Financial statements analysis: meaning, types and techniques

Financial statements analysis is the first analysis most Case Study requirements ask for, and the one that tells the financial story of the business. It is also a skill that must be explained, not just calculated. This topic covers what the analysis is for, the types of analysis, and the four techniques you will use, with worked examples.

Where it fits in the case

The Case Study looks at a business from three perspectives. Financial statements analysis and financial data analysis are both core professional skills. The third perspective is operational and strategic analysis, including business trust and ethical awareness. Each can be viewed alone, but your skill as an independent professional is to combine them into one whole.

The three are linked in scope and in time. Financial statements analysis looks at how the business has performed in its recent past. It informs the financial data analysis, which usually looks at a current issue. Both sit inside the operational and strategic analysis, which looks from the present into the future.

Financial analysis as a whole therefore runs from past performance, through the current viability of a project, to future proposals. It covers everything from one revenue stream to an investment that affects the entire organisation.

What financial statements analysis is

Financial statements analysis is an evaluation and explanation of the financial and related information in the financial statements of a business. That includes summary statements, management accounts, budgets and forecasts. It covers financial performance (the statement of comprehensive income and the statement of changes in equity), financial position (the statement of financial position) and cash flow (the statement of cash flows).

It also considers all the contextual information given about the company and its environment.

The statements alone are not enough to draw conclusions or make judgements. Analysis shows strengths and weaknesses by establishing relationships between the items in the statements. It is how liquidity, solvency, profitability and efficiency are measured, and how short-term and long-term prospects are judged.

Because the statements alone give no judgement, an analyst always adds three things: a comparison, a cause and a consequence. A comparison puts a figure in context, a cause links it to the facts of the case and a consequence says what it means for the client.

The focus depends on who asked and why. An investor wants to predict future performance. Management wants to understand present condition as a base for planning. The analysis should help to:

• evaluate strengths and weaknesses;
• measure profitability;
• show the pattern and trend of performance over the years;
• judge future earning capacity;
• compare the entity with others;
• judge liquidity and solvency; and
• assess growth potential.

In the Case Study, the purpose is to test whether you can select relevant information, analyse it and interpret it to make an informed judgement about past, current and future condition. Use the financial statements, but also market, economic and operational data, and any events that explain the present position or bear on the future.

Types of financial statements analysis

The four techniques

Comparative statements. Compare the income statement and the statement of financial position over at least two years. Work out the absolute and percentage change in each item. The income statement comparison shows the direction of operating performance. The statement of financial position comparison shows how operations have affected assets and liabilities. You can also compare two or more entities.

An analysis of changes in working capital, current assets less current liabilities, belongs here too.

Common size statements. Convert figures to percentages. In the income statement, revenue is 100% and every other line is a percentage of revenue. In the statement of financial position, total assets are 100%.

Trend analysis. Choose a base year, usually the first, and set every figure for that year at 100. Express later years as an index against it. Trend analysis shows whether financial health and operating results are improving or declining.

Ratio analysis. This is the most popular technique. Ratios show relationships between items in the two main statements. They fall into five groups: profitability, liquidity, activity or efficiency, gearing and shareholders’ return or investment. The next topic sets them out.

Worked example: the income statement

1. Comparative statements. Revenue grew by ₦200 million, but cost of sales grew by ₦220 million, so gross profit fell by ₦20 million.
2. Common size. Gross margin dropped from 40% to 30%. Expenses were broadly steady at about a quarter of revenue, so operating margin fell from 15% to 6%.
3. Trend. Against a base of 100, revenue rose to 125 and cost of sales to 146. Operating profit halved to 50.
4. Conclusion. Growth in sales has hidden a serious fall in margin. The cause lies in direct costs, so management should review pricing and purchasing before it looks at overheads.

Worked example: working capital

For the same company, current assets rose from ₦300 million to ₦520 million, of which receivables rose by ₦150 million and inventory by ₦70 million. Current liabilities rose from ₦200 million to ₦400 million. Working capital moved from ₦100 million to ₦120 million, a rise of ₦20 million, and the current ratio fell from 1.50 (300 divided by 200) to 1.30 (520 divided by 400). The rise looks healthy until you break it down.

Customers and stock are absorbing the cash, and short-term borrowing and suppliers are financing it. That is a pressure on liquidity, not a strength.

How to comment on a number

A table of figures earns few marks. The marks come from the comment. Use four steps for every important movement.

1. State what moved, in naira and in percentage.
2. Compare it with the previous year, the industry or the target.
3. Explain the likely cause, using facts from the case.
4. Judge the effect on the business and say what management should do.

Choosing the technique for the question

You rarely need every technique. Let the question decide which one to use first.

Then confirm the finding with a second technique, because two methods that agree make a far stronger point than one.

Common mistakes

• Calculating figures and leaving them without explanation.
• Using only one technique, so that a falling margin hidden by rising sales is missed.
• Mixing the base for common size percentages. Revenue is the base for the income statement and total assets for the statement of financial position.
• Ignoring non-financial data, such as market, economic and operational events.
• Analysing the past only, with no view of prospects.

Quick revision

• Three perspectives: financial statements, financial data, operational and strategic.
• Analysis covers performance, position and cash flow, plus context.
• Types: external, internal, short-term, horizontal, vertical.
• Techniques: comparative, common size, trend (base year 100), ratios.
• Comment in four steps: state, compare, explain, judge.

Practice questions

These are original questions in the style of the Institute of Chartered Accountants of Nigeria exam. Try each one before you open the answer.

Model answer

The next topic covers the ratio analysis toolkit for profitability, efficiency, liquidity, gearing and investors.

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