What is Financial Statement Analysis

Financial statement analysis enables institutions and individuals to evaluate the financial health of a company by analysing key financial documents such as balance sheets, income statements, and cash flow statements. It aids in wiser investing, lending, and strategic business decisions.

What Is Financial Statement Analysis?

Financial statement analysis is the technique of analysing a firm’s financial information to know its history, profitability, and future outlook. The process entails the examination of important financial statements—balance sheet, statement of income, and statement of cash flow by means of different analytical tools.

The financial analysis in accounting assists stakeholders in making informed decisions by detecting trends, comparing how the company has performed, and identifying risks. The coverage of financial statement analysis reaches internal and external stakeholders such as investors, creditors, management, and regulatory bodies.

Why is Financial Statement Analysis Crucial for Decision-Making?

After getting to know what is financial statement analysis, it’s time to dive deep into the reasons behind its importance for various stakeholders:

1. For Investors
   • Assists in evaluating profitability, stability, and growth prospects.
   • Informs buy, hold, or sell recommendations based on financial health.
   • Empowers informed investment decisions.
2. For Creditors & Lenders
   • Evaluates a company’s creditworthiness and repayment ability.
   • It minimises risk by emphasising leverage and liquidity.
   • Assists in evasion of bad debts and credit decisions. 
3. For Company Management
   • Defines operating inefficiencies and profitability shortcomings.
   • Helps in budgeting, forecasting, and measuring performance.
   • Oversees strategic and operating improvements.
4. For Regulatory Authorities
   • Ensures companies comply with financial reporting standards.
   • Identifies anomalies and possible fraudulent practices.
   • Maintains transparency and market integrity.

What Are the Key Statements Being Analysed?

When we talk about what is financial statement analysis, it revolves around three core statements:

1. The Balance Sheet
   • Shows a company’s assets, liabilities, and equity at a point in time.
   • Used to assess financial position and capital structure.
   • Shows what the company owns and is owed.
2. The Income Statement (Profit & Loss)
   • Summarises revenues, costs, and net profit during the period.
   • Helps assess profitability and performance.
   • Determined by the company’s earning capacity.
3. The Cash Flow Statement
   • Tracks inflows and outflows of cash from operations, investing, and financing.
   • Highlights liquidity and cash management.
   • Measures the real-time solvency of the business.

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How Is Financial Statement Analysis Actually Performed?

Financial statement analysis entails several techniques. The following are the three principal ones:

Method 1: Horizontal Analysis (Trend Analysis)

• Compares financial data across multiple periods.
• Distinguishes patterns of growth, decline, and anomalies with time.
• Helps in detecting trends in revenue, cost, or profit development.

Method 2: Vertical Analysis (Common-Size Analysis)

• Expresses financial items as a percentage of a base figure.
• Enables comparison over firms or periods regardless of scope of financial statement analysis.
• Makes financial comparisons more standardised and meaningful.

Method 3: Ratio Analysis

• Involves the key financial ratios covering the ratios of liquidity, profitability, and solvency.
• Measures how effectively a company uses its resources.
• Offers a quantifiable sense of financial health.

Who Are the Primary Users of Financial Statement Analysis?

Financial statement analysis meaning also involves recognising who uses it and for what purposes:

• Investors: To assess risks and returns before investing.
• Lenders & Creditors: To gauge the borrower’s ability to repay.
• Management: To refine strategies and monitor company performance.
• Regulatory Agencies: To ensure accurate reporting and compliance.
• Financial Analysts: To offer insights and recommendations.

Numerous stakeholders rely on financial statement analysis to arrive at important decisions.

What Are the Limitations of Financial Statement Analysis?

Despite its benefits, financial accounting analysis does have limitations:

Reliance on Historical Data

• Most analysis is backward-looking.
• It doesn’t necessarily predict future performance.
• It has to accompany forecasts.

Influence of Inflation and Different Accounting Practices

• Various accounting approaches create distortions in comparison.
• Inflation can overstate or understate asset values.
• Requires contextual comprehension.

Potential for Fraudulent Reporting

• Misleading information is created by manipulating.
• Undermines reliability of analysis.
• Verify Always with independent confirmation.

Lack of Context

• These figures cannot reflect market conditions or qualitative factors.
• Should be accompanied by industry and macroeconomic understanding.
• It’s just one piece of a larger decision-making puzzle.

Master Financial Statement Analysis with CFA

CFA certification is world-renowned for providing professionals with solid analytical expertise in financial statement analysis. It encompasses:

• In-depth knowledge of financial reporting standards. 
• Advanced tools for valuation and forecasting. 
• Application of financial accounting analysis in real-world scenarios. 

In case you wonder what is CFA, it is the abbreviation for Chartered Financial Analyst, and it is a qualification providing in-depth knowledge in investment management, including the range of financial statement analysis.

Proficiency in the analysis of financial statements by getting CFA certification puts you at the forefront of finance careers.

Conclusion

Financial Statement Analysis is the must-study guide to analysing the financial situation of a company and coming to informed decisions. Whether you’re an investor, manager, or student, being aware of what is financial statement analysis puts you at a competitive advantage. From the examination of balance sheets to the implementation of ratio analysis, the methods reveal details leading to more informed decisions. If you want to further your financial analysis career, the CFA program can be your first rung to professional achievement. 

Explore our ACCA e-learning courses to master key papers like FR (Financial Reporting) and FM (Financial Management) that deepen your knowledge of financial statement analysis.

FAQs on Financial Statement Analysis

Where can I find a company’s financial statements for analysis?

They are available on the company’s website, in annual reports, or in databases such as EDGAR.

What is the difference between financial analysis and auditing?

Financial analysis gauges performance, while auditing verifies accuracy and conformity.

What software is used for financial statement analysis?

Tools such as Excel, QuickBooks, and SAP are popular software used for financial data analysis.

What are the tools of financial statement analysis?

The horizontal, vertical, and ratio analyses are the principal tools employed.

Anant Bengani, brings expertise as a Chartered Accountant and a leading figure in finance and accounting education. He’s dedicated to empowering learners with the finest financial knowledge and skills.