How to Analyse Financial Statements: What to Look for and How to Interpret Them
Financial statements serve as a crucial window into the financial health and performance of a business. Analysing these statements is a skill that enables investors, creditors, and stakeholders to make informed decisions.
Here’s a guide on what to look for and how to interpret the key components of financial statements:
1. Understand the Basics:
- Balance Sheet: Presents the financial position at a specific point in time, showcasing assets, liabilities, and equity.
- Income Statement: Depicts the profitability over a specific period, detailing revenues, expenses, and net income.
- Cash Flow Statement: Outlines the inflows and outflows of cash, providing insights into a company’s liquidity.
2. Assess Liquidity:
- Current Ratio: Compares current assets to current liabilities. A ratio above 1 indicates the ability to cover short-term obligations.
3. Evaluate Profitability:
- Gross Margin: Indicates the percentage of revenue retained after the cost of goods sold.
- Net Profit Margin: Measures overall profitability by expressing net income as a percentage of revenue.
4. Examine Solvency:
- Debt-to-Equity Ratio: Compares a company’s debt to its equity. Higher ratios suggest higher financial risk.
5. Analyse Efficiency:
- Inventory Turnover: Measures how many times inventory is sold and replaced in a period.
- Days Sales Outstanding (DSO): Evaluates how quickly receivables are collected.
6. Cash Flow Analysis:
- Operating Cash Flow: Indicates a company’s ability to generate cash from its core operations.
- Free Cash Flow: Reflects the cash available after operating and capital expenses.
7. Look for Trends:
- Horizontal Analysis: Compares financial data over multiple periods to identify trends.
- Vertical Analysis: Expresses each line item as a percentage of a base figure to reveal the composition of financial statements.
8. Assess Financial Health:
- Altman Z-Score: Predicts bankruptcy risk based on financial ratios.
- Interest Coverage Ratio: Measures a company’s ability to meet interest obligations.
9. Evaluate Return on Investment:
- Return on Assets (ROA): Measures how efficiently assets are utilized to generate profit.
- Return on Equity (ROE): Indicates the return generated for shareholders.
10. Consider Industry Benchmarks:
- Comparative Analysis: Benchmark the company’s performance against industry standards to identify outliers.
11. Check for Red Flags:
- Unusual Items: Scrutinize for unusual expenses or gains that might distort financial performance.
- Changes in Accounting Policies: Assess the impact of changes in accounting methods on reported figures.
12. Assess Management Commentary:
- Management Discussion and Analysis (MD&A): Provides context and insights into the numbers reported in the financial statements.
13. Explore Footnotes:
- Footnotes: Often contain crucial information regarding accounting policies, contingent liabilities, and other pertinent details.
14. Consider External Factors:
- Economic Conditions: Evaluate how external factors like economic conditions might impact the company’s performance.
15. Seek Professional Advice:
- Consult Experts: When in doubt, seek advice from financial analysts, accountants, or industry experts.
Over to you:
Analysing financial statements is both an art and a science. It requires a comprehensive understanding of accounting principles, a keen eye for details, and an awareness of the broader economic context.
By dissecting financial statements using these key metrics and considerations, stakeholders can make well-informed decisions about investments, creditworthiness, and overall business performance.
Do you want to learn more about the accounting principles involved in such financial statements, Our AAT approved AAT Level 2 course is just the right beginning step for you.
