Financial statements: What are they?
Financial statements are documents that describe a company’s operations and financial performance. Government organizations, accounting companies, etc. frequently audit financial statements to guarantee accuracy and for tax, financing, or investing purposes. The balance sheet, income statement, statement of cash flow, and statement of changes in equity are the four basic financial statements for for-profit entities. A similar but distinct set of financial statements is used by nonprofit organizations.
The income statement, balance sheet, and cash flow statement are the three essential financial statements.
The relationships between these three financial statements are extremely complex.
One of the crucial phases in developing a financial model is to analyze these three financial statements.
Financial Statement Analysis analyzes a company’s balance sheet, income statement, or statement of cash flows to assess its performance or value. Investors may create a more complex picture of a company’s financial profile by utilizing a variety of methodologies, such as horizontal, vertical, or ratio analysis.
FIVE TECHNIQUES FOR ANALYZING FINANCIAL STATEMENTS
There are five typical approaches to analyzing financial statements. Each technique enables the creation of a thorough financial profile.
They consist of:
- Horizontal Analysis
- Vertical Analysis
- Ratio Analysis
- Trend Analysis
- Cost-Volume Analysis
1. Horizontal Analysis
Horizontal analysis compares historical data (such as ratios and line items) and is usually depicted as a percentage growth over the same line item in the base year. This allows financiers to easily spot trends and growth patterns and forecast future projections. This type of analysis also lends insight into the operational results of an organization and whether it is operating efficiently and profitably, and makes it easier to compare growth rates amongst sectors.
2. Vertical Analysis
Vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item, for example, every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. This gives analysts an understanding of overall performance in terms of revenue and expenses.
3. Ratio Analysis
Ratio analysis allows for comparison between the different elements of a financial statement and is used to reveal a general upward or downward trend. It’s a quick method to obtain an overview of a company’s financial health, but also more granular relationships between data, such as debt and equity or price versus earnings, in addition to liability areas such as staff turnover. Once a ratio has been calculated, it can be compared against the previous period, which is crucial for setting performance targets.
4. Trend Analysis
Trend analysis uses historical data (such as price movements and trade volume) to forecast the long-term direction of market sentiment. It is based on the idea that what has transpired in the past will occur again in the future, which helps a business to better predict and prepare for upward trends and reversals within particular market segments. Trend analysis is a useful technique as moving with tends (and not against them) will result in profit for an investor.
5. Cost Volume Profit Analysis
This analysis technique helps businesses better understand the relationship between sales, costs and business profit. It examines the fixed costs and variable costs and establishes the relationship between sales and variable costs to help business leaders better plan and project profit.