Understanding Financial Statement Analysis and Reporting

Financial statement analysis and reporting involve evaluating a company's financial statements to assess its financial health, performance, and prospects. This process uses different techniques to interpret key financial data, such as profitability, liquidity, and cash flow, helping stakeholders make informed decisions.

Financial analysis involves techniques like ratio, trend, and comparative analysis to identify patterns, assess stability, and evaluate efficiency. Financial statement reporting supports this by clearly presenting the company's financial position. 

Together, these tools help stakeholders understand financial dynamics, assess risks, and make strategic decisions that impact investments, credit evaluations, and business strategies.

The main objectives of financial statement analysis and reporting are listed below.

• Assess the company's financial health and stability
• Evaluate its profitability and operational efficiency
• Identify potential risks and opportunities
• Make informed decisions about investments, lending, or strategic planning
• Communicate financial information to stakeholders such as investors, creditors, and management

A few essential statements will help you do the financial analysis to understand the company’s financial health. What are those? Let’s learn about each of them in detail.

What are the Primary Financial Statements?

The primary financial statements include the balance sheet, income statement, cash flow statement, and statement of changes in equity. These reports provide a comprehensive overview of a company’s financial position, performance, and cash management, offering insights crucial for investors, creditors, and management.

1. Balance Sheet

The balance sheet provides a snapshot of a company's financial position at a specific time. It details what the company owns (assets), what it owes (liabilities), and the residual interest of the owners (equity).

The balance sheet formula is broken down below.

Assets = Liabilities + Owners' Equity

Assets are anything that the company owns. It is further divided into the following.

• Current Assets: It includes cash, accounts receivable, inventory, and other assets that can be turned into cash within a year.
• Non-Current Assets: Long-term investments, property, equipment, and intangible assets like patents.

Liabilities are anything that the company owes to a debtor, including debt payments, taxes, etc. It is further divided into the following categories.

• Current Liabilities: Debts such as accounts payable and short-term loans are due within a year.
• Non-Current Liabilities: Long-term debts, like bonds payable.

Owners’ Equity is a company's share or net worth after deducting liabilities.

• Paid-in Capital: Money raised from selling shares.
• Retained Earnings: Profits kept in the business instead of being paid out as dividends.

2. Income Statement

The income or profit and loss statement shows a company’s financial performance over a specific period. It reports revenues, expenses, and the resulting net income or loss, giving insight into the company’s profitability.

The income statement formula is broken down below.

Revenue - Cost of goods sold = Gross profit - Operating expenses = Operating income - Interest expense = Pre-tax income - Income tax = Net income (or loss)

It includes the information listed below.

• Revenues: Income from sales before expenses.
• Expenses: Costs of running the business.
• Cost of Goods Sold (COGS): Direct costs of producing goods.
• Operating Expenses: Indirect costs like salaries and rent.
• Interest and Tax Expenses: Costs related to financing and taxes.
• Net Income: Profit or loss after all expenses are deducted from revenues.

3. Cash Flow Statement

The cash flow statement tracks the flow of cash into and out of the business over a set period. It categorizes cash flows into operating, investing, and financing activities, helping assess the company’s liquidity and cash management.

The formula for the cash flow statement is shown below.

1. Cash from operating activities = Net income + Non-cash charges +/- Changes in net working capital

2. Cash from investing activities = Capital expenditures - Acquisitions + Proceeds from the sale of investments

3. Cash from financing activities = Cash from debt and equity issuance - Share buybacks and dividends - Debt repayment

Net change in cash balance = Cash from operating activities + Cash from investing activities + Cash from financing activities + Beginning cash balance

• Operating Cash Flows: Cash from daily business activities.
• Investing Cash Flows: Cash used for or earned from investments in long-term assets.
• Financing Cash Flows: Cash from financing activities, like issuing shares or taking loans.

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4. Statement of Changes in Equity

Above are the common financial statements, but some companies also prepare a statement of changes in shareholders' equity, showing how equity has changed over time. 

This statement includes details like new shares issued, dividends paid, and profits kept in the business. It helps understand how these changes affect the value of shareholders' equity.

Also Read: Guide to Understanding Debt Financing for Startups

These primary financial statements are the basis for calculating financial ratios and performing analysis techniques.

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What is the Financial Statement Ratio?

Financial statement ratios compare items from financial statements to assess a company’s efficiency and performance. They help measure aspects like profitability and liquidity. 

Below is the table of various financial statement ratios.

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These ratios provide an overview of your company’s financial performance and allow you to make a well-informed decision.

But how do financial statement analysis and reporting work? In the next section, you will learn various techniques to analyze your financial performance.

