how to analyze financial statements
the financial statements of a company record important financial data on every aspect of a business s activities as such they can be evaluated on the basis of past current and projected performance in general financial statements are centered around generally accepted accounting principles gaap in the united states these principles require a company to create and maintain three main financial statements the balance sheet the income statement and the cash flow statement public companies have stricter standards for financial statement reporting public companies must follow gaap which requires accrual accounting 1 private companies have greater flexibility in their financial statement preparation and have the option to use either accrual or cash accounting 2several techniques are commonly used as part of financial statement analysis three of the most important techniques are horizontal analysis vertical analysis and ratio analysis horizontal analysis compares data horizontally by analyzing values of line items across two or more years vertical analysis looks at the vertical effects that line items have on other parts of the business and the business s proportions ratio analysis uses important ratio metrics to calculate statistical relationships types of financial statementscompanies use the balance sheet income statement and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders all three statements are interconnected and create different views of a company s activities and performance the balance sheet is a report of a company s financial worth in terms of book value it is broken into three parts to include a company s assets liabilities and shareholder equity short term assets such as cash and accounts receivable can tell a lot about a company s operational efficiency liabilities include the company s expense arrangements and the debt capital it is paying off and shareholder equity includes details on equity capital investments and retained earnings from periodic net income the balance sheet must balance assets and liabilities to equal shareholder equity this figure is considered a company s book value and serves as an important performance metric that increases or decreases with the financial activities of a company the income statement breaks down the revenue that a company earns against the expenses involved in its business to provide a bottom line meaning the net profit or loss the income statement is broken into three parts that help to analyze business efficiency at three different points it begins with revenue and the direct costs associated with revenue to identify gross profit it then moves to operating profit which subtracts indirect expenses like marketing costs general costs and depreciation finally after deducting interest and taxes the net income is reached basic analysis of the income statement usually involves the calculation of gross profit margin operating profit margin and net profit margin which each divide profit by revenue profit margin helps to show where company costs are low or high at different points of the operations the cash flow statement provides an overview of the company s cash flows from operating activities investing activities and financing activities net income is carried over to the cash flow statement where it is included as the top line item for operating activities like its title investing activities include cash flows involved with firm wide investments the financing activities section includes cash flow from both debt and equity financing the bottom line shows how much cash a company has available companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company free cash flow statements arrive at a net present value by discounting the free cash flow that a company is estimated to generate over time private companies may keep a valuation statement as they progress toward potentially going public financial performancefinancial statements are maintained by companies daily and used internally for business management in general both internal and external stakeholders use the same corporate finance methodologies for maintaining business activities and evaluating overall financial performance 