Company Financial Statement Analysis & Interpretation of Financial Statements

Company Financial Statement Analysis: Spotting Future Trends

As business owners, we are so busy with the day-to-day operations of running a business that we may forget to take a look at our business as a whole and ignore any company financial statement analysis.

By analyzing Financial Statements, we can:

  • Spot trends over time
  • Identify the mix of Assets and Liabilities within a certain period
  • Examine relationships among items to determine efficient operations.

The analysis of Financial Statements is an evaluation of:

  • A firm’s past financial performance
  • Its prospects for the future

The points above relate to two basic questions in running a business:

  • How well my business is performing, currently?
  • What will happen to it in the future?

The search for answers to these questions begins with an analysis of the firm’s Financial Statements.

Formally defined, analysis of Financial Statements is the selection, evaluation, and interpretation of financial statements data, along with other pertinent information, to assist in investment and financial decision-making, as well as, show how and where to improve the performance of the business.

In general, an analysis of Financial Statements is vital for a person running a business. Because this analysis tells these business owners where they stand in their financial environment.

Business owners can use company financial analysis both internally and externally. They can use them internally to examine issues such as employee performance, the efficiency of operations and credit policies. They can use them externally to examine potential investments and the creditworthiness of borrowers, amongst other things.

Most importantly, Financial Analysis points to the financial destination of the business in both the near future and to its long-term trends.

Analysis can also show a firm’s:

  • liquidity
  • debt
  • profitability
  • how investors perceive the firm
  • help detect emerging problems and strengths.

Besides analyzing the past performance, analysis helps determine the strategy of a company moving forward.

For example, using financial ratios can be helpful in determining costs or identifying changes in processes to increase savings. Thereby, achieving a goal of the budgeting process to determine the firm’s game plan. Or, as in the case of the Sales to Inventory ratio. This ratio is a measure of the ability of a firm to turn Inventory into Sales. In this case, the higher the ratio, the better the business is using Inventory. Because they are turning over their Inventory without the cost of it becoming obsolete.

In addition to analyzing your company’s financials, you also need to analyze your company’s performance to industry peers. This type of peer analysis is known as “benchmarking.”

Know Your Business: Company Financial Statement Analysis

A business owner can use several methods to check the financial health of the business. Three of the most used methods are:

  • Horizontal Analysis – analyzes the trend of the company’s financials over a period of time.

Each line item shows the percentage change from the previous period.

  • Vertical Analysis – compares the relationship between a single item on the Financial Statements to the total transactions within one given period.

It also shows the percentage of change since the last period.

You can perform a Vertical Analysis on both an Income Statement and a Balance Sheet.

  • Ratio Analysis – analyzes relationships between line items based on a company’s financial information.

It also compares a company’s performance from one period to another (current year vs. last year).

Analysis of Financial Statements determines the strength of a business and where there is room for improvement.

Without analysis, a business owner may make mistakes understanding the firm’s financial condition.  Resulting in poor rather than strong decision-making. For example, an Assets to Sales ratio is a measure of a firm’s productive use of Assets. Whereas a low percentage rate compared to the average for the industry usually indicates an efficient use of Assets. Likewise, a high percentage rate indicates the need to improve the use of Assets. Check out our blog post on Ratio Analysis.

The following sections give a detail explanation of Vertical and Horizontal analysis:

Horizontal Company Financial Statement Analysis

With a Horizontal Analysis, also, known as a “trend analysis,” you can spot trends in your financial data over time.

For example, a $2 million profit year looks impressive following a $0.25 million profit year, but not after a $10 million profit year.

Horizontal analysis stresses the trends in:

  • Earnings
  • Assets
  • Liabilities

Over a period, such as, from year-to-year or over several years.

For a business owner, information about trends helps identify areas of wide divergence.

Once identified, these areas become the areas of your business that:

  • need further attention
  • need a course of actions to amend
  • fine-tuning of an adopted strategy

For instance, a large increase in Sales returns and allowances coupled with a decrease in Sales over two years would be cause for concern. The problem may be lower quality or defective goods. If this is the case, you need to address and solve the problem or the company’s reputation and future may be at stake.

