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Can you spot the clues?

Sherlock Holmes and other famous literary detectives are renowned for seeing the clues that no one else can spot. When others are baffled, Holmes puts the pieces of the puzzle together and finds the solution.

Reading financial statements can be a bit like digging for clues. If it were easy everyone would do it. As a finance professional, and with some understanding and practice, you can add value to your SME clients by analysing their financial statements and helping them to make informed decisions.

Financial statement analysis is the process of reviewing a business’s various financial statements to uncover opportunities and rectify issues before they become problems.

It is important to remember that the specific data contained within each financial statement will vary from business to business. Every financial document is unique and offers insight into the health of the operation. They are also essential to monitor a business’s performance over time, as well as understanding how a business is progressing toward key strategic initiatives.

Conducting Financial Statement Analysis

Typically, Finance Professionals will follow one of two common methods to analyse financial statements: Vertical and horizontal analysis, and ratio analysis.

Vertical analysis is the process of reading down a single column in a financial statement. Vertical analysis is used to determine how individual line items in a statement relate to another item in the report. For example, in an income statement, each line item might be listed as a percentage of gross sales.

Horizontal analysis, on the other hand, refers to the process of reading current financial data in comparison to previous reporting periods. Also called “trend analysis,” reading a financial statement in this way allows an individual to see how different financial metrics have changed over time: For example, whether liabilities have increased or decreased from Q1 to Q2.

Ratio analysis is the process of analysing the information in a financial report as it relates to another piece of information in the same report. Having calculated a ratio for the current period, you can compare it against previous periods to understand how the business is performing over time. It is also possible to compare the ratio against industry standards to understand if the business in question is under or over-performing.

Financial Performance

When undertaking comprehensive financial statement analysis, Finance Professionals typically use multiple years of data to facilitate horizontal (or trend) analysis.

Each financial statement is also analysed with vertical analysis to understand how different categories of the statement are influencing results.

Finally, ratio analysis can be used to isolate some performance metrics in each statement and bring together data points across statements collectively.

Some Common Ratio Metrics:

  • Balance sheet: includes asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity.

  • Income statement: includes gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage.

  • Cash flow: includes cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per-share basis.

  • Comprehensive: includes return on assets (ROA) and return on equity (ROE).

Financial statement analysis evaluates a business’s performance or value through its balance sheet, income statement, or statement of cash flows. By using several techniques, such as horizontal, vertical, or ratio analysis, analysts may develop a more nuanced picture of a business's financial profile.

Benefits of Financial Statement Analysis

Whether your self-employed clients want to expand or sell their businesses, raise additional funds or apply for business loans, the Finance Professional needs to be able to present a financial snap-shot of the business. This will help you gain the trust of lenders, investors and potential new partners.

Carrying out a financial analysis of your client’s business has many benefits and could increase its performance.

As a Finance Professional, financial analysis will not only help you understand your client’s business’ financial condition, helping you determine its creditworthiness, profitability and ability to generate wealth but will also provide you with a more in-depth look at how well it operates internally.

In addition, most financial institutions require a balance sheet with a financial analysis to determine your self-employed client’s ability to repay the loan(s) they will receive.

Finally, a financial analysis identifies a business's position in relation to the sector of activity, which allows you to keep an eye on the competition.

Financial Statement Analysis is part of the Business Analysis module in the Business Finance Certification, a professional development program that helps position you as an SME Finance specialist, so you can help your clients succeed and prosper.

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