Financial Statement Analysis: A Comprehensive Guide

Financial Statement Analysis

Creditors, investors, management, and regulatory authorities all have a vested interest in analyzing a company's financial statements.

Purpose of Financial Statement Analysis

Creditors: Assess a company's ability to repay debt by focusing on cash flow measures.

Investors: Evaluate a company's potential for dividends, cash flow generation, and growth to make informed investment decisions.

Management: Conduct ongoing analysis of financial results, comparing them to internal operational metrics for performance evaluation.

Regulatory Authorities: Ensure compliance with accounting standards and regulations, particularly for publicly traded companies.

Methods of Financial Statement Analysis

1. Horizontal and Vertical Analysis

Horizontal Analysis: Compares financial information over multiple reporting periods to identify trends and changes.

Vertical Analysis: Analyzes the proportional relationships between line items within a single financial statement. For example, expressing each income statement item as a percentage of gross sales.

2. Financial Ratio Analysis

Financial ratios measure the relative size of one financial figure to another, providing insights into a company's performance. These ratios are typically compared to prior periods or industry averages.

Types of Financial Ratios

Liquidity Ratios: Assess a company's ability to meet short-term obligations.

• Cash Coverage Ratio: Measures the availability of cash to cover interest expense. A ratio significantly greater than 1:1 indicates a healthy ability to pay interest.
• Current Ratio (Working Capital Ratio): Compares current assets to current liabilities. A ratio of 2 suggests that current assets can cover twice the amount of short-term liabilities.

Financial Statements

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement