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Financial statement analysis

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Financial statement analysis (or just financial analysis) is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity (if applicable). Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, valuation, financial health, and future prospects of an organization.[1]

It is used by a variety of stakeholders, such as credit and equity investors, the government, the public, and decision-makers within the organization. These stakeholders have different interests and apply a variety of different techniques to meet their needs. For example, equity investors are interested in the long-term earnings power of the organization and perhaps the sustainability and growth of dividend payments. Creditors want to ensure the interest and principal is paid on the organizations debt securities (e.g., bonds) when due.

Common methods of financial statement analysis include horizontal and vertical analysis and the use of financial ratios. Historical information combined with a series of assumptions and adjustments to the financial information may be used to project future performance. The Chartered Financial Analyst designation is available for professional financial analysts.

History

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Benjamin Graham and David Dodd first published their influential book "Security Analysis" in 1934.[2][3] A central premise of their book is that the market's pricing mechanism for financial securities such as stocks and bonds is based upon faulty and irrational analytical processes performed by many market participants. This results in the market price of a security only occasionally coinciding with the intrinsic value around which the price tends to fluctuate.[4] Investor Warren Buffett is a well-known supporter of Graham and Dodd's philosophy.

The Graham and Dodd approach is referred to as Fundamental analysis and includes: 1) Economic analysis; 2) Industry analysis; and 3) Company analysis. The latter is the primary realm of financial statement analysis. On the basis of these three analyses the intrinsic value of the security is determined.[4]

Horizontal and vertical analysis

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Horizontal analysis compares financial information over time, typically from past quarters or years. Horizontal analysis is performed by comparing financial data from a past statement, such as the income statement. When comparing this past information one will want to look for variations such as higher or lower earnings.[5]

Vertical analysis is a percentage analysis of financial statements. Each line item listed in the financial statement is listed as the percentage of another line item. For example, on an income statement each line item will be listed as a percentage of gross sales. This technique is also referred to as normalization[6] or common-sizing.[5]

Balance sheet analysis

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Balance sheet analysis examines the composition of a company's assets, liabilities and equity to assess its financial position and financial condition. The balance sheet provides information about how an entity uses its capital (assets) and how those assets are financed through liabilities and equity. This information can be used to assess profitability, capital structure, liquidity, solvency and financial flexibility.[7]

Several financial measures can be derived from balance sheet information and related financial statements:

  • Profitability: Measures such as return on equity (ROE) assess the income generated in relation to the equity invested in the business.
  • Capital structure: The relationship between liabilities and equity indicates how a company finances its assets and the extent to which it relies on debt financing.
  • Liquidity: Liquidity analysis evaluates whether a company can meet its short-term financial obligations when they fall due. It considers the relationship between current assets and current liabilities.
  • Solvency: Solvency analysis assesses a company's ability to meet its long-term financial obligations and repay its debt.
  • Financial flexibility: This refers to an entity's ability to adapt its financing and investment decisions to changing circumstances and to meet unexpected financial requirements.

These dimensions are interrelated. For example, a company's capital structure influences its financial risk, while its liquidity and cash flow generation affect its ability to service debt. Financial statement analysis therefore considers balance sheet information together with information from the income statement and statement of cash flows.[8][9]

Structure and classification of balance sheet items

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A balance sheet presents an entity's assets, liabilities and equity at a specific reporting date. Assets represent the resources controlled by the entity, while equity and liabilities show how those resources are financed.

Under International Financial Reporting Standards (IFRS), balance sheet items include:

  • Non-current assets: Property, plant and equipment, investment property, intangible assets, investments in associates, and other long-term financial assets.
  • Current assets: Inventories, trade and other receivables, cash and cash equivalents, and assets classified as held for sale.
  • Equity: Equity attributable to owners of the parent and, in consolidated financial statements, non-controlling interests.
  • Liabilities: Provisions, pension obligations, financial liabilities, trade and other payables, and current and deferred tax liabilities.

