How to Analyse Financial Statements: What to Look for and How to Interpret Them

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.

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