The financial statement analysis typically involves several techniques and methods to help investors, creditors, and other stakeholders. It reveals a company’s strengths, weaknesses, potential risks, and rewards.
The world of financial management can appear intimidating without proper knowledge. But with the right tools and understanding of financial statements, you can gain valuable insights into a company’s financial state.
This blog aims to familiarize you with the analysis of financial statements so that you can unlock the mysteries behind a company’s financial numbers.
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What is Financial Statement Analysis?
Financial statement analysis is the process of analyzing a company’s financial statements to evaluate its financial performance and condition. It involves reviewing and analyzing financial reports, such as income statements, balance sheets, and cash flow statements, to gain insights into a company’s profitability and overall financial situation.
Understanding a company’s financial management and identifying areas that require improvement are the objectives of financial statement analysis. Also, understanding the meaning of financial statement analysis is essential for investors to assess the profitability and stability of a company before making investment decisions.
Types of Financial Statements
Companies produce financial statements to give crucial information about their financial status and assist stakeholders in making informed decisions.
There are three main types of financial statements: income statement, balance statement, and cash flow statement.
In the below points, we will discuss these types of financial statements.
- Income Statement- An income statement, also known as a profit and loss statement, is a financial report that summarizes a company’s revenue, expenses, and profits or losses over a specific period, generally for a quarter or a year.
The income statement provides an overview of a company’s financial performance by showing how much money the company generated from sales or services, and how much it spent on expenses like salaries, rent, and taxes. The difference between revenue and expenses is the company’s net income or profit.
It is a tool that provides insights into a company’s financial health, profitability, and operating efficiency. It can also be used to compare a company’s performance to its competitors.
- Balance Sheet- A balance sheet is a financial statement that provides a clear picture of a company’s financial position at a specific point in time, typically at the end of a quarter or a year.
It provides insights into how the company is financing its operations and investments.
The balance sheet shows a company’s assets, liabilities, and equity.
- Assets are resources that the company owns or controls and can use to generate future economic benefits, such as cash, investments, inventory, and property.
- Liabilities are the company’s debts to creditors, such as loans, accounts payable, and taxes owed.
- Equity represents the residual interest in the assets of the company after deducting liabilities, and it includes the company’s retained earnings and stockholder’s equity.
- Cash flow Statement- A cash flow statement is a financial statement that shows the inflows and outflows of cash and cash equivalents for a company during the quarter or a financial year.
The cash flow statement is divided into three main sections: operating activities, investing activities, and financing activities.
- The operating activities section shows the cash flow from the company’s primary operations, such as cash received from customers and payments to suppliers and employees.
- The investing activities section shows the cash flow related to the purchase and sale of long-term assets, such as property, and land; as well as investments in securities and other businesses.
- The financing activities section shows the cash flows related to the company’s financing activities, such as the issuance or repayment of the debt, and the payment of dividends to shareholders.
The cash flow statement is an important financial statement that provides insights into a company’s ability to generate cash and manage its cash flows. Moreover, it is used in financial analysis and can be compared to analyses from previous years to identify trends and changes in a company’s cash flow position.
There are several tools used in financial statement analysis. Here in the following points, we will discuss the most commonly used tools. The methods of financial statement analysis encompass various techniques, such as ratio analysis and trend analysis, which help investors and analysts assess a company’s financial health and performance.
- Comparative Financial Statement- A comparative financial statement is a tool used in financial statement analysis that shows the financial performance and position of a company over multiple periods.
It allows for a side-by-side comparison of the company’s financial statements for different periods, such as year-over-year or quarter-over-quarter.
By comparing the financial statements from different periods, analysts can identify trends and changes in a company’s financial performance, position, and growth over time.
The comparative financial statement is especially useful for identifying changes in key financial metrics, such as revenue growth, expenses, and profitability.
- Common Size Statements- A common size statement is a financial statement that expresses all items as a percentage of a common base value, such as total assets or total revenue.
This helps identify trends and changes in a company’s financial position over time and also allows for easy comparison between companies in the same industry.
- Ratio Analysis- Ratio analysis involves the calculation of financial ratios using data from financial statements. These ratios are used to assess a company’s financial performance and health. Common ratios include liquidity ratios, profitability ratios, and solvency ratios.
- Trend Analysis- Trend analysis of financial statements involves the identification of patterns and changes in a company’s financial performance over time. This is done by comparing financial data from multiple periods and looking for trends and changes in key financial ratios and metrics.
- Vertical and Horizontal Analysis- Vertical analysis involves the comparison of financial statement items to a base value, such as total assets or total revenue. This allows for the identification of trends and changes in a company’s financial position over time.
The horizontal analysis involves the comparison of financial statements from different periods, such as year-over-year or quarter-over-quarter.
How to Analyze Financial Statement?
Financial statement analysis is crucial for understanding a company’s financial standing. It involves a thorough review of financial statements to evaluate the company’s performance, profitability, and overall financial health. Investors, creditors, and stakeholders utilize this analysis to make well-informed decisions about the company’s current situation and future prospects.
Here’s a breakdown of steps crucial in analyzing financial statements:
Step 1 – Obtain the Required Financial Statements:
To comprehensively analyze a company, gather its income statement, balance sheet, and cash flow statement. These critical financial statements are typically available on the company’s official website or within its annual report, providing essential insights into its financial performance and position.