The recognition, measurement and presentation of these items are addressed by different IFRS Accounting Standards. For example, IAS 16 addresses property, plant and equipment, IAS 38 intangible assets, IAS 2 inventories, IAS 40 investment property and IFRS 9 financial instruments. IAS 1 historically provided the general requirements for the presentation of financial statements. IFRS 18 replaces IAS 1 for annual reporting periods beginning on or after 1 January 2027, subject to permitted early application.[10]

Current and non-current assets and liabilities

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Under IAS 1, assets and liabilities are generally classified as current or non-current in the statement of financial position. This distinction provides information about an entity's operating cycle, liquidity and financial position.[11]

An asset is classified as current if it meets at least one of the following criteria:

  • It is expected to be realised, sold or consumed in the entity's normal operating cycle.
  • It is held primarily for trading.
  • It is expected to be realised within twelve months after the reporting period.
  • It is cash or a cash equivalent that is not restricted from being exchanged or used to settle a liability for at least twelve months.

Assets that do not meet these criteria are classified as non-current.

A liability is classified as current if:

  • It is expected to be settled in the entity's normal operating cycle.
  • It is held primarily for trading.
  • It is due to be settled within twelve months after the reporting period.
  • The entity does not have the right at the end of the reporting period to defer settlement for at least twelve months.

Liabilities that do not meet these criteria are classified as non-current.[11]

IAS 1 permits an alternative presentation in which assets and liabilities are presented broadly in order of liquidity rather than divided into current and non-current categories, when this provides information that is reliable and more relevant. This approach is particularly relevant for financial institutions, which may not have a clearly identifiable operating cycle.[11]

The presentation of additional line items depends on the nature and liquidity of assets, the function of assets within the entity, and the amounts, nature and timing of liabilities. The standard therefore allows judgement in determining the most useful structure for presenting financial information.[11]

Information provided by the balance sheet

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The structure of a balance sheet provides information about several aspects of an entity's financial position. Its classification of assets, equity and liabilities allows analysts to examine the composition of an entity's resources and the sources of its financing.[7]

  • Asset structure: The composition of assets can be analysed by distinguishing between non-current assets, such as property, plant and equipment, intangible assets and financial investments, and current assets, such as inventories, receivables and cash and cash equivalents. Further analysis may consider the liquidity and recoverability of individual asset categories.[12]
  • Capital structure: The composition of financing can be examined by distinguishing between equity and liabilities. Analysts may consider the proportion of equity financing, the maturity structure of liabilities and the nature of financial obligations, including provisions and secured borrowings.[13]
  • Asset coverage: Asset coverage ratios compare non-current assets with equity or long-term capital. Examples include the ratios of non-current assets to equity and of non-current assets to long-term capital. These measures are used to assess the extent to which long-term assets are financed by long-term sources of capital.[14]
  • Liquidity position: The classification of assets according to their expected conversion into cash and of liabilities according to their maturity provides a basis for analysing short-term liquidity. Liquidity ratios can be calculated from these figures. However, balance sheet-based liquidity measures refer to a particular reporting date and do not by themselves show the timing of all future cash inflows and payments.[15]
  • Related-party relationships: Information about receivables from and payables to related parties can help users assess financial relationships within a corporate group and between an entity and its key management personnel. Under IAS 24, disclosures include related-party relationships, transactions and outstanding balances, as well as key management personnel compensation.[16]

These areas of analysis are interrelated. For example, the financing of non-current assets affects the assessment of capital structure and long-term financial stability, while the maturity of liabilities influences liquidity analysis.[7]

Limitations of balance sheet information

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Although the balance sheet provides important information about an entity's financial position, it does not necessarily represent the full economic value of a business.

One limitation is that internally generated intangible resources, such as employee expertise, organisational capabilities and certain forms of intellectual capital, are generally not recognised as assets unless the applicable recognition criteria are met. Consequently, the carrying amounts of recognised assets may not reflect all the resources that contribute to a company's economic value.[7]

Historical cost measurement can also limit the usefulness and comparability of balance sheet information. Assets recorded at their original acquisition or production costs may differ substantially from their current market values or replacement costs. Changes in general price levels can further reduce the comparability of amounts reported at different dates.

Furthermore, the balance sheet generally presents individual assets and liabilities separately and does not fully capture the economic benefits arising from synergies between different resources. As a result, the reported net assets of an entity may differ from its overall economic or market value.

