How would you Analyze the Financial Statements of a firm? Explain each step thoroughly:
To make better economic decisions, the process to review and analyze financial statements of any company is called financial statement analysis or financial analysis. Financial statement analysis asses the financial performance and health of the company by analyzing financial statements including:
- Changes in Equity Statement
- Balance Sheet Statement
- Income Statement
- Cash-flow Statement
Financial statement analysis mainly involve six steps framework as mentioned below:
Six Steps Framework
- Establish the Purpose or Objective
- Gathering Information or Data
- Data Processing
- Conducting Analysis
- Recommendation or Conclusion
- Review or Follow-up
Establish the Purpose or Objective:
The purpose of the financial statement analysis is to evaluate
- Financial Performance of the Company
- Financial Position of the Company
- Prediction of the Company’s Future Performance
- Company’s Operating Efficiency
Gathering Information or Data:
- Industry identification
- Economy size and trend
- Statement of financial position and performance of the company
- Any other necessary documents, statements or notes
Data Processing:
It diagnoses the profitability position, solvency, liquidity and stability of the company. It also helps. to analysis comparison between companies (either in the same or different industries) or over the period of time for the company. For this purpose, different tools shall be used including:
- Trend Analysis
- Ration Analysis
- Comparative Financial Statement
- Statement of Funds
- Statement of Cash-flow
Conducting Analysis:
Interpret and analysis the data collected in step 3 which includes Time Series Analysis, where figures are expressed as a percentage and compared to base year performance. Similarly, statements of financial position are compared to different years’ statements, is called comparative statement or horizontal analysis. To express as the ratio, the figures of the statements of finance converted into percentages to compare against total assets and liabilities. Ratio analysis is the most commonly used method to analysis financial statements. The study of ratios between various items and groups are analysis through:
- Liquidity Ratios – ability to meet current obligations.
- Leverage Ratios – proportion of debt and equity of the company.
- Activity Ratios – efficiency in utilizing company’s assets.
- Profitability Ratios – performance and effectiveness of the company.
Recommendation or Conclusion:
This is crucial step of the entire process. The accuracy of financial statements is essential to maintain accuracy of analysis. Because financial statement analysis monitors only monetary position of the company and ignores non-monetary aspects.
Review or Follow-up:
On the basis of above conclusion, process followed and recommendation, it is necessary to review or make adjustment if necessary. Analyst shall repeat or perform periodic reviews in order to determine initial recommendations still hold on.