Financial statement analysis and valuation is a fundamental part of any investor’s and business owner’s toolkit, having a major influence on success or failure. Quite simply, accurate assessment of a company’s financial position and potential helps buyers, lenders, and other creditors understand the risks and rewards associated with their investments and financing.
The purpose of this article is to explain the basics of financial statement analysis and valuation for both investors and business owners. Included herein are definitions of key terms and concepts, suggestions on the information to include in an analysis, different approaches that can be taken, and examples of when an analysis might be used.
What is Financial Statement Analysis and Valuation?
Financial statement analysis and valuation seek to assign value to a company based on its financial performance. Valuation involves the weighing of both tangible and intangible assets, liabilities, and income to determine the company’s worth in terms of equity or a dollar value. The goal of financial statement analysis is to assess the company’s financial health and performance.
The analysis of a company’s financial statements, in terms of its financial strengths, weaknesses and resources can provide key insights into multiple areas of operations. Financial statement analysis and valuation are particularly important when considering mergers, acquisitions, public offerings, and other corporate activities, allowing investors and decision makers to understand the potential risk and reward associated with any given transaction.
Components of Financial Statement Analysis
The main components of financial statement analysis include a review of the company’s balance sheet, income statement, cash flow statement and statement of changes in equity. A review of each of these components provides essential data and insight into the company’s financial performance and operations.
Balance Sheet:
The balance sheet provides a snapshot of a company’s financial position and is composed of a list of assets, liabilities and equity. Assets are made up of resources such as cash, inventory, and other items owned by the company. Liabilities represent financial obligations such as accounts payable, loans, and other forms of debt. Equity is everything that remains after liabilities have been subtracted from assets, and it provides information on the company’s financial health and solvency.
Income Statement:
An income statement (sometimes called the profit and loss statement) is a list of the company’s revenues and expenses over a given period of time. This statement reveals the company’s net profits or losses and provides information on operational costs, profitability, and sustainability.
Cash Flow Statement:
The cash flow statement provides a comprehensive view of a company’s cash flow activity over a specific period. This statement is a detailed accounting of all cash entering (inflows) and leaving (outflows) a company’s accounts and includes information on operating, investing and financing activities. It is an essential tool for investors and managers to review a company’s liquidity and solvency.
Statement of Changes in Equity:
The statement of changes in equity (or statement of owners’ equity) provides information on the owners’ investment in the company’s assets and any changes to those investments over a given period of time. This statement explains how the company’s equity has changed due to items such as share repurchases, earnings, or losses from investments or operations.
Purposes of Financial Statement Analysis and Valuation
Financial statement analysis and valuation can be used for multiple purposes, from assessing the potential of investments to detecting fraud. Here are five common uses for financial statement analysis:
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Assessing Investment Potential: Investors use financial statement analysis and valuation to identify opportunities for investment and determine if a company is worth investing in. By studying financial statements, investors can identify trends that can be converted into an opportunity to buy stock in an undervalued company or to sell the stock of a company whose value is overinflated.
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Evaluating Performance: Financial statement analysis can also be used to evaluate a company’s performance over time. By noting variances in profits, cash flow, shareholder’s equity, and other indicative figures, managers can assess how well a company is doing and where improvements need to be made.
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Making Informed Decisions: Financial statement analysis is a key component to making informed decisions in business. Whether it’s a decision to merge, acquire or enter into a new industry, understanding a company’s financial position and potential can help decision makers make an informed and profitable decision.
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Detecting Fraud: Analyzing financial statements can also be an effective way to detect fraud. By looking for patterns or irregularities in the statements, accountants and auditors can identify fraudulent activity or potential issues that need to be further investigated.
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Determining Valuation: Financial statement analysis and valuation are used to determine the intrinsic value of a company. This helps investors and business owners understand the profitability, solvency and sustainability of an investment.
Approaches to Financial Statement Analysis and Valuation
There are multiple approaches to financial statement analysis and valuation, each with their own advantages and shortcomings, and all involving varying degrees of complexity.
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Comparative Analysis: Comparative analysis involves comparing a company’s financial position to that of its peers or competitors. It helps to identify areas of strength and weakness to determine how it’s performing against its competitors. It also helps to inform decisions on pricing, strategic investments and other operational elements.
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Ratio Analysis: Ratio analysis is a mathematical approach to financial statement analysis that involves calculating ratios to understand the relationships between data points. Common ratios include the current ratio, return on assets, return on equity and the debt-to-equity ratio.
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Common-Size Analysis: Common-size analysis is a technique used to compare the values of different financial statements. This approach expresses all values as a percentage of related items, allowing for comparison and better understanding of the data.
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Trend Analysis: Trend analysis focuses on the number and size of changes between consecutive periods. This approach reveals trends in financial performance, helping managers to understand the direction in which the company is headed.
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Fundamental Analysis: Fundamental analysis is a more in-depth approach to financial statement analysis and valuation. This approach involves using other economic and market data to assess a company’s intrinsic value. It’s used to identify the underlying strengths and weaknesses of a company and to inform investment decisions.
When is Financial Statement Analysis and Valuation Most Important?
Financial statement analysis and valuation are important for all investors and business decision makers. Here are a few of the most important times to take a close look at the financials:
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IPO: One of the most important times to analyze a company’s financials is during the pre-IPO process. Unknown or uncertain financials can lead to an undervalued stock price or insufficient investor interest in the stock, damaging the chances of a successful IPO.
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Mergers and Acquisitions: A company’s financial statement analysis and valuation can help inform decisions about potential mergers and acquisitions. Performing a full analysis of a company’s financial statements helps assess the benefits, risks, and potential liabilities associated with any given merger or acquisition.
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Financing: When a company is considering taking on debt financing, or if a potential lender wants to finance a company, an in-depth analysis of the company’s financials is necessary to understand the potential risks.
Financial statement analysis and valuation is an essential tool for any investor, business owner, and decision maker. The analysis goes beyond simply getting a “feel” for a company’s financials; it helps identify the potential risks and rewards associated with any given investment or activity. By studying a company’s financial statements and associated data, investors and fundamental analysts can gain valuable insight into the company’s operations and the potential associated with any given transaction.