A financial statement can help businesses evaluate their financial stability and address the challenges. Professionals working in the financial sector can benefit from learning how to read a financial statement. Understanding the basic concepts of financial statements can help you interpret the financial progress of a business. In this article, we define financial statements, explain effective steps to conduct an analysis of financial statements and provide some additional tips to further your finance knowledge.
What is the analysis of financial statements?
Analysis of financial statements refers to the process of reading and assessing the financial statements of a company. This process allows professionals like financial analysts to analyse past and current company performance and make forecasts depending on the results in the statement.
A financial statement may contain records of debits, credits, debts and investments of a company. Analysing this data can also help investors in making decisions.
Here are four types of financial statements in basic accounting:
- Balance sheets: A balance sheet contains all the information about the assets, liabilities and equities of a company.Â
- Income statement: An income statement can provide information about the profit and expenses of a company during a specific accounting period.Â
- Cash flow statement: A cash flow statement can tell if a company is able to pay debts and expenses and fund investments.Â
- Shareholder’s equity statement: This document can tell information about the stock equity of shareholders for a specific accounting period.Â
How to analyse financial statements
Here are effective steps to analyse financial statements:
1. Review objectives of the company
Reviewing the objectives of a company can help you understand its financial expectations. It can be important to ensure the information on the financial statement aligns with company objectives. You can check if the profits and expenses support the objectives of the company.
2. Select the method of analysis
Find the right method to conduct financial statement analysis. With the help of the right method, you can identify which data to collect, process and interpret. There are three common techniques of financial method analysis are horizontal, vertical and ratio analysis. Here are different methods of conducting these statement analysis:
Conducting a vertical analysis
First, select a financial statement you want to analyse. You can analyse documents from both current and previous years. Consider analysing the figures appearing in the same column. You can focus on checking total sales and expenses. You can also compare specific line items to others in the report.
Conducting a horizontal analysis
To conduct a horizontal analysis, collect current or previous financial statements that you want to analyse. You can compare two of the same line items and observe the changes. For example, you can check if the sales increased or decreased over a specific period of time. With the help of horizontal analysis, you can also identify trends that can be helpful in making the right business decisions. It can also help in planning for future expenses.
Conducting a ratio analysis
To conduct a ratio analysis, first determine the ratios you want to find. By using this method, you can find debt-to-income, liquidity and profitability ratios. After determining the ratios, you can compare them to the previous ones. It can provide an overview of the profit or loss in the business.
3. Research industry standards
You can benefit from researching industry standards. The financial capacity of each company can be different. It can help you analyse how the company is performing in the industry. Researching industry standards may also help in implementing strategies that align with the current industry trends.
4. Prepare forecasted statements
You can prepare forecasted statements to provide necessary information to stakeholders. Evaluate if the company is financially healthy for the foreseeable future. Check if the company is able to make purchasing decisions or expand the business. It can also help in evaluating the hiring potential of the company.
How to read a balance sheet
A balance sheet is an example of a financial statement that tells the information about the liabilities, equities and assets. Here are the steps to read a balance sheet:
1. Set reporting date
A balance sheet can help you analyse the assets, liabilities and equities of a company for a specific period of time. In general, companies may issue these reports quarterly. The reporting date for each quarter can be its last date such as March 31, June 30, September 30 and December 31. You can set a reporting date as per the company’s guidelines and complete the balance sheets accordingly.
2. Calculate your assets
The next step for analysing a balance sheet can be calculating total assets based on the reporting date. The assets may get listed as individual and total assets on the balance sheet. You can separate assets in different lines and understand their sources. The final analysis may involve adding total assets. There can be two types of assets in a balance sheet which are current and non-current.
3. Identify the liabilities
After calculating the assets, focus on identifying liabilities. There can be two categories of liabilities, current and non-current. Liabilities can be in both line items and total in a balance sheet. Due taxes and wages may come under current liabilities. On the contrary, long-term lease obligations and bonds by a company may come under non-current liabilities. Consider adding subtotals and totals to determine liabilities.
4. Calculate shareholders’ equity
The equity section of a balance sheet may include common stock, retained earnings and treasury stock. Shareholders’ equity is the difference between assets and liabilities in a balance sheet. Analyse if the shareholders’ interests show fluctuations over a specific period of time.
5. Compare liabilities with assets
In the last step, you can add total liabilities and total shareholders’ equity. Compare the result with the total assets. This step can help you in the final analysis of a balance sheet. Make sure all the entries are correct and accurate. Revise and find any omitted or inaccurate information.
How to read an income statement
An income statement is also a financial statement that provides information about the profit and loss of a company for a certain time period. It is also called a profit and loss statement. Here are the steps to read an income statement:
1. Assess sales revenue
An income statement may include information about sales, associated costs and current operating costs. Find the total goods or services sold in an income statement.
2. Find the gross profit
By analysing an income statement, you can learn about the gross profit and net income of a company. The difference between sales and the associated costs is gross profit. For example, if a company generates ₹50,000 in sales and the costs associated are ₹20,000 then the company has a gross profit of ₹30,000.
3. Find the operating costs
After identifying the operating costs, find the operating costs associated with running the business. Operating costs may include utilities and administrative costs such as subscriptions for tools or salaries. You can add all the costs involved in running a business and determine the operating cost. For example, if a company spends ₹20,000 on administration and ₹20,000 on rent then the total operating cost is ₹40,000.
4. Calculate the taxes
The next step is to evaluate the taxes in the income statement. You can focus on taxes that a company pays on its profits. There can be a set corporate tax rate for annual profits exceeding a profit limit.
5. Determine the net income
Net income is the amount that remains with the company after removing sales and expenses. To get net income, subtract total overhead costs from the gross profits. For example, if the gross profit and overhead costs of a company are ₹50,000 and ₹10,000 respectively then the net income is ₹40,000. In an income statement, net income is usually present at the bottom.