The use of fair value measurement under certain IFRS requirements, including IFRS 9 and IFRS 13, provides alternative measurement bases for particular assets and liabilities. However, fair value measurement does not eliminate all limitations associated with financial statement information.

Income statement analysis

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The analysis of an income statement examines an entity's financial performance over a reporting period. It provides information about the income and expenses generated during the period and helps users assess the entity's profitability and its ability to generate sustainable earnings. It also provides information about how management has used the resources entrusted to it.[17]

An important objective of income statement analysis is to distinguish between the results generated by an entity's ordinary business activities and other income and expense items. This distinction can help analysts assess the sustainability of earnings and develop forecasts of future financial performance.[18]

Profit or loss and other comprehensive income

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Under IAS 1, an entity presents all income and expenses recognised in a reporting period either in a single statement of profit or loss and other comprehensive income or in two separate statements: a statement of profit or loss and a statement presenting other comprehensive income. The statement of comprehensive income includes changes in equity during the period other than those arising from transactions with owners in their capacity as owners.[17]

Profit or loss includes income and expenses recognised in determining the entity's result for the period. Other comprehensive income (OCI) comprises income and expense items that other IFRS Accounting Standards require or permit to be recognised outside profit or loss. These items are classified according to whether they may subsequently be reclassified to profit or loss.[19]

Structure of the statement of profit or loss

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IFRS Accounting Standards do not prescribe one rigid format for the statement of profit or loss. Instead, IAS 1 requires certain minimum line items and permits entities to present additional items, headings and subtotals when these are relevant to understanding their financial performance.[19]

Expenses may be analysed either by their nature or by their function:

  • By nature: Expenses are classified according to their economic nature, such as employee benefits, depreciation, raw materials and other operating expenses.
  • By function: Expenses are classified according to their role within the entity, for example as cost of sales, distribution costs or administrative expenses.

An entity must select the method that provides information that is reliable and more relevant. If expenses are presented by function, additional information about their nature is required in the notes, including depreciation and employee benefits expense.[19]

IAS 1 also requires the separate presentation of certain items, including finance costs, the share of profit or loss of associates and joint ventures accounted for using the equity method, income tax expense and a single amount relating to discontinued operations. Additional line items must be presented when their size, nature or function is relevant to understanding the entity's financial performance.[19]

Classification of expenses by nature and by function

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IAS 1 distinguishes between two methods of analysing expenses in the statement of profit or loss: classification by nature and classification by function. An entity selects the method that provides information that is reliable and more relevant to users of its financial statements.[20]

  • Classification by nature of expense: Expenses are grouped according to their economic nature, without allocating them to different functions within the entity. Examples include employee benefits, depreciation and amortisation, purchases of materials, transport costs and advertising expenses. This method may be simpler to apply because it does not require expenses to be allocated to functional categories. It can also show changes in inventories of finished goods and work in progress as well as work performed by the entity and capitalised as an asset.[20]
  • Classification by function of expense: Expenses are allocated according to the activities or functions for which resources are consumed. Typical categories include cost of sales, distribution costs and administrative expenses. This method presents the costs associated with goods or services sold separately from other operating expenses. However, allocating expenses to functions may require judgement and can involve subjective allocations. An entity using this method must also disclose additional information about the nature of certain expenses, including depreciation and employee benefits.[20]

The two methods provide different perspectives on an entity's financial performance. Classification by nature highlights the types of resources consumed, whereas classification by function provides information about the activities to which those resources relate. The choice of presentation depends on the nature of the entity, its industry and which method provides more relevant and reliable information to users.[20]

Financial ratio analysis

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Financial ratios are very powerful tools to perform some quick analysis of financial statements. There are four main categories of ratios: liquidity ratios, profitability ratios, activity ratios and leverage ratios. These are typically analyzed over time and across competitors in an industry.

