Use these techniques to determine your company's financial performance Show
Westend61/Getty Images Updated February 01, 2021 Financial statement analysis is the use of analytical procedures to evaluate the financial health, risks, performance, and future potential of a business. Even the smallest business can benefit from the results of financial statement analysis as a guide for the business owner. There are several types of financial statement analysis ranging from the most general to very specific. Business owners can choose the level of detail they need in order to make good decisions for the business. If a business is publicly held, or if it is for sale, external parties, like investors, use the results of financial statement analysis to make their investing decisions. What Is a Financial Statement?A financial statement is a document that contains information that communicates the financial position and performance of a business to management and external parties. The three most important financial statements that are generally used for financial statement analysis are:
Analyzing these financial statements gives visibility into your company's financial position and trends. The financial data that you generate allows you to make changes to steer your company towards more profitability and efficiency. Types of Financial Statement AnalysisThere are a number of financial statement analysis techniques depending on the information you need: Basic Financial Ratio AnalysisFinancial ratios are useful tools that help business managers and investors analyze and compare financial relationships between the accounts on the firm's financial statements. Here are the most useful ratios for a basic financial ratio analysis: Liquidity ratios show how easily a firm's current assets can be converted to cash in order to pay off short-term liabilities. The most important liquidity ratios are:
Efficiency ratios let you see how well your business uses its assets. Common efficiency ratios are:
Solvency ratios demonstrate the ability of a business to pay its long-term debt obligations. Common solvency ratios are:
Coverage ratios measure the ability of a business to service its debt. The most often-used coverage ratio is:
Profitability ratios are measurements of whether a company is turning a profit and maximizing shareholder wealth and how much is being generated. The most often-used ratios are:
There are a plethora of financial ratios beyond those listed for more advanced financial ratio analysis. Financial ratios give you very limited information unless you have something to compare them to, preferably ratios from other time periods or ratios from other companies in your business sector or industry. Trend AnalysisTrend or time-series analysis is analyzing a company, using financial ratios, by comparing multiple time periods of financial information. Financial ratio analysis is only one type of trend analysis. Using other financial information, a company can also compare the current year's performance to previous years' performance. Trend analysis is usually performed using a company's income statement and balance sheet. Financial ratio analysis provides owners with data on changes during time periods in the same year or compares a time period with the same time period in previous years. For example, if you were to look at your debt-to-asset ratio from the fourth quarter of one year and compare it to the first quarter of the next year, you will see whether or not the amount of debt you have used to finance your assets has increased or decreased. Trend analysis using financial ratios allows the financial manager to determine if positive or negative changes are occurring in the liquidity, efficiency, solvency, coverage, and profitability financial positions of the business firm and take the appropriate action. Industry AnalysisIndustry analysis, also called cross-sectional analysis or benchmarking, is analyzing a company by comparing the financial ratios to those of an entire industry to see how the company performs in comparison. Time periods are matched and industry average ratios are used for purposes of comparison. Industry average ratios are publicly available. Industry analysis gives the financial manager a different picture of the company than trend analysis. The company is compared to a sample of companies in the same industry rather than by time period against itself. Industry analysis is valuable because the financial manager can get at least a rough idea if the company is on the right track. Horizontal AnalysisHorizontal analysis is analyzing a company by comparing multiple time periods of financial information. The financial manager can compare the current year's performance to previous years' performance. This type of analysis is usually performed using a company's income statement and balance sheet. This analysis provides owners with data on changes during time periods in the same year or compares a time period with the same time period in previous years. Horizontal analysis can be performed in three different ways, in addition to financial ratio analysis:
Horizontal analysis allows you to spot trends in your company's financial position between years. It shows you where your company is doing well and where any red flags might lie. It is not only helpful to financial managers but also to investors and creditors. Vertical AnalysisVertical analysis is simpler than a horizontal analysis. The most basic vertical analysis deals with a one-year period from the firm's balance sheet and income statement. To do a vertical analysis, you prepare common-size income statements and balance sheets. In other words, to prepare the income statement, sales are considered 100%. Every other line item is stated as a percentage of sales. For the balance sheet, total assets are considered to be 100% and every other line item is stated as a percentage of total assets. An income statement vertical analysis provides you with a look at the cost of goods sold, gross margin, and your expenses as a percentage of the value of sales for the period. A balance sheet vertical analysis is used in the same manner as the income statement. It can be used to show the line item percentages of your total assets. For instance, if you had total assets of $2,000,000 and $200,000 in cash, your cash is 10% of your total assets. Likewise, if your current liabilities were $500,000, then your liabilities are 25% of your total assets. As you become more familiar with the ratios and financial statements, you'll be able to make more sense of the information horizontal and vertical analysis can provide. Which method is used in analyzing financial statements?Three of the most important techniques include horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years.
In which method of financial analysis the items of income statement are shown as percentage of sales?Vertical analysis is a method of analyzing financial statements that list each line item as a percentage of a base figure within the statement.
What is it called when we report an amount on financial statements as a percentage of another item on the same financial statement?Vertical analysis is reporting an amount on a financial statement as a percentage of another item on the same financial statement.
In which financial statements figures are converted into percentage?A common size income statement is an income statement whereby each line item is expressed as a percentage of revenue or sales. The common size percentages help to show how each line item or component affects the financial position of the company.
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