Financial Statement Analysis, how to do it and how to evaluate a company

Financial statement analysis is a fundamental tool for understanding the financial health of a company. This technique allows you to examine in detail the financial statement data, including the income statement and the financial statement ratios, to evaluate the performance and solidity of a company.

But what does it mean to carry out a financial statement analysis? What are the fundamental phases and techniques?

The balance sheet analysis serves precisely this purpose: to provide management with all the data on which to base the planning and business strategy.

Understanding what a balance sheet is and how to interpret it is essential for anyone involved in the business world, from investors to managers, to small entrepreneurs who want to monitor their business. Here’s what you need to know.

What is Financial Statement Analysis: the fundamentals to know

Financial Statement Analysis consists of the processing of the data contained in the financial statements, in particular in the balance sheet and the income statement, with the aim of obtaining a currency measurement of the dynamics of the business. This technique allows you to examine in detail the financial, economic and patrimonial situation of a company, providing valuable information for business management and performance evaluation.

The Financial Statement Analysis is based on the reclassification of balance sheet data, which are reworked and aggregated in order to obtain information that goes beyond the representation required by the civil code. This process allows you to have a clearer and more in-depth vision of the company’s reality, allowing you to identify strengths and weaknesses, as well as evaluate the company’s ability to generate profit and meet its financial commitments.

What are, then, the objectives of the balance sheet analysis?

There is no single answer to this question. Usually the objectives are distinguished depending on the person who carries out the analyses themselves.

• If the person is an analyst within the company, his objective will probably be to analyze the company’s strengths and weaknesses; or to evaluate future development prospects. Let’s think for example of the owner of the company: what will he be most likely interested in? He will probably want to know the return on his investment especially in terms of opportunity cost, that is, evaluating how much the invested capital would have returned if allocated to other activities.
• If, on the other hand, the analyst is an external subject, the objective changes depending on the type of subject: a financier will be interested in knowing the company’s solvency, an investor will want to know the profitability, etc. etc.

Required documents

To conduct an effective balance sheet analysis, it is necessary to have a series of fundamental documents.

• Financial statements: this is the essential starting point, including the balance sheet, the income statement and the explanatory notes.
• Budget and business plans: these documents provide information on the company’s forecasts and objectives, allowing the actual results to be compared with those expected.
• Balance sheets and interim financial statements: these documents offer a more detailed and up-to-date view of the company’s economic and financial situation.
• Financial statement: a document is essential for analyzing the company’s cash flows and liquidity.
• Management report: provides qualitative and quantitative information useful for better understanding the context in which the company operates.

How to do a balance sheet analysis: techniques and phases

The balance sheet analysis is a complex process that requires a series of methodical steps to obtain a complete and accurate view of the economic and financial situation of a company. This process is based on different techniques, each of which provides valuable information for evaluating the financial health and performance of the company.

The first phase of the balance sheet analysis consists of the reclassification of the data contained in the balance sheet and income statement. This operation is essential to make the balance sheet data more suitable for analysis and interpretation.

The reclassification of the balance sheet generally follows a financial and functional logic, highlighting the nature of the uses (investments) and sources of financing. As regards the income statement, the most common reclassification logics are at cost of sales, at contribution margin and at added value.

Once the statements have been reclassified, the various analysis techniques are applied. The main ones are analysis by ratios, analysis by flows and comparative analysis.

Analysis by ratios

analysis by ratios, or ratio analysis, is a fundamental technique that allows you to examine the relationships between different balance sheet items through the calculation of significant ratios. These ratios offer a concise but effective overview of the company situation, allowing to evaluate crucial aspects such as profitability, financial strength and financial balance.

Among the most relevant ratios we find:

• ROE (Return on Equity): measures the profitability of equity and is calculated as the ratio between operating profit and net equity;
• ROI (Return on Investment): evaluates the profitability and efficiency of operational management, relating operating income to invested capital;
• ROS (Return on Sales): provides a measure of the company’s typical revenue-generating capacity, calculating the ratio between operating income and sales revenue;
• Availability ratio: compares current assets with current liabilities, providing an assessment of short-term financial balance;
• Debt ratio: measures the company’s degree of dependence on external sources of financing, comparing net equity to total debt.

Flow analysis

Cash flow analysis is a dynamic approach that studies changes in investments and financing over time. This technique aims to overcome the limitations of ratio analysis, providing a more in-depth view of the company’s economic, financial and equity situation.

The flow analysis therefore consists in the study of financial movements (sources and uses) that occur during management. The reference table for this type of analysis is the financial statement, a document that illustrates the changes in liquidity that occurred in a given period.

The financial statement classifies flows into three main categories:

• flows from operating activities: they reflect the company’s ability to generate liquidity through its characteristic activity;
• flows from investment activities: they show how the company uses resources to maintain or expand its production capacity;
• flows from financing activities: they highlight the ways in which the company obtains the necessary financial means.

The analysis of financial flows allows us to understand how liquidity has moved in operational management, in investment or financing operations, offering a dynamic view of company management.

Benchmarking

Benchmarking is a technique that consists of comparing the company’s financial data with different benchmarks.
These can include:

• historical data of the company itself: allows you to evaluate the evolution of performance over time;
• data of competing companies or industry averages: allows you to position the company with respect to competitors and the reference market;
• company budget and forecasts: helps verify the achievement of the set objectives;
• industry benchmark: allows you to compare company performance with the standards of excellence of the industry.

Benchmarking is particularly effective in identifying trends, anomalies or significant deviations that may require further investigation. It is a valuable tool for strategic planning and management control.

How to evaluate a company from the balance sheet: what are the phases of the interpretation of the balance sheet?

The interpretation of the balance sheet is implemented in different phases. Schematically, at least three can be listed:

1) the literal interpretation, allows to identify the meaning of the individual items of the balance sheet, in order to understand and evaluate their content. This phase is facilitated by the processes of:

• accounting unification, has formal value since it concerns the schemes or methods of representing the accounts with the aim of ensuring that all companies of a certain type operating in a certain system and territory, make use of the same or very similar, balance sheet schemes (unifying them or making them uniform);
• accounting standardization, has substantial value, since it specifically concerns the informative content of the balance sheet. Standardizing the balance sheets means conventionally establishing accounting rules that translate into drafting/evaluation criteria, both general and operational, common to all companies that carry out their activity within the system considered;
• accounting harmonization, has legal value, it is in fact the process of adopting the same accounting rules by companies operating in different national contexts (think of what happens within the European Union).

2) the revisional interpretation allows to verify the regularity and truthfulness of the balance sheet. This function is attributed by law to the accounting control body (board of auditors, statutory auditor, board of auditors, etc. etc.).

3) the prospective interpretation allows to predict the future trends of company results through the extrapolation and analysis of the appropriately reclassified balance sheet data.

Original article published on Money.it Italy. Original title: Analisi di bilancio, come si fa e come valutare un’azienda