Financial Statement Analysis Course
Master the art of interpreting financial statements to make informed decisions.
Introduction to Financial Statement Analysis
Financial Statement Analysis (FSA) is the process of reviewing and analyzing a company's financial statements to make better economic decisions. These statements provide a snapshot of a company's financial health, performance, and cash flows over a period.
Why is FSA Important?
- Investment Decisions: Helps investors decide whether to buy, sell, or hold securities.
- Credit Decisions: Assists lenders in evaluating a company's ability to repay debt.
- Management Decisions: Provides insights for internal management to improve operational efficiency and strategy.
- Performance Evaluation: Allows for comparison of a company's performance over time or against competitors.
The Three Core Financial Statements
FSA primarily focuses on these three statements:
- Balance Sheet: A snapshot of a company's assets, liabilities, and equity at a specific point in time.
- Income Statement (Profit & Loss Statement): Shows a company's revenues, expenses, and net income over a period (e.g., quarter or year).
- Cash Flow Statement: Reports the cash generated and used by a company during a period, categorized into operating, investing, and financing activities.
The Balance Sheet
The Balance Sheet represents a company's financial position at a single point in time. It adheres to the fundamental accounting equation: Assets = Liabilities + Equity.
Key Components:
- Assets: What the company owns (e.g., cash, accounts receivable, inventory, property, plant, equipment). Assets are typically listed in order of liquidity (how quickly they can be converted to cash).
- Current Assets: Expected to be converted to cash within one year (e.g., Cash, Accounts Receivable, Inventory).
- Non-Current Assets: Long-term assets not expected to be converted to cash within one year (e.g., Property, Plant & Equipment, Intangible Assets).
- Liabilities: What the company owes to others (e.g., accounts payable, loans, bonds).
- Current Liabilities: Obligations due within one year (e.g., Accounts Payable, Short-term Debt).
- Non-Current Liabilities: Obligations due beyond one year (e.g., Long-term Debt, Deferred Tax Liabilities).
- Equity: The residual value after liabilities are subtracted from assets; what's left for the owners (e.g., common stock, retained earnings).
Example Balance Sheet (Simplified - US$):
| Account | Amount ($) |
|---|---|
| Assets | |
| Cash | $50,000 |
| Accounts Receivable | $70,000 |
| Inventory | $80,000 |
| Total Current Assets | $200,000 |
| Property, Plant & Equipment | $300,000 |
| Total Assets | $500,000 |
| Liabilities & Equity | |
| Accounts Payable | $60,000 |
| Short-term Debt | $40,000 |
| Total Current Liabilities | $100,000 |
| Long-term Debt | $150,000 |
| Total Liabilities | $250,000 |
| Common Stock | $150,000 |
| Retained Earnings | $100,000 |
| Total Equity | $250,000 |
| Total Liabilities & Equity | $500,000 |
The Income Statement (Profit & Loss)
The Income Statement reports a company's financial performance over a specific accounting period. It shows how much revenue a company generates, the expenses it incurs, and ultimately, its net income (profit or loss).
Key Components:
- Revenue (Sales): The total amount of money generated from the sale of goods or services.
- Cost of Goods Sold (COGS): The direct costs attributable to the production of the goods or services sold.
- Gross Profit: Revenue - COGS. Represents profit before operating expenses.
- Operating Expenses: Costs not directly tied to production, such as selling, general, and administrative (SG&A) expenses, and depreciation.
- Operating Income (EBIT): Gross Profit - Operating Expenses. Earnings Before Interest and Taxes.
- Interest Expense: Cost of borrowing money.
- Pre-tax Income (EBT): Operating Income - Interest Expense. Earnings Before Taxes.
- Income Tax Expense: Taxes paid on the company's income.
- Net Income: The "bottom line"; what's left after all expenses, including taxes, have been deducted from revenue.
Example Income Statement (Simplified - US$):
| Account | Amount ($) |
|---|---|
| Revenue | $1,000,000 |
| Cost of Goods Sold | $400,000 |
| Gross Profit | $600,000 |
| Selling, General & Administrative Expenses | $200,000 |
| Depreciation Expense | $50,000 |
| Operating Income (EBIT) | $350,000 |
| Interest Expense | $20,000 |
| Pre-tax Income (EBT) | $330,000 |
| Income Tax Expense | $80,000 |
| Net Income | $250,000 |
The Cash Flow Statement
The Cash Flow Statement details the actual cash inflows and outflows over a period, providing a clear picture of how a company is generating and using its cash. It is often considered the most important statement as it deals with actual cash, unlike the Income Statement which can be affected by accounting accruals.
Three Sections of Cash Flow:
- Operating Activities: Cash flows from a company's normal business operations (e.g., cash from sales, cash paid for expenses, changes in working capital).
Often starts with Net Income from the Income Statement and adjusts for non-cash items (like depreciation) and changes in current assets/liabilities.
