Methods of Analyzing Financial Statements

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Financial statements that are most commonly analyzed by management and outside investors include the balance sheet, income statement and cash flow statement. These statements can be subjected to ratio analysis, where critical items such as debt and equity are divided by each other. Historic trends can be analyzed to understand how the firm did compared to its past performance. Competitive analysis, on the other hand, aims to compare the firm to its closest rivals.

Trend Analysis

  • Trend analysis compares the performance of the firm during the most recent accounting period to its past performance. Changes are often expressed in percentage terms and the changes in related metrics are cross checked to see key trends. An analyst may, for instance, analyze how much sales, marketing expenses and personnel costs grew compared to last year. While the percentage change in each of these line items is critical, their relation to each other provides additional insights. If sales grew by 20 percent, for instance, while marketing costs and personnel costs rose by around 10 percent each, the firm is headed in the right direction as it managed to get more out of each marketing dollar spent and personnel employed.

Ratio Analysis

  • Financial ratios express the firm's performance and current state in easy-to-understand figures. Such ratios are found by dividing one line in the statements by another. Gross profit ratio, for instance, equals gross profits divided by net sales. Debt leverage ratio, on the other hand, can be found by dividing total debt by total assets. Such ratios enable analysts and managers to compare firms of vastly different sizes. While one firm may sell a million cars and record billions of dollars of net profits, a smaller competitor could sell half as many and make a far smaller profit. Ratio analysis may reveal, however, that the smaller firm is turning a larger portion of sales into profits.

Competitive Analysis

  • In a competitive analysis, financial statements of firms operating in the same industry are compared to each other. A corporation that aims to be the largest manufacturer of steel could compare its income statement to that of its closest competitors to analyze sales trends and cost of goods sold. By analyzing the total amount of debt outstanding for similar corporations, a chief financial officer might gauge how much more it may be able to borrow before investors get nervous. Such analysis may also help the next key moves of a company's rivals. Investors, too, rely heavily on competitive analysis when deciding where to put their money.

Vertical Analysis

  • When performing a vertical analysis, all items in a statement are expressed as a percentage of a key figure. In the income statement, for instance, all figures might be expressed as a percentage of net sales. Sales costs, cost of goods sold, overhead expenses and so on would all be reported as a percentage of net sales. Vertical analysis is quite similar to ratio analysis. However, a key difference is that the denominator for all ratios is the same in vertical analysis. When using this method to analyze the balance sheet, all key figures could be divided by cash or liabilities.

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