Financial Statement Analysis

Analyzing and Interpreting Financial Statements

Financial statement analysis uses analytical methods and ratios to evaluate the performance of a business, including the business’s liquidity, solvency, and profitability. Horizontal, vertical, and ratio analysis are common methods used to analyze financial statement information.

The primary objective of financial statement analysis is to use the information gleaned from the organization's past performance to assess its future performance. Financial statement analysis captures the liquidity, profitability, efficiency, and cash flow measures needed to evaluate financial performance. Additionally, financial statement analysis is used to identify possible problem areas and work through a solution to avoid pitfalls in the future or to identify areas of success to further exploit. Financial statement analysis also identifies performance trends through the use of comparisons of statement types and by comparing multiple periods.

During the financial statement analysis process, the common financial statements used are the income statement, the balance sheet, and the statement of cash flows. The income statement provides a summary of the revenues and expenses, which in sum reflect the organization's net income or net loss for a period of time. The balance sheet is a depiction of the assets, liabilities, and stockholders' equity for a specific point in time. The statement of cash flows provides a summary of cash inflows and outflows from operating, investing, and financing activities.

Internal users, such as management and owners, use the information garnered from financial statement analysis to make improved business decisions. Owners or managers can use financial statement analysis to evaluate profitability or business efficiency. External users such as investors, creditors, and government agencies use financial statement analysis for different purposes. Investors use financial statement analysis to make investment decisions, and creditors use financial statement analysis to make credit decisions. Government agencies use financial statement analysis to ensure compliance.

In addition, horizontal, vertical, and ratio analysis can be used to evaluate business performance. Horizontal analysis provides a year-to-year comparison of the business entity's financial performance. Vertical analysis provides a means of comparison across divisions or companies. Ratio analysis is characterized as an effective manner in which to evaluate a business entity's financial performance, including assessing performance among industry competitors. A wide variety of ratios is helpful in assessing the liquidity, solvency, and operational effectiveness of an organization.