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What are the Techniques Used in Financial Statement Analysis and Reporting?

After calculating key financial ratios, analysts use various techniques to interpret these results and better understand a company's performance. These techniques help uncover trends, compare performance with industry standards, and assess the company's financial health. 

They provide valuable insights into trends, operational efficiency, and financial health, enabling stakeholders to assess a company's position relative to its peers and industry standards.

1. Horizontal Analysis

Horizontal analysis, also known as trend analysis, involves comparing financial data over multiple periods to identify trends and growth patterns. This technique helps analysts assess a company's performance by evaluating year-over-year changes in specific financial statement items.

Horizontal Analysis formula = [(Amount in Comparison Year – Amount in the Base Year)/ Amount in a Base Year] x 100

Key Characteristics of Horizontal Analysis.

• Compares line items in financial statements across consecutive periods.
• Expresses changes as both absolute values and percentages.
• Useful for identifying growth trajectories and operational trends.

2. Vertical Analysis

Vertical analysis involves analyzing each line item in a financial statement as a percentage of a base figure, typically total revenue or assets. This technique allows for a detailed examination of the internal structure of financial statements within a single reporting period.

Vertical Analysis, Income Statement = Income Statement Line Item ÷ Revenue

Vertical Analysis, Balance Sheet = Balance Sheet Line Item ÷ Total Assets

Key Characteristics of Vertical Analysis.

• Provides insights into the proportional relationships between line items.
• Useful for benchmarking and understanding cost structures.
• Facilitates comparisons across companies of different sizes.

3. Common Size Statements

Common size statements express all financial statement items as a percentage of a base item to enhance comparability. This technique is particularly useful for comparing financial performance across companies or industries, regardless of size.

Key Characteristics of Common Size Statements.

• Allows for straightforward comparisons of financial metrics.
• Facilitates analysis of trends over time and across companies.
• Helps stakeholders assess financial health relative to peers.

4. DuPont Analysis

DuPont analysis dissects return on equity (ROE) into its parts—profitability, efficiency, and leverage. This technique provides a comprehensive view of the factors driving a company's ROE and helps identify areas for improvement.

ROE = Net Profit Margin X Total Asset Turnover X Equity Multipliers

Key Characteristics of DuPont Analysis.

• Breaks down ROE into three components: profit margin, asset turnover, and financial leverage.
• Provides insights into operational efficiency and financial structure.
• Useful for evaluating performance over time and against competitors.

These analysis techniques are essential for evaluating a company's financial performance and making informed decisions. 

Also Read: Startup Inventory Financing: Key Insights and Loan Options for Emerging Businesses

Do you know how linking the financial statements is crucial to analysis? Let’s find out!

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Why is Linking Financial Statements Essential for Comprehensive Analysis?

Linking the financial statements allows for a comprehensive analysis of a company's financial performance and position. It helps stakeholders understand how net income flows into the balance sheet and how it is adjusted in the cash flow statement, providing insights into profitability, liquidity, and solvency.

Analysts can create financial models to predict business and asset performance, determine fair prices, and assess capital requirements by understanding the interconnections between the income statement, balance sheet, and cash flow statement.

Below are some methods of linking financial statements.

Net Income Linkage

Net Income is the profit remaining after all expenses, taxes, and costs are deducted from total revenue, reflecting the company's profitability.

- Income Statement: Net income is the final figure, showing the company’s profit for the period.

- Cash Flow Statement: It starts with net income and adjusts for non-cash items and changes in working capital to determine cash flow from operations.

- Balance Sheet: Net income increases retained earnings, boosting shareholders’ equity. A net loss reduces retained earnings.

Why Does It Matter?

This linkage shows how profits flow through the financial statements, influencing cash flow and equity and giving a clear picture of the company’s financial health.

Depreciation Linkage

Depreciation is the gradual expense recorded for the wear and tear of fixed assets over their useful lives.

- Income Statement: Depreciation reduces net income as an operating expense, though it doesn't involve cash outflow.

- Cash Flow Statement: Depreciation is added back to net income in the cash flow from operations, ensuring accurate cash flow representation.

- Balance Sheet: Depreciation reduces the book value of fixed assets, reflecting their decreasing value over time.

Why Does It Matter?

Depreciation affects reported profits but not cash flow, helping stakeholders see the difference between asset usage and cash generation.

Net income and depreciation are crucial for understanding a company’s financial performance. Net income links profitability to cash flow and equity, while depreciation highlights the impact of asset management on profits and cash flow, providing a full view of financial health.

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The Takeaway!

Financial analysis and reporting are crucial for maintaining complete control over your business. They allow you to make well-informed decisions with confidence.

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