What is Financial Statement Analysis?

The term ‘financial statement analysis ‘refers to determining the firm’s financial position by reviewing and analysing the balance sheet items, profits and loss accounts, cash flow statements, funds flow statements, etc.

The financial analysis aims to understand the company’s financial health to judge the firm’s profitability. Several groups of stakeholders are interested in the analysis of financial statements.

Owners are interested in knowing how their business is performing, and trends help them determine whether to expand the business or discontinue a particular product or service. Investors are interested in knowing whether it is worth investing in the shares of a particular company.

Similarly, bankers, lenders and financial institutions want to gauge the financial performance and position before offering their financial assistance in loans and advances.

Just like a doctor examines his patient by recording his body temperature, blood pressure, etc., before making a conclusion regarding the illness and giving his treatment, a financial analyst uses various tools to judge the soundness of the firm.

Tools/ Methods of Financial Analysis

Comparative statements

In this method, either the financial statements of two or more years are presented in a comparative form or they are presented for two or more firms for the same years. It helps to understand which year performed better or which firm performed better.

Trend analysis

In this method, the trend of a particular income or expense is observed for several years and compared with income or profitability to ensure whether the movement is justified or it is abnormal.

Common size statements

A common-size income statement is one in which each line item is stated as a percentage of a base number, as opposed to a split-size income statement. This is sometimes referred to as total revenues or total sales. In a similar way to the financial ratio analysis, a common-size income statement serves a similar goal. In addition, it allows for comparable comparisons across periods, companies, and industry sectors.

Funds flow analysis

Funds flow analysis (FFA) measures all the flows of money in and out of business. It’s a useful tool in understanding how money moves in a business and can reveal vital information about the health of a business. It helps to analyse sources and applications of funds.

Cash flow analysis

Cash flow analysis helps to analyse cash and non-cash activities to ascertain net actual cash movement that happened during the year.

Put simply, it’s a process of reviewing your business’s cash inflows and outflows in order to better understand your financial health. This can be done on a monthly or yearly basis and will give you a clear picture of where your money is coming in and going out.

There are a number of different methods you can use to track your cash flow, but one of the simplest is to create a cash flow statement. This document summarizes your cash inflows and outflows for a specific period of time, which can be monthly, quarterly, or yearly.

One of the main benefits of cash flow analysis is that it can help you to make better use of your working capital. By tracking your cash inflows and outflows, you can better manage your inventory levels and accounts payable, which can free up cash flow and improve your bottom line.

Ratio analysis

Ratio analysis is a tool of financial analysis that is used to evaluate a company’s financial performance. Ratios are calculated by dividing one financial statement item by another. Financial ratio analysis can be used to assess a company’s liquidity, solvency, profitability, and efficiency.

This is the most popular and powerful tool which can be used to analyse several performance-related indicators such as sales, profitability, return on investment, share price etc.

Cost-volume-profits analysis

Profitability (CVP) analysis, also known as break-even analysis, is a financial planning technique that company executives use to determine short-term goals for their organisations. Profitability is conveyed to company decision-makers through the use of changes in selling prices, costs, and volume of sales (in the short term).