One of the major aspects of making a sound investment decision is analyzing the financial statements of a company. Financial statement analysis is the process of selecting, evaluating, and interpreting financial data to assess a company’s past, present and future financial performance. Various questions about the company—such as whether it has the capacity to repay debt, whether it is financially sound or stressed, whether it has an appropriate financial mix, whether it is positioned to provide returns to shareholders, its revenue-generating efficiency, and its working capital management, can be extensively analyzed through financial reports. Although the information used is historical, the purpose is to forecast future performance and estimate the company’s potential. Now, let’s get started with the blog!
Academically, we are all aware of common size analysis, which involves restating financial information in a standardized format. This can be done through horizontal analysis which compares two or more years of financial data in both currency and percentage terms, and vertical analysis where each category of accounts on the balance sheet is shown as a percentage of the total accounts. This can be complemented with the DuPont model and ratio analysis. Furthermore, we use relationships among financial statement accounts to forecast the company’s future income statements and balance sheets, assessing how the company’s performance is likely to evolve. This step is typically based on the guidance provided by company management.
Financial analysis is carried out by investors, regulators, lenders, and suppliers to decide whether to invest in a particular company or extend credit to it. The management of the company also conducts financial analysis to evaluate current performance and implement future strategies. A thorough financial analysis of a company involves examining its
To start, acquire the annual reports from the past 3-5 years of the company. The various components of the annual report contribute to the conclusions drawn about the company.
Different parts of the financial statements need to be scanned for abnormalities and if any are found, the reasons for them should be identified.
The revenue model is derived from the reported income statement. Past data must be examined to model the company’s growth. Consistency is preferred over fluctuations in the statement, as erratic movements raise suspicion. The expense part of the model should include calculations of percentages relative to sales such as the percentage of cost of goods sold over sales and general and administrative expenses over sales. This helps determine spending trends and reflects the company’s strategy.
Furthermore, non-recurring and non-operating expenses need to be analyzed to assess earnings quality. One major expense that needs to be calculated is the cost of raw materials, adjusted for inventory changes (increase/decrease). The operating ratio, commonly known as EBITDA, is also crucial as it reflects management’s efficiency in controlling costs and the effective utilization of installed capacity.
It is a reflection of what the company owns and owes. The balance sheet stands on the three important pillars that indicate the quality of investments, namely working capital adequacy, asset performance and capitalization structure. The major components of the balance sheet; under the scanner are the assets, liabilities and equity.
Assets, or the means used to operate the company, are balanced by a company’s financial obligations along with the equity investment brought into the company and its retained earnings. Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. The various components of each like Assets: Current Assets (Cash and Cash equivalents, accounts receivables and inventory) and noncurrent (tangible and intangible assets), Liabilities: current (will come due for payment in a years’ time) and long-term (more than a year of repayment), also need to be analysed for any abnormalities which could be an indicator for the future projections. Reasons for the growth or slowdown seen in these individual numbers are also to be registered.
Equity represents what shareholders own, so it is often called shareholders’ equity. It is very important to analyze whether the company has issued new shares or conducted a buyback. We need to closely examine how the company utilizes retained capital and generates returns on it, as these figures reflect the company’s long-term strategy.
Additionally the higher the proportion of owners’ equity compared to debt, the more financially autonomous and solvent the company is.
The cash flow statement very clearly presents how cash is generated and used in the company’s business. This information is crucial for investors making decisions about the company. The total net cash flow of a company over a period equals the change in the cash balance during that period: positive if the cash balance increases (more cash becomes available), and negative if the cash balance decreases. The total net cash flow is the sum of cash flows classified into three areas, each of which needs to be individually researched: Operational Cash Flow, Investment Cash Flow, and Financing Cash Flow.
All the previously discussed financial statements ultimately help build the ratios used for final analysis. Different ratios across various categories—such as liquidity ratios, leverage ratios, profitability ratios and efficiency ratios—help analyze the overall health of the company. The trend in each ratio can indicate any favorable or unfavorable numbers reported by the company. These ratios can also be compared with data from other companies in the same industry.