- Investing Activities: Cash flows from the purchase and sale of long-term assets (e.g., buying or selling property, plant, equipment, or investments in other companies).
These typically relate to significant expenditures or proceeds from assets used for the long-term growth of the business.
- Financing Activities: Cash flows from debt and equity transactions (e.g., issuing or repaying debt, issuing new stock, paying dividends, repurchasing shares).
These show how a company raises and repays capital from investors and creditors.
Example Cash Flow Statement (Simplified - US$):
| Account | Amount ($) |
|---|---|
| Cash Flow from Operating Activities | |
| Net Income | $250,000 |
| Add: Depreciation | $50,000 |
| Change in Accounts Receivable | ($10,000) |
| Change in Inventory | ($5,000) |
| Change in Accounts Payable | $15,000 |
| Net Cash from Operating Activities | $305,000 |
| Cash Flow from Investing Activities | |
| Purchase of Property, Plant & Equipment | ($100,000) |
| Sale of Equipment | $20,000 |
| Net Cash from Investing Activities | ($80,000) |
| Cash Flow from Financing Activities | |
| Issuance of Long-term Debt | $70,000 |
| Repayment of Short-term Debt | ($30,000) |
| Payment of Dividends | ($25,000) |
| Net Cash from Financing Activities | $15,000 |
| Net Increase in Cash | $240,000 |
| Beginning Cash Balance | $10,000 |
| Ending Cash Balance | $250,000 |
Ratio Analysis
Financial ratios are powerful tools that derive meaningful insights by comparing two or more line items from financial statements. They help assess a company's performance, liquidity, solvency, efficiency, and profitability.
1. Liquidity Ratios: Ability to meet short-term obligations.
- Current Ratio: Current Assets / Current Liabilities
A ratio of 2:1 or more is generally considered good.
- Quick Ratio (Acid-Test Ratio): (Current Assets - Inventory) / Current Liabilities
A stricter measure than current ratio, as inventory may not be easily convertible to cash.
2. Solvency Ratios: Ability to meet long-term obligations.
- Debt-to-Equity Ratio: Total Liabilities / Shareholder Equity
Indicates the proportion of debt and equity used to finance assets. Lower is generally better.
- Debt Ratio: Total Liabilities / Total Assets
Shows the percentage of assets financed by debt.
3. Profitability Ratios: Ability to generate earnings.
- Gross Profit Margin: (Gross Profit / Revenue) × 100%
Measures the percentage of revenue left after deducting COGS.
- Net Profit Margin: (Net Income / Revenue) × 100%
Indicates the percentage of revenue remaining after all expenses, including taxes.
- Return on Assets (ROA): Net Income / Average Total Assets
Measures how efficiently a company is using its assets to generate earnings.
- Return on Equity (ROE): Net Income / Average Shareholder Equity
Measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners.
4. Efficiency Ratios: How well a company uses its assets and manages its liabilities.
- Inventory Turnover: Cost of Goods Sold / Average Inventory
Measures how many times inventory is sold and replaced over a period. Higher is generally better.
- Accounts Receivable Turnover: Net Credit Sales / Average Accounts Receivable
Indicates how efficiently a company collects its receivables.
Advanced Analysis & Limitations of FSA
Beyond basic ratios, several other techniques enhance financial statement analysis. However, it's also crucial to understand the inherent limitations.
Advanced Analysis Techniques
- Vertical Analysis (Common-Size Analysis):
Expresses each line item on a financial statement as a percentage of a base amount. For the Income Statement, items are a percentage of Revenue. For the Balance Sheet, items are a percentage of Total Assets. This helps in comparing companies of different sizes or tracking changes over time.
- Horizontal Analysis (Trend Analysis):
Compares financial statement line items over multiple accounting periods to identify trends and growth rates. Each item is expressed as a percentage of a base year or period amount.
- DuPont Analysis (briefly):
A framework for decomposing Return on Equity (ROE) into three components: Net Profit Margin, Asset Turnover, and Financial Leverage. It helps pinpoint the drivers of a company's profitability.
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
Limitations of Financial Statement Analysis
- Historical Data: Financial statements present past performance, which may not be indicative of future results.
- Accounting Methods: Different accounting policies (e.g., depreciation methods, inventory valuation) can impact reported numbers, making comparisons difficult.
- Inflationary Effects: Historical cost accounting may not reflect current market values, especially during periods of high inflation.
- Non-Financial Information: FSA primarily uses quantitative data and doesn't fully capture qualitative factors like management quality, brand strength, or innovation.
- Industry Specificity: Ratios and metrics vary significantly across industries, requiring careful peer comparison within the same sector.
- Manipulation: Financial statements can sometimes be manipulated or window-dressed, requiring analysts to be vigilant for red flags.
Effective FSA combines quantitative analysis with qualitative factors, industry knowledge, and economic outlook.