Statements

1. Statement of Financial Position (Balance Sheet)

• Shows the entity’s financial position at a specific date.
• Includes assets, liabilities, and equity classified as current or non-current.
• Helps assess liquidity, solvency, and capital structure.

2. Statement of Profit or Loss and Other Comprehensive Income (Income Statement & OCI)

• Reports revenues, expenses, profits, and losses for a specific period.
• Can be presented as:
  • A single statement (combining profit/loss and OCI).
  • Two separate statements (one for profit/loss, another for OCI).
• Other Comprehensive Income (OCI) includes unrealized gains/losses (e.g., foreign currency translation adjustments).

3. Statement of Changes in Equity (Equity Statement)

• Shows movements in equity components (e.g., share capital, retained earnings, reserves).
• Highlights dividends, new share issuances, and changes in retained earnings.

4. Statement of Cash Flows

• Reports cash movements classified into:
  • Operating activities (cash from core business operations).
  • Investing activities (cash used for assets, investments).
  • Financing activities (cash flows from borrowings, equity transactions).
• Helps assess cash liquidity and financial flexibility.

5. Notes to the Financial Statements

• Provides additional details and explanations about accounting policies, estimates, and risk exposures.
• Ensures transparency and compliance with IFRS requirements.

Ways to Analyze Financial Statements:

1. Vertical Analysis:

Vertical Analysis assesses financial statements by expressing each line item as a percentage of a large total. In an income statement, for instance, every item is shown as a percentage of gross sales, while in a balance sheet, each entry is recorded as percentage of total assets. Similarly, in a cash flow statement, cash inflows and outflows are represented relative to total cash inflows. This method is commonly applied within a single reporting period, such as a quarter, to understand the proportional relationships between financial statement item. It is particularly useful for identifying cost structures, assessing financial health, performing regression analysis, and conducting ratio trend analysis. Analysts use vertical analysis to identify shifts in a company’s financial position and operational efficiency over time.

2. Horizontal Analysis:

Horizontal Analysis is a method used to examine financial statement by comparing data across different periods to identify trends and changes over time. Analysts use this approach to track changes, such as increase and decrease in specific financial values by comparing the current year’s figures to a base year, using either percentage or absolute terms. A company’s financial statements provide value insights into its operational performance. By examining key metrics like return on equity, inventory turnover, and profit margin, analysts can identify strengths or potential issues. It can also assess liquidity by exploring ratios like interest coverage and cash flow-to-debt, helping determine if a company can meet its financial obligations.

Horizontal analysis provides valuable insights into a company’s operational performance by highlighting trends in financial data over multiple periods.”

3. Ratio Analysis:

Ratio Analysis is a financial tool used to evaluate a company’s performance by analyzing key figures from its financial statements. It helps external analysts assess various aspects of a business, such as profitability, liquidity, solvency, and operational efficiency. By examining current and past financial data, analysts can identify trends, determine if a company’s financial health is improving of declining, identify financial risks and opportunities, hence playing a key role in decision making. Furthermore, Ratio Analysis provides clear and quantifiable financial metrics for investors, creditors, and other stakeholders.

Key Uses for Ratio Analysis:

• Comparative Analysis: Ratio analysis enables businesses to compare their financial performance against industry competitors, helping identity market gaps, evaluate strengths and weaknesses, and develop strategies for improvement.
• Trend Analysis: Helps in tracking financial performance over multiple periods, predict future outcomes, and identify potential financial challenges that may not be evident from single-period review.
• Operational Efficiency: Assesses asset and liability efficiency, identifies inefficiencies like underutilized resources or excess costs, and optimizes resource allocation to enhance overall performance.

Financial statement analysis is essential for assessing a company’s financial health and performance. By utilizing techniques such as vertical, horizontal, and ratio analysis, stakeholders can gain valuable insights into financial trends, strengths, and potential risks.

These methods support informed decision-making for managers, investors, and creditors, enabling them to develop strategies for sustainable growth and financial stability.