Techniques Of Financial Statement Analysis: As an investor, you’ll find yourself at a crossroads when choosing between companies to invest in. Both companies might have great brand value, strong sales, and market presence, which makes it all that much harder to pick one. How do you make the right investment and what can you do to make the right decision?
Three words – Financial Statement Analysis! This blog will explain Financial Statement Analysis as well as techniques of Financial Statement Analysis. Read ahead for the latest Fingrad blog on investing!
What Is Financial Statement Analysis?
Before becoming a listed company, all businesses have no obligation to provide their financial statements to the public. It’s confidential information so long as the company is private and has not taken any public funds.
But, upon going public, the company has a legal obligation to keep its investors informed about its financial records of the company. This includes everything from balance sheets and income statements to mergers and acquisitions.
Studying the financials and assessing the company is known as financial statement analysis. It allows investors and stakeholders to understand the company’s performance as well as its business value.
Types Of Financial Statements
There are three types of financial statements that an investor can research about a company. They are –
1. Balance Sheet
A balance sheet consists of three important sections – Assets, liabilities, and shareholders’ equity. The purpose of a balance sheet is simple – To assess the book value of the business at the end of the financial year.
The most simple formula to find book value or shareholders’ equity = Debt minus assets.
2. Income Statement
An income statement is the most important report for investors and stakeholders of a company, and it’s for one simple reason – It tells us how much money they are making. It’s also known as the profit or loss statement. Simply stated, the income statement shows if the company is making or losing money, besides other important details.
3. Cash Flow Statement
All businesses, whether listed or not, have a regular flow of cash in and out of the firm. But how do you know if that cash is being used correctly? By studying the cash flow statement. It shows how well cash is being used by the business. In effect, it also exposes the financial health of the company.
For Financial Statement Analysis, the above three statements are imperative to understand the techniques we will be talking about below. Now, if you understand them, let’s move ahead to the different techniques of financial statement analysis.
Techniques Of Financial Statement Analysis
There are multiple methods of studying a company’s financials. Due to standardized accounting principles and standards, all companies are required to follow one format of accounting that has to be followed. This means that every company will have the same format of accounting, and learning how to study them is an important skill to make better investment decisions.
1. Horizontal Analysis
A horizontal analysis studies the reports of a company through two or more periods of time, across the same metrics. Here, you’re studying the same metrics but across different time quarters/years.
When a company claims that its revenues are up by 30%, but you don’t see it reflected in the profits, then a horizontal analysis should give the full picture.
2. Vertical Analysis
In Horizontal analysis, we studied metrics across time and learned the company’s patterns. Under vertical analysis, the focus is on the overall performance of different items in the statement.
|Selling, Administration Expenses
|Profit Before Tax
3. Ratio Analysis
Ratios are a measure of different formulas that are applied to the company’s financial statements. Through one value, we can understand the financial position of a company compared to previous years.
For example – The debt to equity (D/E) ratio tells us how much debt is used for operations compared to using its capital. D/E can also be used to compare it with its competitors.
4. Trend Analysis
Finally, we have a trend analysis. Studying the financial statements over time, you might notice trend patterns that companies follow over and over again. For example – The revenues of a listed Air Conditioning company always show exponential revenues from February to May, as compared to the rest of the year.
Studying companies takes time and learning to study their reports is an acquired skill. Like most skills, it is best learned through experience. You can sign up for free on stock screening applications such as Trade Brains Portal and perform your own analyses on companies. Simultaneously, you can also go to the company website and study individual reports and understand how their business works.
That’s the end of our blog on – Techniques of Financial Statement Analysis. New To Analysis? Go through our course on Financial Ratio Analysis for Stock Picking. Happy Investing!
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