Analyzing Financial Statements


Analyzing Financial Statements

Whether you are a simple investor, or a decision maker in a company, the ability to understand the performance of a company by analysing the financial data is a mighty useful skill to have.

Financial statement is a summary of the financial performance of a company. The three main reports in a financial statement are the Balance Sheet, Income Statement and the Cash Flows statement.

One excellent way of analysing a financial statement is through financial ratios.   A ratio is quite simply,   dividing an item with another.

For example, Gross Profit Margin is calculated by dividing gross profit by net sales.   There are different types of   ratios that help one measure the profitability,   liquidity,   debt,   operating performance,   cash flow performance and investment valuation of   a company.

There are a  number  of   published  ratio  benchmarks  that  will  help  you understand  if   a  particular  ratio  is  red,   green  or  amber. For  example,   the  Debt  Ratio  is  helpful  in  assessing  the  ability  of   a  firm to  pay  back  long- term  debts.

Debt ratio = Liabilities/Assets

The normal benchmark for debt ratio is 0.6-0.7.   The higher the number, the higher is the debt.   So you know that if the number is very different  from  the  benchmark,   you  got  to  take  a  closer  look.

Another  important  approach  to  understand  the  performance  of   a business  over  time  is  ‘Trend  Analysis’ .   By analyzing  the movement of   the  same  financial  information  over multiple  periods,  may  give you important signals  –  whether  the  revenue  is  growing  over  the  past period  of   reporting,   whether  costs  are  going  up  or  down,   whether debt  is  going  up  or  down  etc.

Comparing the  financial  performance  of   a  company  against  its  peers is  another  very  useful  indicator  of   relative  performance.

If   you are examining financials data for just one period,   ‘Vertical Analysis’   works best.   The main advantage  of   vertical  analysis  is  that the  information  of   two  companies  can  be  compared  irrespective  of their  sizes.

The following simple example from Investopedia drives home the point:

Suppose XYZ  Corp  has three  assets:  cash  and  cash equivalents  (worth  $3 million) , inventory  (worth  $8 million) , and property  (worth  $9 million) .

If vertical analysis is used,   the asset column will look like:

Cash and cash equivalents:  15%

Inventory:  40%

Property:  45%

By knowing how to examine a financial report, you will gain good understanding of the general trends and  performance of a business.