  • Liquidity ratios are used to determine how quickly a company can turn its assets into cash if it experiences financial difficulties or bankruptcy. It essentially is a measure of a company's ability to remain in business. A few common liquidity ratios are the current ratio and the liquidity index. The current ratio is current assets/current liabilities and measures how much liquidity is available to pay for liabilities. The liquidity index shows how quickly a company can turn assets into cash and is calculated by: (Trade receivables x Days to liquidate) + (Inventory x Days to liquidate)/Trade Receivables + Inventory.
  • Profitability ratios are ratios that demonstrate how profitable a company is. A few popular profitability ratios are the breakeven point and gross profit ratio. The breakeven point calculates how much cash a company must generate to break even with their start up costs. The gross profit ratio is equal to gross profit/revenue. This ratio shows a quick snapshot of expected revenue.
  • Activity ratios are meant to show how well management is managing the company's resources. Two common activity ratios are accounts payable turnover and accounts receivable turnover. These ratios demonstrate how long it takes for a company to pay off its accounts payable and how long it takes for a company to receive payments, respectively.
  • Leverage ratios depict how much a company relies upon its debt to fund operations. A very common leverage ratio used for financial statement analysis is the debt-to-equity ratio. This ratio shows the extent to which management is willing to use debt in order to fund operations. This ratio is calculated as: (Long-term debt + Short-term debt + Leases)/ Equity.[21]

DuPont analysis uses several financial ratios that multiplied together equal return on equity, a measure of how much income the firm earns divided by the amount of funds invested (equity).

A Dividend discount model (DDM) may also be used to value a company's stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value.[22] In other words, it is used to value stocks based on the net present value of the future dividends.

Financial statement analyses are typically performed in spreadsheet software — or specialized accounting software — and summarized in a variety of formats.

Recasting financial statements

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An earnings recast is the act of amending and re-releasing a previously released earnings statement, with specified intent.[23]

Investors need to understand the ability of the company to generate profit. This, together with its rate of profit growth, relative to the amount of capital deployed and various other financial ratios, forms an important part of their analysis of the value of the company. Analysts may modify ("recast") the financial statements by adjusting the underlying assumptions to aid in this computation. For example, operating leases (treated like a rental transaction) may be recast as capital leases (indicating ownership), adding assets and liabilities to the balance sheet. This affects the financial statement ratios.[24]

Recasting is also known as normalizing accounts.[25]

Certifications

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Financial analysts typically have finance and accounting education at the undergraduate or graduate level. Persons may earn the Chartered Financial Analyst (CFA) designation through a series of challenging examinations. Upon completion of the three-part exam, CFAs are considered experts in areas like fundamentals of investing, the valuation of assets, portfolio management, and wealth planning.

Automation

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In November 2023, research conducted by Patronus AI, an artificial intelligence startup company, compared performance of GPT-4, GPT-4-Turbo, Claude 2, and LLaMA-2 on two versions of a 150-question test about information in financial statements (e.g., Form 10-K, Form 10-Q, Form 8-K, earnings reports, earnings call transcripts) submitted by public companies to the U.S. Securities and Exchange Commission. One version of the test required the generative AI models to use a retrieval system to find the specific SEC filing to answer the questions; the other gave the models the specific SEC filing to answer the question (i.e., in a long context window). On the retrieval system version, GPT-4-Turbo and LLaMA-2 both failed to produce correct answers to 81% of the questions, while on the long context window version, GPT-4-Turbo and Claude-2 failed to produce correct answers to 21% and 24% of the questions, respectively.[26][27]

