Financial Statement Analysis

Financial Statement analysis helps figuring out strengths and weaknesses of a firm. This is done by matching the income statements to balance sheets.

The three most common statements used for analysis are

a) Cash Flow Statements- A compilation of the cash receipts and disbursements of a company.

b) Profit and Loss account- indicates how a company’s revenue is converted to net income

c) Balance Sheet- A compilation of assets and liabilities of the company and tells the value of the company

Types of analysis

1) Trend analysis

Trend analysis- comparing values over the years. It gives a sort of a trend certain values follow. For e.g an investor would want to know the future growth prospects of the company and he would forecast that value based on the past revenues, EBITDA, net income etc. Therefore such an analysis can give a growth estimation. Also it can be used to observe sudden improvement or decline in the performance the company in a particular year, the reasons for which can be found out

2) Ratio Analysis (comparables analysis)

Ratio Analysis is generally of use to the investors and acquirers. It helps investors compare two different stock based on certain ratios. The most common ratios are P/E, EV/ EBITDA(Enterprise Value/ EBITDA). Each ratio has a different utility. For example P/E ratio may be useful in determining whether a stock is undervalued or overvalued by comparing it to the industry standards. Lower the value of P/E more chances of the stock being undervalued if the fundamentals and growth prospects of the company are good.  EV/EBITDA is a multiple that might be used by the acquirers to value a company.

Similarly other ratios such as Current Ratio and also information like operating cycle and debt to equity ratio can help banks decide whether to see how leveraged the firm and also to see if short terms loans be given to them etc.

Thus these statements have multiple utility and can be used by Shareholders, Investors, Acquirers, Banks and even the internal management.

To the internal Management these statements give an account of where the company is standing. Cash flows help the company understand how much cash is it actually generating which is the ultimate aim of a company. The profit and loss statement helps companies decide how profitable their operations and what the major areas of expenditure. It also helps analyzing the operations in part. It is possible to know exactly where the major issue is incase of losses. It could be a lower gross margin, higher administrative expenditure etc.

Disadvantages of Financial Statement Analysis

If the financial statements are not prepared properly they may actually end up misleading the user leading to poor decision making

Financial statements may not be useful for planning at times since they are based on the historical data and the conditions that prevailed then may not be applicable now

Financial Statements only provide a quantitative aspects about a business’s position, therefore, a complete financial statement analysis may lead to ignorance of qualitative factors affecting the business..

Financial statement analysis is highly subjective and may vary from person to person. One may consider a growth of 10% as high but other may consider it low. Therefore, conclusions may vary from person to person.