Definition and Examples of Financial Statement Analysis
Financial statement analysis involves reviewing financial reports with a goal of learning about a company’s financial health. Investors study income, expenses, cash holdings, profitability, and other financial measures to learn how successful a business has performed. With that knowledge, some investors hope to predict how the business will perform going forward.
Three of the most popular financial statements are:
- Balance sheets
- Income statements
- Cash flow statements
Those are the most commonly used financial reports, but there are others. Investors can use the reports that meet their needs.
How Does Financial Statement Analysis Work?
Investors who research companies use financial statements to understand the past and make informed decisions about investing in a company. By reviewing financial details, you can see how a company’s financial information has changed over time and how it compares to competitors in the same industry.
Note
Financial statements are used by investors as well as managers who evaluate internal operations and regulators who monitor financial activity. Creditors and regulators also review financial statements.
Financial statements provide information you can use for financial ratio analysis, or the practice of calculating financial data to try to understand a company’s financial position. For example, you might calculate the price-to-earnings ratio using the earnings per share (EPS) information from an income statement.
Balance Sheet
A balance sheet details a company’s assets and liabilities. With that information, you can see if a company has high levels of debt relative to assets. And reviewing previous balance sheets, you might uncover trends, such as an increasing reliance on debt or debt elimination. Balance sheets also include the statement of shareholder equity, which explains the value of outstanding shares. This statement of shareholder equity reports changes in the number of shares as well as buybacks and other activities.
Income Statements
Income statements, also known as profit and loss statements, show how much revenue a company brings in and where that money goes. Expenses are organized into categories such as operating expenses and the cost of goods sold, which helps investors identify where a business spends money. The bottom line of an income statement shows net profits, which is the amount left over after paying all expenses. Income statements show investors whether the company operates at a loss.
Cash Flow Statements
A cash flow statement lists payments into and out of a company. Cash flow is critical, as running out of liquid cash can cause a company to become insolvent. Cash flow is different from profits shown on an income statement. The income statement might include “expenses” that are not related to cash flows (such as depreciation or amortization), so its profits may not provide enough precision about a company’s cash position. As a result, it’s important to evaluate a company’s cash inflows and outflows separately from figures on an income statement.
What It Means for Individual Investors
Financial statement analysis helps investors familiarize themselves with the company’s finances to make informed investing decisions. But it’s critical to consider several key points about the practice of using financial statements:
- Each report is a snapshot of financial data at a specific point in time, and the company’s finances can change after a report is generated.
- You can understand how a company’s finances evolve over time by using more than just one financial statement.
- Many investors choose to learn how competitors’ financial statements compare to the company they’re studying.
- If you rely on financial statement analysis, you should still continually monitor the company and industry.
- Seemingly positive trends can quickly reverse course and are sometimes actually signs of trouble.
The numbers you find in financial reports are just one piece of a bigger picture. For more clarity on any company you’re considering investing in, you also need a qualitative understanding of what’s going on. That may require reading through narrative descriptions, news reports, and other sources.
Note
Financial statement analysis is an ongoing process for investors—not a one-time task.
You do not necessarily need to dive into financial statement analysis if you want to invest. This practice is primarily for stock pickers, and you don’t need to analyze and select individual stocks when you invest. As an alternative, you can practice passive investing using index funds and passive ETFs. With that approach, you invest in the market as a whole instead of choosing individual securities (or having somebody pick stocks for you).
Key Takeaways
- Financial statement analysis is the practice of reading company reports to learn about an organization’s financial health.
- Financial statements provide information you can use for calculations, ratio analysis, and trend analysis.
- Investors who take a passive investing approach do not need to select individual stocks or analyze company reports.
- Try to go beyond the numbers available in financial statements. Research big-picture trends, competitors, management issues, and more.
FAQs
For the majority of Level I candidates, Financial Statement Analysis is one of the harder topics. Although it assumes no prior knowledge, the level of detail of some of the later readings can be tricky if the fundamentals haven't been fully understood yet.