See also

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References

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  1. ↑ White, Gerald I.; Sondhi, Ashwinpaul; Fried, Dov (1998). The Analysis and Use of Financial Statements. John Wiley & Sons, Inc. ISBN 0-471-11186-4.
  2. ↑ Morgenson, Gretchen (August 16, 1998). "Market Watch- A Time To Value Words of Wisdom". The New York Times.
    Graham, Benjamin; Dodd, David (1934). Security Analysis (1st ed.). McGraw-Hill.
  3. ↑ New York Times, January 2, 2000 Business Section Humbling Lessons From Parties Past By BURTON G. MALKIEL “BENJAMIN GRAHAM, co-author of "Security Analysis," the 1934 bible of value investing, long ago put his finger on the most dangerous words in an investor's vocabulary: "This time is different." Burton G. Malkiel is an economics professor at Princeton University and the author of "A Random Walk Down Wall Street" (W.W. Norton).
  4. 1 2 Dodd, David; Graham, Benjamin (1998). Security Analysis. John Wiley & Sons, Inc. ISBN 0-07-013235-6.
  5. 1 2 "Accountingtools.com - Financial Statement Analysis". Archived from the original on 2014-08-11. Retrieved 2014-08-01.
  6. ↑ Perceptual Edge-Jonathan Koomey-Best practices for understanding quantitative data-February 14, 2006
  7. 1 2 3 4 Coenenberg, Adolf G.; Haller, Axel; Schultze, Wolfgang (2024). Jahresabschluss und Jahresabschlussanalyse (29th ed.). Stuttgart: Schäffer-Poeschel.: 1125 
  8. ↑ "A Financial Statement Analysis". OpenStax. Retrieved 9 November 2026.
  9. ↑ "Financial Analysis Techniques". CFA Institute. Retrieved 9 November 2026.
  10. ↑ "IFRS 18 Presentation and Disclosure in Financial Statements". IFRS Foundation. Retrieved 9 November 2026.
  11. 1 2 3 4 "IAS 1 Presentation of Financial Statements". IFRS Foundation. Retrieved 9 November 2026.
  12. ↑ Wöhe, G.; Kaiser, H.; Döring, U. (2002). Übungsbuch zur Einführung in die Allgemeine Betriebswirtschaftslehre [Workbook for Introduction to General Business Administration] (10th ed.). Munich: Vahlen. pp. 402–403.
  13. ↑ Wöhe, G.; Kaiser, H.; Döring, U. (2002). Übungsbuch zur Einführung in die Allgemeine Betriebswirtschaftslehre [Workbook for Introduction to General Business Administration] (10th ed.). Munich: Vahlen. pp. 402–403.
  14. ↑ Wöhe, G.; Kaiser, H.; Döring, U. (2002). Übungsbuch zur Einführung in die Allgemeine Betriebswirtschaftslehre [Workbook for Introduction to General Business Administration] (10th ed.). Munich: Vahlen. pp. 402–403.
  15. ↑ Wöhe, G.; Kaiser, H.; Döring, U. (2002). Übungsbuch zur Einführung in die Allgemeine Betriebswirtschaftslehre [Workbook for Introduction to General Business Administration] (10th ed.). Munich: Vahlen. pp. 402–403.
  16. ↑ "IAS 24 Related Party Disclosures". IFRS Foundation. Retrieved 9 November 2026.
  17. 1 2 "IAS 1 Presentation of Financial Statements". IFRS Foundation. Retrieved 9 November 2026.
  18. ↑ Coenenberg, Adolf G.; Haller, Axel; Schultze, Wolfgang (2024). Jahresabschluss und Jahresabschlussanalyse (27th ed.). Schäffer-Poeschel. pp. 1197–1207. ISBN 978-3-7910-6192-4.
  19. 1 2 3 4 "IAS 1 Presentation of Financial Statements" (PDF). IFRS Foundation. Retrieved 9 November 2026.
  20. 1 2 3 4 "IAS 1 Presentation of Financial Statements" (PDF). IFRS Foundation. Retrieved 9 November 2026.
  21. ↑ Investopedia Staff (2010-08-12). "Financial Statement Analysis". Investopedia. Retrieved 2018-07-14.
  22. ↑ McClure, Ben (2004-04-12). "Digging Into The Dividend Discount Model". Investopedia. Retrieved 2018-07-14.
  23. ↑ "Earnings Recast".
  24. ↑ "Recasting". Archived from the original on 2020-01-21. Retrieved 2019-03-15.
  25. ↑ Schenck, Barbara Findlay; Davies, John (3 November 2008). Selling Your Business For Dummies. ISBN 9780470381892.
  26. ↑ Leswing, Kif (December 19, 2023). "GPT and other AI models can't analyze an SEC filing, researchers find". CNBC. Archived from the original on December 19, 2023. Retrieved December 19, 2023.
  27. ↑ "Patronus AI Launches Industry-first LLM Benchmark for Finance to Address Hallucinations" (Press release). PR Newswire. November 16, 2023. Archived from the original on December 19, 2023. Retrieved December 19, 2023.
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Associations

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  • SFAF - French Society of Financial Analysts
  • ACIIA - Association of Certified International Investment Analysts
  • EFFAS - European Federation of Financial Analysts Societies
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