Foundations of Financial Statement Analysis

What is financial statement analysis?

According to Financial statement analysis, financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. It is used by external stakeholders to understand the overall health of an organization and to evaluate its financial performance and business value.

Why is financial statement analysis important for decision making?

The main purpose of financial statement analysis is to support decisions. As explained in Financial statement analysis, users study financial statements so they can assess how well a business is performing and judge its financial position. This helps stakeholders make informed decisions about the company.

• It helps users understand the overall health of the organization.
• It helps evaluate financial performance.
• It helps assess business value.

Main tools of financial statement analysis

Financial statement analysis identifies three main tools used to analyze financial statements:

• Common size analysis
• Comparative analysis
• Ratio analysis

1. Common size analysis

In Financial statement analysis, common size analysis is described as a method in which each account or item in the financial statement is expressed as a percentage of a base account.

For example, for the income statement, the base account is sales revenue, which is treated as 100%. Every other item is then expressed as a percentage of sales revenue. This makes it easier to see how much each item contributes relative to sales.

Types of common size analysis

Financial statement analysis states that common size analysis is categorized into two types:

• Vertical analysis
• Horizontal analysis

Vertical analysis

Vertical common size analysis expresses each financial statement item as a percentage of a base figure. This helps an analyst see the structure of the income statement or balance sheet more clearly.

• For the income statement, sales revenue is the base.
• For the balance sheet, items are shown as a percentage of total assets or total equity and liabilities.

2. Comparative analysis

Financial statement analysis shows comparative analysis as the comparison of financial statement figures across periods. It involves looking at a base year and a subsequent year to identify changes.

The source explains two key steps:

• Compute the absolute change: subsequent year minus base year.
• Compute the percentage change: absolute change divided by base year.

This tool helps show whether items such as revenue, expenses, or profit have increased or decreased over time. For example, the source summarizes that revenue increased and net profit also increased from one year to the next.

3. Ratio analysis

According to Financial statement analysis, ratio analysis uses relationships between financial statement figures to evaluate different aspects of business performance and position.

The source highlights several decision-making uses of ratio analysis:

• Determining the company’s ability to meet financial obligations, especially through liquidity ratios.
• Showing the extent to which the company has borrowed funds through gearing ratios.
• Comparing company performance with industry performance.
• Comparing company performance with competitors.

Examples of ratio analysis areas

Financial statement analysis includes several categories of ratios, such as:

• Liquidity ratios
• Gearing or debt-related ratios
• Efficiency ratios
• Investor-related ratios such as earnings per share and price-earnings ratio

How the three tools differ

• Common size analysis focuses on expressing items as percentages of a base figure within a statement.
• Comparative analysis focuses on changes in amounts and percentages between periods.
• Ratio analysis focuses on relationships between figures to evaluate liquidity, borrowing, efficiency, and performance.

Key takeaway

Based on Financial statement analysis, financial statement analysis is a decision-making process used to evaluate a company’s financial health, performance, and value. Its three main tools are common size analysis, comparative analysis, and ratio analysis. Together, these tools help users understand structure, track changes over time, and assess important financial relationships.