The ability to spot this trend over time empowers you to intervene and be pro-active in solving the problem.

No company lives in a bubble, so it is also helpful to compare these results with those of competitors to determine whether the problem is industry-wide, or just within the company itself. If no problems exist industry-wide, one will observe a shortfall in Sales and rise in the dollar amount of Sales returns.

By identifying a problem, businesses can then devise a strategy to cope with it. The key to analysis is to identify potential problems provide the necessary data to legitimize change.

In a Horizontal Analysis, we state both the dollar amount of change and the percentage of change, because either one alone might be misleading.

For example, although interest expense from one year to the next may have increased 100 percent, this might not need further investigation; because the dollar amount of increase is only $1,000.

Likewise, a large change in dollar amount might result in only a small percentage change which will not cause concern for the business owner.

How to Create a Horizontal Company Financial Statement Analysis

Financial Statements often contain current data and the data of a previous period. This way, the reader of the financial statement can compare to see where there was change, either up or down.

Horizontal Analysis takes this comparison goes one step further. It depicts the amount of change as a percentage to show the difference over time as well as the dollar amount.

The following illustration depicts a Horizontal Analysis:

Note that the line-items are a condensed Balance Sheet and that the amounts are shown as dollar amounts and as percentages and the first year is established as a baseline.

A baseline is established because a financial analysis covering a span of many years may become cumbersome. It would require the arrangement and calculation of interlinked numbers and dates. Particularly, interlinks among the numbers make financial analysis tiresome and complex for a typical businessperson. A solution is to create Comparative Financial Statements, which depicts the results of Horizontal Analysis and show the trends relative to only one base year. The baseline acts as a peg for the other figures while calculating percentages. For example, in this illustration, the year 2012 is chosen as a representative year of the firm’s activity and is therefore chosen as the base. Each account of the baseline year is assigned an index of 100%.

Once the baseline is established, the percentage of each respective account is found by:

  1. Subtracting the previous year amount from the current year amount
  2. Dividing the account’s amount by the previous year amount
  3. Multiplying by 100 to derive the percentage.

For example, if we let 2012 be the base year in the Balance Sheet of Learning Company, Current Assets would be given an index of 100%.

Then for 2013, to derive the percentage of change, we look at each line item:

In this case,

Current Assets for 2013 are $210,000 subtract the baseline amount of $100,000:

$210,000 – $100,000 = $110,000

Determines the difference of $110,000.

Divide this difference by the baseline amount, so

$110,000 / $100,000 = 1.1

Multiply by 100 to calculate the percentage:

1.1*100 = 110%

And we can see that Current Assets grew by 110% from 2012 to 2013.

To calculate 2014, we DO NOT go back to the baseline to do the calculations; instead, 2013 becomes the new baseline so that we can see percentage growth from year-to-year.

In our illustration,

The calculation to determine the Current Assets 2014 percentage change becomes:

$463,000 – $210,000 = $253,000

Determines the difference of 253,000.

Divide this difference by the baseline amount, so

$253,000 / $210,000 = 1.2

Multiply by 100 to calculate the percentage:

1.1*100 = 120%

And we can see that Current Assets grew by 120% from 2013 to 2014.

By seeing the trend, which is a remarkable growth of over 100% from one year to the next, we can also see that the trend itself is not that remarkable of only 10% change from 2013 at 110% to 120% in 2014. Which could show, that perhaps growth is starting to stagnate or level-off.

Therefore, additional analysis is required.

Vertical Company Financial Statement Analysis

Vertical analysis is the comparison of various line items within a single period. It compares each line item to the total and calculates what the percentage the line item is of the total. It can be done with the company’s Financial Statements or with the use of the Common Size Statements.

