Wednesday, January 27, 2021

Financial Statement Analysis: 6 Steps to Analyze Financial Statements Effectively

Financial statement analysis is the process of examining and analyzing a company's financial statements for economic decision-making purposes. Generally, there are 6 steps to developing an effective financial statement analysis.

Financial Statement Analysis

How Do You Do Financial Statement Analysis? - 6 Steps to Analyze Financial Statements

 

What is Financial Statement Analysis?

Financial Statement Analysis is the evaluation of the company's financial situation in various entities by analyzing profits and losses, following up on administrative decisions, and contributing to the preparation of financial statements.

Financial statements include the income statement, cash flow statement, notes to accounts, balance sheet and the statement of changes in equity.

 

Financial statement analysis includes gaining an idea of a company's financial situation and providing assistance in making effective economic decisions.

Financial statement analysis is auditing and examining the financial statements of an entity, which contributes to determining the ability to implement its financial obligations and make better economic decisions to earn income in the future.

 

Types of Financial Statement Analysis

Financial statement analysis is divided into three main types:

 

Horizontal analysis: Horizontal analysis is the comparison of the financial performance of the organization over two years or more.

The financial analyst compares the sales revenue with the financial amounts, which helps to calculate the percentages of changes between years for all financial balances, such as inventory balance and cash balance.

 

Vertical analysis: the vertical analysis is the calculation of each item in the financial statements as a percentage of the total.

The term vertical analysis is used because the annual figures are listed vertically in the financial statements.

The total of the income statement is the net income from sales, while the total of the balance sheet is the amount of assets in the enterprise.

 

Ratio analysis: Ratio analysis provides the financial analyst with the ability to compare the items of one financial statement or examine the relationships between all the items within two financial statements.

A relative valuation model is a method of determining the worth of an asset that takes into account the value of similar assets. It compares a firm's value with that of its competitors to assess the company's financial worth.

The implementation of the financial analysis to calculate the ratios of the financial statements every year helps analysts to study the trends of the entity over a set of years.

The use of this type of financial analysis facilitates the application of the comparison process between companies, and a set of terms and concepts are used in the relative analysis, including profitability ratios, financial suitability ratios, and liquidity ratios.

 

6 Steps to Analyze Financial Statements Effectively

The success of applying financial statement analysis depends on key steps.  Generally, there are 6 steps to developing an effective financial statement analysis: 

 

Identify the industry economic characteristics: Determining a value chain analysis for the industry is the first step in the analysis of financial statements. This forms a chain of activities related to the production, manufacture, and distribution of special products or services in the facility.

 

Identify Company’s Investment Strategies: Identifying company strategies is the second step in financial statement analysis, and it is concerned with identifying the nature of the products or services provided by the company, and also studying the level of profit margins, the creation of brand loyalty, and control of costs.

It also considers some factors such as supply chain integration and industrial and geographic diversity.

With the help of financial statements, one gets to know about the company in detail, and investors will only invest in a profit-making company.

 

Assess the quality of the Company’s financial statements: The assessment of the entity’s financial statements is a review of all private financial data in the firm, within the context of the relevant accounting standards associated with this field.

When studying the private financial accounts in the balance sheet, it is important to ensure that the recognition, rating and classification are key elements of a correct evaluation.

When studying the income statement, it is important to assess the quality of earnings and as they represent the firm’s economic performance.

 As for the assessment of the statement of cash flows, it provides information on the nature of the firm’s financial liquidity by following up its activities and investments within the financial period.

Everyone relies on financial statements and annual reports to know if the company is able to repay back the loans or not.

 

Analyze current profitability and risk: Profitability and risk analysis is the step that helps financial statement analysts to evaluate the facility and its financial statements. 

When analyzing profitability, it is important to determine the extent of the enterprise’s operations profits in relation to its assets, and the shareholders ’opinion of the nature of its profits. Also, the nature of the risk affecting the firm must be evaluated.

In the last, it is important to analyze any financial data ratios in a comparative manner, considering the current ratios in relation to those from prior periods or relative to companies or industrial averages.

 

Prepare forecasted financial statement: Preparing the expected financial statements is very important in the analysis of financial statements, and it includes a set of assumptions that financial analysts must prepare; In order to predict the future of the firm and its field of work, and then measure the impact of these assumptions on funding and cash flows.

 

Value the firm: There are many valuation approaches for deriving the value of the firm. The most common amongst the lot is the discounted cash flow methodology. 

Discounted cash flow (DCF) is a valuation method to value security, project, company, or asset using the concepts of the time value of money.

Economic value added is the second most favorable approach for deriving the value of the firm.

 

Objectives of Financial Statement Analysis

The financial statements analysis contributes to achieving many goals in the work environment, including:

  • Analyzing the financial situation of the company.
  • Providing visualization of the operational and financial performance of the company.
  • Evaluating the possibility of paying short or long-term liabilities, and settling debts owed by enterprises.
  • Contributing to preparing future plans for activating the role of internal control.
  • Determining the firms' weaknesses and search for suggested solutions that contribute to providing the appropriate treatment.

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