Fundamentals of Financial Statement Analysis

  • By AFP Staff
  • Published: 12/12/2023

Fundamentals of Financial Statement AnalysisFinancial statement analysis tells a story about your company’s choices.

The relationship between the elements of financial statements might tell you how the company is financing growth or reinvesting its earnings. They could reveal how efficient and effective the company is at managing its assets and liabilities. Or they could help determine if the company is in a position to experience significant growth.

The ability to interpret the story correctly and make it easily accessible to decision-makers is the unique and valuable asset that FP&A professionals bring to any organization. Oana Labes, President & Founder of Financiario, explained the fundamentals of financial statement analysis.

Financial Analysis Starts with Data

There are several points of data you need before beginning your analysis. The first is financial statements. Good, reliable financial statements are created when all transactions during a certain period are recorded following the appropriate rules and principles of accounting.

In addition to reliable accounting records, you will also need a good grasp on:

  1. The industry landscape.
  2. The company's competitive positioning.
  3. The quality of its management.

The methods used to obtain this type of information include:

  • The PESTLE Framework — This looks at external factors that can affect your business, including political, economic, social, technological, legal and environmental factors. It also considers market trends that could impact your company’s direction, performance and position in the marketplace.
  • Porter's Five Forces — There are five competitive forces that shape every industry. This model identifies and analyzes these forces to help determine where your company’s strengths and weaknesses lie, which then influences corporate strategy.
  • SWOT — Identify your company’s strengths, weaknesses, threats and opportunities and determine its competitive position using this strategic analysis model.
  • Value Chain Analysis — Used to analyze the value of a product or service in order to increase the efficiency of production, this method allows a company to deliver maximum value for the least possible cost.

Determine Your Objective for Financial Analysis

Once you have reliable financial statements and the associated qualitative information ready to analyze, you need to determine your objective for performing the analysis. What is your goal? Your CFO might want to assess whether the company is on track to meet its strategic objectives, or a business partner might want to check performance metrics. Maybe an investor is deciding if investing in a particular stock is a good idea, or you might have a capital provider who wants to know the amount of financing needed as well as the terms your company will be extending to a borrower or investee.

The General Business Context Matters for Financial Analysis

Before conducting financial analysis, Labes advises FP&A professionals to run a series of general business health tests. Just like a doctor runs tests in order to determine the health of their patient, so too does a financial analyst run health tests on the company in order to determine the scope of their basic financial analysis and explore specific areas before drawing any final conclusions.

You may shorten this process based on the extent of your knowledge of the company and/or are under significant time constraints, in which case you may choose to selectively use financial analysis techniques and not run an end-to-end process.

Labes’ 4-Step Process for Financial Statement Analysis

Labes shared her four-step process for analyzing financial statements.

1. Study Historical Trends and Expectations

Labes expands the analysis from current results to include multiple historical and forecasted periods. “I start with trend and common size analysis for the balance sheet and income statement to compare period over period changes in key figures like revenues and margins, and also to understand how key figures evolved in proportion to others — such as how receivables or cash balances evolved relative to total assets,” said Labes.

2. Conduct Balance Sheet and Income Statement Ratio Analysis

She then moves on to a balance sheet and income statement ratio analysis. Labes uses a set of key ratios for each company she works with that covers liquidity, solvency, profitability and deficiency. For example, she will only use quick ratio to assess liquidity for companies with material inventory balances and will stick with the current ratio for the rest. She also typically favors a fixed charge coverage ratio before choosing an interest coverage ratio when analyzing a company with term debt obligations.

3. Conduct Cashflow Statement Analysis

Next, Labes analyzes the cashflow statement separately, looking at both cashflow ratios and the evolution of cash balances, which tell the story of the company's cashflow across various periods. “At this point, I usually have a basic understanding of the company's health and how that plays into my specific objectives for performing that particular financial analysis,” she said.

4. Move on to More Advanced Work

Finally, she is ready to move on to more advanced work, which means choosing more complex financial ratios alongside scenario analysis, stress tests, margin of safety calculations, discounted cashflow valuations, and industry or target benchmarking.

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