The following illustration shows a Vertical Analysis of a company’s Balance Sheet:

The Learning Company
Vertical Analysis of the Balance Sheet
(Expressed as a Percent)
Dec. 31, 2014, 2013 and 2012
2014 2013 2012
$ % $ % $ %
Current Assets 463,000 56% 210,000 46% 100,000 36%
Plant Assets 365,000 44% 243,000 54% 180,000 64%
Total Assets 828,000 100% 453,000 100% 280,000 100%
Current Liabilities 306,000 47% 140,200 47% 73,000 48%
Long-Term Liabilities 340,000 53% 157,800 53% 78,000 52%
Total Liabilities 646,000 100% 298,000 100% 151,000 100%
Stockholders’ Equity
Common Stock 120,000 66% 110,000 71% 100,000 78%
Retained Earnings 62,000 34% 45,000 29% 29,000 22%
Total Stockholders’ Equity 182,000 100% 155,000 100% 129,000 100%
Total Liabilities and Stockholders’ Equity 828,000 100% 453,000 100% 280,000 100%

Note that in this illustration, each line item is shown as a percentage of the total for its category. For example, in 2012, Current Assets are 36% of Total Assets for that year; whereas, in 2014, Current Assets are 56% of Total Assets. While you can still compare from one year to the next, the calculation to determine the percentage is within the same period i.e. down the column (unlike Horizontal Analysis where the calculation is based on the difference in items from one year to the next).

Also, note that in this illustration, the Balance Sheet is a condensed version. You may also want to do a Vertical Analysis on a full Balance Sheet to more clearly highlight potentially problematic areas. For instance, if you break out all Current Assets and see that the line item of Accounts Receivable is a large percentage of Total Assets, then you’ll know that there is a problem with collections and that you need to look into ways of receiving payment in a more timely manner

How to Create a Vertical Company Financial Statement Analysis

A Vertical Analysis can be completed on both an Income Statement and a Balance Sheet. Unlike Horizontal Analysis, a Vertical Analysis is confined within one year (or one vertical column of the Balance Sheet); so we only need one period of data to derived the percentages and completed the analysis.

In our sample Balance Sheet, we want to determine the percentage or portion a line item is of the entire category.

For example, for 2014, to derive the percentage of Current Assets:

Current Assets are $463,000 and Total Assets are $828,000

Divide Current Assets by Total Assets

$463,000 / $828,000 = .56

Multiply by 100 to calculate the percentage:

.56 * 100 = 56%

And so we can see that Current Assets are 56% of Total Assets. This high percentage means most of your Assets are liquid, and it may be time to either invest that money or use it to purchase additional Plant Assets.

Likewise, to complete a Vertical Analysis of Current Liabilities:

In 2014, Current Liabilities are $306,000 and Total Liabilities are $646,000

        Divide Current Liabilities by Total Liabilities

                    $306,000 / $646,000 = .47

        Multiply by 100 to calculate the percentage

                    .47 * 100 = 47%

And so we can see that Current Liabilities are 47% of Total Liabilities. In this case, you may want to double-check if this is wise or if you are paying more interest than if you re-financed and move some of the Current Liabilities to Long-Term Liabilities for a better interest rate and a lower monthly payment.

When creating a Vertical Analysis of an Income Statement, the amounts of individual items are calculated as a percentage of Total Sales.

The following illustration depicts a Vertical Analysis of an Income Statement:

company financial statement analysis

Through the use of percentages of Total Sales, you can see that Sale Returns and Allowances is a whopping 20% of Total Sales in 2014. When, only a year ago in 2013, Sale Return and Allowances was only 7%, meaning that there is most likely more instances of defective items. Then, consider that in 2014, 50% of Cost of Goods Sold was 50% where it was 55% a year ago.

While Cost of Goods decreased, quality has suffered. Meaning, the Net Income, also known as “the Bottom Line” has suffered as well.

As a business owner in this situation, you would need to examine the situation in more detail:

  • Work with the supplier or change suppliers to receive higher quality materials
  • Or investigate to see if this situation is a coincidence based on other factors.

Either way, this is a clear sign that action is required.