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The analysis of financial statements is one of the methods used by companies to monitor their performance and make decisions, as well as by investors for the same purposes. The company was profitable and growing, or it was declining, and it is worth noting that this is the general concept of analyzing financial statements, as there are other uses and benefits for it by the country’s lenders and regulatory authorities.
Methods of analyzing financial statements
There are three methods used for analyzing the financial statements, which are horizontal, vertical, and relative, and the following is an explanation for each of them:
Horizontal analysis of the financial statements
This type of financial statement analysis is concerned with studying the company’s performance over several accounting periods. By comparing the information included in the financial statement for the current period with its counterpart information in financial statements for previous accounting periods and by finding growth or decline rates, the analyst can evaluate the company’s performance as a whole. Among the information that can be studied through the horizontal analysis is the profit margin and the inventory turnover rate, and it can also explain some changes such as the increase in the company’s earnings per share, as the reason for this is the decline in the cost of goods sold as a result of the increase in sales.
Vertical analysis of financial statements
During this method, the analyst studies each list separately, so that he converts all the list information into percentages, so that the top of the list, such as sales in the income statement, is the complete and reference percentage of the rest of the information, and for example, if sales are equal to $5 million and below it the cost of goods sold is equal to $1 million, then the percentage given to the cost of goods sold is compared to the sales value, meaning that $1 million is 20% of the $5 million, and if the total profit is equal to $4 million, then it is compared to sales and its rate is 80%, and so the rest of the list values are converted to ratios.
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Ratio analysis of the financial statements
This type of analysis is based on studying financial information by comparing it with other financial information in the same list in the form of ratios, called financial ratios. There are many financial ratios that can be studied, the most prominent of which are as follows:
- Liquidity ratios: These ratios show the amount of liquidity or assets convertible into liquidity owned by the company, and this ratio shows the company’s ability to fulfill its obligations as well as its ability to continue to operate.
- Leverage ratios: These ratios show the extent to which the company relies on debt in order to continue its business. One of the most important leverage ratios is the debt-to-equity ratio.
- Profit ratios: Through their name, these ratios show the company’s ability to achieve profits, the most famous of which are the gross profit ratio and the break-even point.
- Activity ratios: These ratios measure the company’s ability to invest its resources. Among the most prominent of these ratios are the receivables turnover rate, the inventory turnover rate, and the working capital turnover rate.
Read also: What are the types of financial statement fraud?
