DIY Financial Analysis: Basic Financial Statement Analysis
Updated: Nov 30, 2020
When most people hear, "Financial Analysis" they immediately envision complicated spreadsheets, convoluted formulae, and highly technical mathematical models. While this is required for some instances, there numerous financial analysis techniques that are actually quite simple mathematically, yet provide great insights into the operational efficiency and efficacy of an organization. We will discuss three very common and easy to use methods here. All three involve expressing each line of your financial statements as a percentage of a base amount which makes it easier to compare them across years and with other companies of different sizes.
Vertical Analysis (Common-Sized Financial Statements)
Creating a vertical common-sized financial statement requires dividing each line item by either sales (on the income statement), by total assets (on the balance sheet), or by cash flows from operations, investing, or financing respectively (on the cash flow statement). This restates all items on the income statement as a percentage of sales, and all items on the balance sheet as a percentage of total assets. See the simplified example below:
Reviewing your financial statements in this way allows for easy comparison between years. Trends in your financial statements become easily visible and anomalies are readily spotted allowing management to dig deeper to ascertain the cause. Also, it becomes possible to compare your common size (AKA percentage-based) statements against other companies in your industry, and against benchmarks or targets that you set. When comparing against other companies, be sure to compare against companies of similar size to your firm; larger companies can achieve economies of scale for various processes that will make them unrealistic comparisons against smaller firms. This form of is also an excellent tool to have when creating budgets since it is useful to compare your common-sized budgeted financial statements with your previous year's as a reasonableness check.
This is one of the most popular methods of analysis and a version of this is available by default in QuickBooks Online for your income statement.
Another method is known as a horizontal analysis. To perform this analysis, select a year to use as a base year, and express each line item in the subsequent years as a percentage of the base. Simply divide the account value in the latter year, by the same account's value in the base year. These are known as "trend percentages". See the example below:
Often considered another form of Horizontal Analysis, Growth Analysis expresses each line of the financial statements as the percent change over the year prior. The formula for this is simply:
Applying this technique to the same financial statements in the example above looks like this:
Both Horizontal and Growth Analysis make relative changes between line items readily apparent and easily facilitate management by exception - the practice of directing management attention to investigating and correcting the largest or most unexpected cost increases over last year's performance or over budgeted performance.
These analysis techniques are simple, yet powerful ways to look deeper into your financial statements, look across years, and better understand the trends and performance interactions in and between different cost and profit centers in your business. These techniques are actually a form of ratio analysis, a larger group of financial analysis techniques. Ratio analysis techniques typically involve simply dividing one key number by another and then comparing the result to a benchmark or standard. Their simplicity and ubiquity is why they are so popular. The ability to quickly calculate ratios and compare them to other businesses or industry standards who calculate similar ratios make them invaluable. We will cover other forms of ratio analysis in future blog posts.
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