Besides these major points, other factors also shed light on the business, strategy and positioning of the company.
It is important to see if the company’s dividend policy supports its strategies. For example, a growing company would retain its earnings to reinvest in the business rather than distributing them to investors. This is also an indicator of the company’s future strategies.
One of the key elements in fundamental analysis is the Management’s Discussion and Analysis (MD&A) section of the annual report, which portrays the management’s style of doing business. It provides investors with insights into how the business has performed in the past, its current financial condition, and projections of future performance. It offers a view of management on growth and strategy, challenges and opportunities, historical performance and future outlook, including financials and investments, to mention a few. This information is very important when forming an opinion on the company. However it’s important to note that while it provides insight into management’s thinking, MD&A represents their thoughts and is not audited.
These are the footnotes to all financial statements of a company. One needs to read them very carefully as they provide a lot of information regarding the accounting methods that have been followed in preparing the accounts, such as inventory calculations (LIFO, FIFO, weighted average), and depreciation methods, to mention a few. Reading this part is also important as it gives detailed discussion on the contingent liabilities the company is facing, which are not provided in the accounts as they have yet to materialize in concrete terms.
The company’s stock price also indicates to a great extent what researchers feel about the company. Reactions of the market towards the company’s moves also help in drawing conclusions on a broader scale.
Financial analysis determines a company’s health and stability, providing insight into how the company conducts its business. However, it is important to note that financial statement analysis has its limitations as well. Different accounting methods adopted by different firms change the visible health and profit levels for better or worse. Different analysts may derive different results from the same information. Hence, we must conclude that financial statement analysis is only one of the tools (although a major one) to consider when making an investment decision.
If you are keen to learn more about the concept and many others that provide knowledge about the finance industry, we recommend you take a look at the cfa course. The CFA® program, which stands for Chartered Financial Analyst®, is a designation offered by the CFA® Institute in the United States. Its curriculum exclusively focuses on investment analysis and portfolio management, offering comprehensive knowledge about investment principles and ethics. If you are looking for a trusted training partner in this educational aspiration, then look no further—EduPristine is your one-stop solution.
At EduPristine, we not only provide coaching for the cfa course, but we also offer end-to- end career support. Now, you might be wondering what end-to-end career support entails. It means we provide you with everything you need, along with technical knowledge about the course, and also handle all the administrative needs that arise during the process of attainment or journey of passing the involved levels. This includes assistance for smooth registration, examination, and placement. We also offer soft skills training after course completion, along with mentorship for support and doubt-solving during the program. And when we say we arrange doubt-solving sessions, rest assured that we accommodate even last-minute requests before exams. We encourage you to visit our testimonial page to verify the credibility and offerings we claim.
In addition to all this, we take the aspect of flexibility seriously. While you may find online lectures as the most flexible option, we have gone one step further and equalized the prices of both physical classroom and Live Virtual Classroom instruction modes. How does this offer greater flexibility? By allowing students to switch between modes without having to worry about price differences. We also provide the facility of attending ‘n’ number of batches for the price of one batch until the Learning Management System validity has been exhausted which is for one year. Additionally, you receive recordings of live lectures. Now, isn’t this offering greater flexibility? Our values of student success and employability are reflected in every decision we make.
However, if there are any stones left unturned, we invite you to book a free career counseling session with our dedicated team of career counselors, who are ready to guide you on the cfa course details, cfa course curriculum, and much more. They are also available to resolve any queries you may have. We wish you all the best with your aspirations! Happy learning!
Hello, and welcome back to our new blog. Are you preparing to take on the…
Hello, and welcome back to our new blog. As the financial world continues to evolve,…
CFP® Course Curriculum: What You’ll Learn in Financial Planning Education | EduPristine Welcome back learners…
Capital Investment Decision in CFA® | EduPristine Welcome back, learners, to another insightful blog post…
Techniques Used by CFP® Practitioners to Enhance Client Wealth | EduPristine Welcome back, financial planning…
Hello, and welcome back to our latest blog. Have you ever wondered if you could…