How to analyze financial statements

Deciphering your company's financial statement data can be challenging, especially if you're not familiar with accounting or finance. 

This article will help you learn the basics of how to analyze financial statements. Use the tips to better understand your company’s financial health and identify ways to improve it.

Key components of financial statements

There are three financial statements used to analyze a company’s financial position and performance. They include the balance sheet, income statement, and statement of cash flows.

Balance sheets identify the current liabilities, assets, and shareholder’s equity of your company. Performing balance sheet analysis helps you evaluate the liquidity and efficiency of your organization.

Balance Sheet

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The income statement shows your company's revenues and operating expenses for a period. Income statement analysis helps you identify opportunities for growth or cost-cutting.

Income Statement

Common financial ratios and metrics

There are four main types of financial ratios: liquidity, solvency, profitability, and efficiency.

1. Liquidity ratios evaluate financial stability. They tell you whether you have enough money available to pay off short-term debts should they become immediately due. The current ratio is a liquidity ratio, along with the quick ratio.
2. Solvency ratios are similar to liquidity ratios in that they evaluate a company's ability to pay off debt. However, solvency ratios look at long-term obligations instead of short-term ones. Instances of solvency ratios include the debt-to-equity ratio and interest coverage ratio.
3. Profitability ratios tell you how well your company generates revenues from its current assets, liabilities, and equity. Return on equity is a profitability ratio, as is gross profit margin.
4. Efficiency ratios examine your internal performance, such as how quickly you collect outstanding receivables or turn over inventory. Efficiency ratios encompass things like fixed asset turnover and accounts receivable turnover.

Steps to analyze financial statements

It's good financial reporting practice to analyze your company's financial statements regularly. Most companies review their statements monthly, quarterly, and yearly. 

Here are five steps to get you started.

1. Gather and review financial statements

Your first step is to gather your balance sheet, income statement, and cash flow statement for the period. You'll want to review each financial report before you start the comparative analysis process. 

Look for any anomalies that signify mistakes in your statements. For instance, if you see a significant unexpected revenue shift, your income statement may be incorrect.

The analysis process won't yield correct results if your financial statements are inaccurate. Make sure you're working with a complete statement before you dive in.

2. Calculate financial ratios

Your next step is calculating financial ratios for each statement. It's a good idea to select a variety of liquidity, solvency, profitability, and efficiency ratios. Not every ratio will be appropriate for your business. 

For instance, if you don't have any long-term debt, there's no need to calculate the interest coverage ratio because you don't have to pay any interest.

Some accounting and financial modeling software will calculate your financial ratios for you. Automated calculations can save you time and improve accuracy. 

However, if your financials are complex, you may still need to perform some ratio analysis manually.

3. Compare ratios and industry benchmarks

It's a good idea to compare ratios across different periods. Start with a monthly comparison, then look at quarterly and yearly differences. 

Comparing ratios allows you to identify patterns that may be important to your business.

You can also compare your business performance to your industry's. You can find industry averages from various sources, including your bank. 

Banks use industry ratios to evaluate company performance for lending purposes. Your banker may share ratios if you ask for the financial data.

Dun & Bradstreet publishes ratios for over 800 industries, which you can access with a subscription. Some public libraries allow you to access their publications for free. You can check with your library to determine if it's available.

If you have competitors that publish their financial statements, you can use them to compare your company's performance. You may be able to find their current financials on their company website, which you can use for benchmarking. 

However, remember that differences in operating structures and company size may make comparison difficult.

4. Identify trends over time

Once you begin analyzing your financial statements, you'll want to track performance over time. Keep a record of all your ratios, and compare results monthly, quarterly, and yearly. 

You'll likely see trends and patterns that help you better understand your company's performance. Evaluating trends can help you pinpoint financial or operational efficiency shifts that need further analysis.

Remember, financial ratios come directly from your financial statements. You will need to look at underlying transactions to learn more about their meaning. 

Your accountant or financial analyst can help you decipher your transactions and how they impact your ratios.

5. Interpret findings and draw conclusions

When you have a solid set of financial ratios, you can interpret their meaning. You'll use your results to determine where your company is doing well and where improvements might help your net income. 

To do so, you'll need to understand what each ratio signifies.

You can also use your ratios to set risk management goals for your business. For instance, if your current ratio is low, you may have difficulty paying your short-term debts. You can improve your current ratio by paying off obligations or increasing assets.

Keep in mind that ratio results will differ depending on many factors. Your company's financing activities and structure, as well as its industry, can impact your results. 

Don't assume your business is in trouble based on a single ratio. Instead, look at your business from a holistic perspective. If you recently took on debt, your solvency ratios may be lower than you like. 

However, the debt might be necessary for future business growth.

Financial statement analysis examples

Imagine it’s time to review your retail company’s financial performance for the year. You start by gathering your balance sheet, income statement, and cash flow statement.

After double-checking them for accuracy, you calculate the financial ratios you use as benchmarks and compare them to your previous year's numbers and industry standards. The results include:

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The increased current ratio signals improved liquidity compared to the previous year. However, your rising debt-to-equity ratio suggests that it is at least partly due to taking on more long-term debt.

Since debt-to-equity is getting further from the industry standard, this could indicate increased risk. However, the stronger net profit margin shows your overall financial performance is currently improving.

Meanwhile, your inventory turnover ratio has increased compared to last year but remains under the industry benchmark, suggesting there’s still room to optimize inventory management.

Different ways to analyze financial statements

Calculating and comparing financial ratios isn’t the only way to analyze financial statements. Here are some other valuable approaches to consider:

• Trend analysis: This involves examining financial data over several accounting periods to identify long-term patterns. It helps you identify performance shifts, which may indicate growth opportunities or emerging risks.
• Cash flow analysis: Focused on the cash flow statement, this is the practice of reviewing cash inflows and outflows to assess the strength of cash flow management. It can help you predict potential shortfalls, which threaten stability.
• Horizontal analysis: This involves comparing individual line items between two specific periods and measuring both the dollar and percentage change. It can help you identify recent shifts in performance that you may need to address.
• Vertical analysis: This involves expressing each line item as a percentage of a base figure within the same period, such as total sales or assets. It reveals the relative weight of each component, supporting comparisons between companies of different sizes.

Leverage financial analysis for informed decision-making

Financial statement analysis helps eliminate confusion around your company's performance. You'll feel much more comfortable knowing you have a solid grasp of your organization's operations. 

By calculating your profitability, liquidity, efficiency, and solvency ratios, you'll discover information that helps you make knowledgeable business and investment decisions.  

Consider speaking with a professional if you need help analyzing your financial statements. Experienced financial analysts can identify financial ratios critical to your business. They'll also help you interpret their meaning and help you set goals for improvement.