Introduction to Financial Statement Analysis

Financial analysis is the process of interpreting and evaluating a company’s performance and position in the context of its economic environment. Financial analysis is used by analysts to make decisions and recommendations such as whether to invest in a company’s debt or equity securities and at what price. A debt investor is concerned about a company’s ability to pay interest and to repay the principal lent, while an equity investor is interested in a company’s profitability and per-share value. Overall, a central focus of financial analysis is evaluating the company’s ability to earn a return on its capital that is at least equal to the cost of that capital, to profitably grow its operations, and to generate enough cash to meet obligations and pursue opportunities.

Financial analysis starts with the information found in a company’s financial reports. These financial reports include audited financial statements, additional disclosures required by regulatory authorities, and any accompanying (unaudited) commentary by management. Analysts supplement their analysis of a company’s financial statements with industry and company research.

• Financial analysis for a company often includes obtaining an understanding of the target company’s business model, financial performance, financial position, and broader information about the economic environment and the industry in which the company operates. When analytical tasks are not well defined, the analyst may need to make decisions about the approach, the tools, the data sources, the format for reporting the results, and the relative importance of different aspects of the analysis.
• Financial analysis will include evaluating financial results, and structuring and scaling data to facilitate comparisons by calculating percentages, changes, and ratios. Answers to analytical questions often rely not just on numerical results but also on the analyst’s interpretation of the numerical results to support a conclusion or recommendation.
• The role of financial statement analysis is to form expectations about a company’s future performance, financial position, and risk factors for the purpose of making investment, credit, and other economic decisions.
• Regulatory authorities require publicly traded companies to prepare f inancial reports in accordance with specified accounting standards and other securities laws and regulations. An example of such a regulatory authority is the Securities and Exchange Commission in the United States.
• Other organizations exist without explicit regulatory authority and develop reporting standards, facilitate cooperation, and advise governments. Examples include the International Organization of Securities Commissions, the European Securities Committee, and the European Securities and Market Authority.
• Sources of information for analysts and investors include standardized forms that are filed with regulatory authorities, disclosures made in notes, supplementary schedules, and management commentary that accompany financial statements, and audit reports. In an audit report, an independent auditor expresses an opinion on whether the information in the audited financial statements fairly presents the f inancial position, performance, and cash flows of the company in accordance with a specified set of accounting standards.
• Despite increasing convergence over time, differences still exist between IFRS (International Financial Reporting Standards) and US GAAP (Generally Accepted Accounting Principles) that affect financial reporting. Analysts must be aware of areas where accounting standards have not converged.
• In addition to information required by regulatory authorities, issuers also communicate through earnings calls, investor day events, press releases, company websites, and company visits. Analysts may also get information by speaking with management, investor relations, and other company personnel.
• Third-party sources for additional information include industry whitepapers, analyst reports, economic information from governments, general and industry-specific news outlets, and electronic data platforms. Analysts also use surveys, conversations, and product evaluations to generate their own information.