Step 2 – Assess key Financial Ratios:
Utilize financial ratios to evaluate different dimensions of the company’s performance. Some commonly used financial ratios include the current ratio, debt-to-equity ratio, gross profit margin, and net profit margin offer insights into the company’s financial picture
Step 3 – Conduct Vertical and Horizontal Analysis:
Conduct vertical analysis by representing individual items on a financial statement as a percentage of a key reference, often total revenue or assets. Simultaneously, perform horizontal analysis by comparing data across multiple time periods, which helps to identify patterns, trends, and alterations in financial performance.This helps in understanding the relative importance of each item and tracking changes over time.
Step 4 – Analyze Cash Flow Statements:
Review the Cash Flow Statement to gain an understanding of the company’s cash situation. Analyze how the company generates and uses cash through operational, investing, and financing activities. This analysis is essential for evaluating liquidity and forecasting future operational capabilities.
Step 5 – Consider Qualitative Factors:
Looking beyond just the numbers, take into account qualitative aspects such as the company’s leadership, industry position, competitive advantages, and market projections. These qualitative variables wield significant influence over the company’s future performance and must be integrated into the analysis.
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Limitations of Financial Statement Analysis
While financial statement analysis is a powerful tool for evaluating a company’s financial status, there are several limitations to it. As an investor, one should consider the below-mentioned limitations when making investment or business decisions.
- Historical Data- Financial statements only provide historical data for a company’s performance and it may not reflect its future performance or potential. Market conditions, economic trends, and other factors may change in the future. All of these factors can impact a company’s financial position and performance.
- Accounting Standards- Financial statements are prepared according to accounting standards and can vary across different regions and may not fully reflect the economic reality of a company’s operations. This can make it difficult to compare financial statements across different companies or industries.
- Lack of Information- Financial statements may not provide a complete picture of a company’s financial position. This happens because the statements may not include information on non-financial factors such as the quality of management, intellectual property, or brand recognition.
- External Factors- Financial statements can be impacted by external factors such as changes in economic conditions, industry trends, or changes in business requirements. These factors may not be reflected in the financial statements and might require some additional analysis to understand the impact.
Case Study – Infosys
Infosys, a Bangalore-based multinational IT firm founded in 1981 by seven engineers, offers business consulting, software development, and outsourcing services in over 50 countries. With a workforce exceeding 350,000, it is listed on the National Stock Exchange of India and the New York Stock Exchange. Recognized as one of India’s largest IT companies, Infosys holds a strong position in the global IT services market. Prepared to benefit from escalating demand while upholding its strong financial position and global brand reputation.
Analyzing the Financial Statements of Infosys:
The financial statements of Infosys for the fiscal year concluding on March 31, 2023, can be readily accessed on the company’s official website. These statements provide a comprehensive insight into Infosys’ financial performance, encompassing key figures such as revenues, expenses, profits, and other significant financial data
In the pursuit of comprehensive financial analysis, essential financial ratios have been calculated for Infosys. Noteworthy ratios include the current ratio at 1.85, indicating a favorable liquidity position. Additionally, the debt-to-equity ratio stands at 0.50, demonstrating a balanced capital structure. The gross profit margin and net profit margin are observed at 39.5% and 23.6%, respectively, showcasing efficient operations and robust profitability.
| Ratio | Formula | Value |
| Current ratio | Current assets / Current liabilities | 1.85 |
| Debt-to-equity ratio | Total liabilities / Total equity | 0.50 |
| Gross profit margin | (Revenue – Cost of goods sold) / Revenue | 39.5% |
| Net profit margin | Net income / Revenue | 23.6% |
Comparisons have been made between Infosys’ financial ratios and the industry benchmarks for companies within the information technology (IT) sector. The company’s ratios generally exceed the industry averages, displaying favorable performance in areas such as liquidity and profitability.
| Ratio | Infosys | IT industry Average |
| Current ratio | 1.85 | 1.75 |
| Debt-to-equity ratio | 0.50 | 0.60 |
| Gross profit margin | 39.5% | 38.0% |
| Net profit margin | 23.6% | 22.0% |
Furthermore, an examination of Infosys’ financial ratios over the last three financial years reveals consistent figures. The stability in these ratios suggests a continuous and steady financial performance throughout this period.
| Ratio | 2023 | 2022 | 2021 |
| Current ratio | 1.85 | 1.80 | 1.75 |
| Debt-to-equity ratio | 0.50 | 0.55 | 0.60 |
| Gross profit margin | 39.5% | 39.0% | 38.5% |
| Net profit margin | 23.6% | 23.1% | 22.6% |
In addition to numerical analyses, qualitative aspects of Infosys are pivotal in the assessment. Infosys, a prominent player in the Indian IT sector, demonstrates a formidable global presence, catering to a diverse spectrum of clients. Despite the industry’s competitive nature, Infosys maintains several strengths, including its strong brand identity, extensive global footprint, and a talented workforce.
Conclusion for this Case Study:
Infosys emerges as a financially sound and stable company, equipped with numerous advantages including its brand strength, global presence, and experienced staff. The company’s financial ratios remain consistent and outperform industry averages. However, prospective investors should remain attentive to the challenging competitive environment in which Infosys operates.
Conclusion
In conclusion, we can say that financial statement analysis is a continuous process. There is a core need for financial statement analysis. It requires ongoing analysis and adjustments to maintain the company’s financial success. It involves having access to accurate and reliable financial information and an in-depth knowledge of accounting principles and financial analysis techniques.
By mastering the various financial statement analysis tools and considering the limitations associated with financial statements, you can dig deeper into the financial numbers of a company. This will help you uncover the true story behind financial statements.