How do you get good at financial statement analysis? ›
There are generally six steps to developing an effective analysis of financial statements.
- Identify the industry economic characteristics. ...
- Identify company strategies. ...
- Assess the quality of the firm's financial statements. ...
- Analyze current profitability and risk. ...
- Prepare forecasted financial statements. ...
- Value the firm.
However, they have many limitations, which include cost basis, unusual data, lacking data, the diversification effect, and the use of estimates and different accounting methods.
Why is a careful reading of the financial statements not enough? ›
Simply reading financial statements may not be enough because they only show numbers without explaining the full story. To understand better one needs to analyze the numbers, compare them over time, and consider other factors like market trends and company goals.
Is financial analysis a hard skill? ›
Technical training, financial literacy, accounting knowledge, and analytics training are among the hard skills required for Financial Analysts. They should also possess soft skills such as critical thinking, clear communication, problem-solving, and leadership.
What are the hardest finance tests? ›
The CFA (Chartered Financial Analyst) exam is recognized as one of the most rigorous exams globally. Annually, more than 100,000 candidates undertake this comprehensive assessment. Divided into two levels, the exam aims to evaluate financial professionals' proficiency in relevant practices and tools.
How can I be good at financial analysis? ›
Some tips to enhance financial analysis skills: Take courses or pursue certifications in financial analysis. Analyse real financial statements and reports regularly. Familiarise yourself with financial modelling tools and spreadsheet software. Keep up with industry trends, news, and changes in regulations.
Is it hard to be a financial analysis? ›
A successful career as a financial analyst requires strong quantitative skills, expert problem-solving abilities, adeptness in logic, and above-average communication skills. Financial analysts have to crunch data, but they also have to report their findings to their superiors clearly, concisely, and persuasively.
What is a financial statement analysis for beginners? ›
What Is Financial Statement Analysis? Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization and to evaluate financial performance and business value.
What are the 3 most important financial statements in financial analysis? ›
The income statement, balance sheet, and statement of cash flows are required financial statements. These three statements are informative tools that traders can use to analyze a company's financial strength and provide a quick picture of a company's financial health and underlying value.
Financial statements analysis ignore qualitative elements as it is confined to the monetary matters only because quality cannot be measured in monetary terms. Ans. Financial statement analysis enables the 'top management' to evaluate the overall efficiency of the business.
Why is financial analysis important? ›
Financial analysis allows you to identify potential risks and vulnerabilities in your business's financial performance. By addressing these risks proactively, you can mitigate their impact and protect your business from financial setbacks.
What are the techniques of financial statement analysis? ›
There are five commonplace approaches to financial statement analysis: horizontal analysis, vertical analysis, ratio analysis, trend analysis and cost-volume profit analysis.
What limitations must be kept in mind while evaluating the financial statements? ›
There are 8 limitations: Historical Costs, Inflation Adjustments, No Discussion on Non-Financial Issues, Bias, Fraudulent Practices, Specific Time Period Reports, Intangible Assets, and Comparability.
Is financial analysis difficult? ›
The Bottom Line. A career as a financial analyst requires preparation and hard work. It also has the potential to deliver not just financial rewards but the genuine satisfaction that comes from being an integral part of the business landscape.
Is it hard to be a financial analyst? ›
They need both strong math skills—specifically in statistics and probability—and computer literacy, as analysts use software to look at trends and make forecasts. These professionals should also have a good grasp of economics and know how to read and interpret financial statements.
Is financial analysis stressful? ›
Although careers in finance are known to require long hours and be stressful to a certain degree, incentives such as high pay, bonuses, job security, and opportunities for career advancement are just a few reasons why Financial Analysts like this field of work.
What is the hardest part of being a financial analyst? ›
Many analysts report that the hardest part of their job is communicating sophisticated analysis and insights to decision-makers in a way that is both comprehensible and actionable.
