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How Do You Do Financial Statement Analysis?

Use These Techniques to Analyze the Business Firm's Financial Statements

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There are a number of techniques you can use to perform financial statement analysis for your business firm, depending on what you are trying to find out. The financial statements you want to use in your analysis is the balance sheet, income statement, and statement of cash flows. First, you need to know how to prepare the financial statements. After learning preparation, financial analysis comes next. Here are some techniques to use to analyze your financial statements:

1. Trend Analysis

Trend analysis is also called time-series analysis. Trend analysis helps a firm's financial manager determine how the firm is likely to perform over time. Trend analysis is based on historical data from the firm's financial statements and forecasted data from the firm's pro forma, or forward-looking, financial statements.

One popular way of doing trend analysis is by using financial ratio analysis. If you calculate financial ratios for a business firm, you have to calculate at least two years of ratios in order for them to mean anything. Ratios are meaningless unless you have something to compare them to, in this case other year's of data. Trend analysis is even more powerful if you have and use several years of financial ratios. Here is an example of a trend analysis using financial ratios.

2. Common Size Financial Statement Analysis

Common size financial statement analysis is analyzing the balance sheet and income statement using percentages. All income statement line items are stated as a percentage of sales. All balance sheet line items are stated as a percentage of total assets. For example, on the income statement, every line item is divided by sales and on the balance sheet, every line item is divided by total assets. This type of analysis enables the financial manager to view the income statement and balance sheet in a percentage format which is easy to interpret.

If you look at this income statement, for example, you can develop a common size income statement. If you calculate the percentage that net income is of total sales, the formula is $64,000/$1,000,000 = 6.4%. You can apply that formula to every line item on the income statement to develop your common size income statement. As with financial ratio analysis, you can compare the common size income statement from one year to other years of data to see how your firm is doing. It is generally easier to make that comparison using percentages rather than absolute numbers.

Here is an example of a common size analysis of an income statement and balance sheet.

3. Percentage Change Financial Statement Analysis

Percentage change financial statement analysis gets a little more complicated. When you use this form of analysis, you calculate growth rates for all income statement items and balance sheet accounts relative to a base year. This is a very powerful form of financial statement analysis. You can actually see how different income statement items and balance sheet accounts grew or declined relative to grows or declines in sales and total assets.

Here is an example of percentage change analysis. Let's say that XYZ, Inc. has $500 in inventory on its balance sheet in 2011 and $700 in inventory on its balance sheet in 2012. How much has inventory grown in 2012? The formula to calculate the growth rate in inventory is the following: Change in inventory/Beginning inventory Balance = $200/$500 = 0.40 = 40%. The change in inventory for XYZ, Inc. in 2012 is 40%.

If you do a percentage change analysis for all balance sheet and income statement items, you can see how helpful it would be to the financial manager. Here is a handy calculator you can use to calculate percentage change.

4. Benchmarking

Benchmarking is also called industry analysis. Benchmarking involves comparing a company to other companies in the same industry in order to see how one company is doing financially compared to the industry. This type of analysis is very helpful to the financial manager as it helps to see if any financial adjustments need to be made.

Financial ratio analysis are usually used for benchmarking analysis. Financial ratios for other companies can be obtained from a number of sources. Here is an excellent source of industry average ratios. You can also obtain industry average ratios from Value Line and Dun and Bradstreet.

In order to do benchmarking, you compare the ratios for one company to the ratios for other companies in the same industry. You have to be sure that the industry average ratios are calculated in the same way the ratios for your company are calculated when you do benchmarking.

Using these four financial statement analysis techniques help a financial manager know where a business firm is financially both internally and as compared to other firms in the industry. Together, they are powerful analysis tools that will help every business firm stay solvent and profitable.

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