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A Comprehensive Guide to Analyzing Financial Statements

To assess a company's financial health, performance, and future prospects, financial statement analysis is critical (Kenton, 2024). Internal and external stakeholders use the aforementioned analyses to evaluate business performance and value (Kenton, 2024). The following is intended to guide you through the multiple facets of financial statement analysis, including the types of financial statements, three analysis techniques, and lastly, a few practical applications. 

There are three types of financial statements, each with its own purpose. The first is a balance sheet. This statement provides a summary of a company's financial position at a specific point in time and provides its assets, liabilities, and shareholders' equity (Kenton, 2024). As the name implies, the balance sheet should balance, and assets should equal the sum of liabilities and equity (Kenton, 2024). The second, is an income statement. An income statement, or profit and loss statement, provides a company's revenues, expenses and profits over a period and aids in comprehending the company's profitability and operational efficiency (Warnes, 2022). Lastly, the third is a cash flow statement. A cash flow statement provides both cash inflows and outflows from operating, financing, and investing activities and is used to assess a company's liquidity and cash management (Remesh, 2024). 

There are also three techniques for analyzing financial statements. First is a horizontal analysis. A horizontal analysis involves comparing financial data across multiple time periods (Kenton, 2024). The comparison allows identification of trends and growth patterns such as comparing revenue figures over time to discern if a company is growing (Kenton 2024). Second is a vertical analysis. This method presents each line item as a percentage of a base figure within a given and same time period (Warnes, 2022). This may look like analyzing each expense as a percentage of total sales to gain a better understanding of the underlying cost structure (Warnes, 2022). Third and last is the ratio analysis. As the name implies, ratios are used to evaluate how different financial statement items relate to one another (Remesh, 2024). Some common ratios included in this type of analysis include current ratios (liquidity), return on equity (profitability), and debt-to-equity (leverage) (Remesh, 2024).

Practical applications of financial statement analysis include investment decisions, credit evaluation, and performance monitoring (Warnes, 2022). To expand, investors often use financial statement analysis of a company to determine how viable investing in that company would be (Kenton, 2024). Specific facets investors home in on to provide them guidance are profitability, liquidity, and solvency ratios (Kenton, 2024). When it comes to credit evaluation, lenders use financial statement analysis to assess the creditworthiness of a business and look for cash flow statements and liquidity ratios to verify the business can meet its debt obligations (Warnes, 2022). Financial statement analysis provides an avenue for performance monitoring in that business owners are able to use analysis information to make strategic decisions, plan for future growth, and identify areas for improvement (Remesh, 2024). 

Understanding and applying the various financial statement analysis techniques affords one valuable insights into a company's financial health and improves the ability to make informed decisions (Warnes, 2022). For anyone involved in business or finance, analyzing financial statements constitutes as an indispensable tool (Warnes 2022). 

References:

Kenton, W. (2024, February 19). Financial statement analysis: How it's done, by statement type. Investopedia. https://www.investopedia.com/terms/f/financial-statement-analysis.asp

Warnes, B. (2022, June 8). How to read (and analyze) financial statements. Bench. https://www.bench.co/blog/accounting/how-to-read-and-analyze-financial-statements

Remesh, A. (2024, January 1). Financial statement analysis: Definition, types, how to do, example. Strike. https://www.strike.money/fundamental-analysis/financial-statement-analysis

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