Is the company overvalued or undervalued?
I get this question a lot of times from different investors….
With over 8 years of experience in investment advisory whilst leveraging on investment reports and analysis from the research unit in my institution to enable me to provide professional investment advice to my clientele, I would probably rate myself a 7/10 in analysing and understanding a company’s financial statement.
Corporate financial accounting course has extremely helped me in gaining in-depth knowledge of financial accounting, having gone through 3 months learning period with 2 weeks of intensive practical sessions, I can confidently say I am becoming a financial expert.
On today’s episode, I will talk about Financial statement analysis and the different methods. Public companies release their financial statements quarterly, Half-year, bi-annually and annually, Investors and analysts look into these statements to give their view about the overall performance of the company.
Financial statement analysis is simply the process of analyzing a company’s financial statement for decision-making purposes. Analyst and investors use it to understand the overall health of a company as well as evaluate financial performance and market value.
There are five methods of financial statement analysis:
- Trend analysis
- Common-size financial analysis
- Financial ratio analysis
- Cost volume profit analysis
- Benchmarking industry analysis
In today’s episode, I will share my understanding of the trend analysis.
The trend Analysis: This consist of two types – The vertical and the horizontal analysis
Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of a base figure within the statement. Thus, line items on an income statement i.e. Administrative expenses, Taxes e.t.c. can be stated as a percentage of sales, while line items on a balance sheet i.e. cash, receivables e.t.c. can be stated as a percentage of total assets or liabilities, and vertical analysis of a cash flow statement shows each cash inflow or outflow as a percentage of the total cash inflows.
Why Vertical Analysis:
The vertical analysis makes it easier to understand the correlation between each item on a balance sheet and the bottom line, expressed in a percentage.
How Vertical Analysis Works:
Vertical analysis makes it much easier to compare the financial statements of one company with another, and across the same industries. This is because one can see the relative proportions of account balances. It also makes it easier to compare previous periods for time series analysis, in which quarterly and annual figures are compared over a number of years, in order to gain a picture of whether performance metrics are improving or deteriorating.
For example, by showing the various expense line items in the income statement as a percentage of sales, one can see how these are contributing to profit margins and whether profitability is improving over time. It thus becomes easier to compare the profitability of a company with its peers.
Financial statements that include vertical analysis clearly show line-item percentages in a separate column. These types of financial statements, including detailed vertical analysis, are also known as common size financial statement and are used by many companies to provide greater detail on a company’s financial position.
Vertical analysis is used in order to gain a picture of whether performance metrics are improving or deteriorating.
Another form of financial statement analysis used in ratio analysis is horizontal analysis or trend analysis. This is where ratios or line items in a company’s financial statements are compared over a certain period of time by choosing one year’s worth of entries as a baseline, while every other year represents percentage differences in terms of changes to that baseline.
For example, the amount of cash reported on the balance sheet on December 31 of 2021, 2020, 2019, 2018, and 2016 will be expressed as a percentage of the December 31, 2016, amount. Instead of value amounts, you might see 152%, 145%, 123%, 118%, and 100%. The year 2016 is the baseline.
This shows that the amount of cash at the end of 2021 is 152% of the amount it was at the end of 2016. By doing the same analysis for each item on the balance sheet and income statement, one can see how each item has changed in relationship to the other items.
Below is an example of Vertical and Horizontal Analysis
A company has gross sales of N10 million and cost of goods sold of N1.5 million and general and administrative expenses of $3 million and a 25% tax rate. The income statement will look like the below using vertical analysis.
The Income Statement
|Cost of goods sold||1,500,000||15%|
|General and Administrative Expenses||3,000,000||30%|
Horizontal analysis which shows the percentage increase or decrease in some selected items in a company’s financial statement.
In my next episode, I will highlight some key financial ratios used in analysing a financial statement.
See you next time as I share my journey on becoming a financial analyst….