The Role of Financial Statement Analysis in Risk Management and Credit Decisions

Financial statement analysis (or just financial analysis) is the process of reviewing and analysing a company’s financial statements to make better economic decisions to earn income in the future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts, and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, valuation, financial health, and prospects of an organisation. It is used by a variety of stakeholders, such as credit and equity investors, the government, the public, and decision-makers within the organisation. These stakeholders have different interests and apply a variety of techniques to meet their needs. For example, equity investors are interested in the long-term earnings power of the organisation and perhaps the sustainability and growth of dividend payments. Creditors want to ensure the interest and principal are paid on the organisation’s debt securities (e.g., bonds) when due.

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On the part of management, AI bank statement analysis reveals and pinpoints areas of the organisation that call for corrective actions, from the investors’ standpoint and the company’s profitability. It is a tool for gauging financial outlook and deciding upon the viability of their investment in the entity related to accounts, short-term current assets. For vendors and suppliers, it helps dig into the entity’s creditworthiness and guides them in deciding whether or not they should consider providing goods and/or services to the entity on credit.

Understanding How Financial Statement Analysis Works

Financial statement analysis is the process of assessing a company’s financial health and performance by examining its financial statements, including the income statement, balance sheet, and cash flow statement. This analysis involves using various metrics and methods to assess profitability, liquidity, solvency, and efficiency, helping stakeholders make informed decisions about the financial status of a company. Financial statement analysis offers a clear and comprehensive view of a company’s financial health for both internal stakeholders, such as the finance team and business leaders, and external stakeholders, such as investors. This analysis helps stakeholders identify key insights into a company’s performance. It also keeps finance professionals and investors informed about business and market trends, enabling better decision-making.

In addition, evaluating key financial ratios such as profitability, liquidity, and solvency helps finance teams and business leaders assess resource management and progress toward financial goals. Investors also use ratio analysis to gauge a company’s financial health and growth potential for informed investment decisions.

The Benefits of Performing Financial Statement Analysis Include

• Informed Decision Making

  Financial statement analysis provides critical information to business leaders for making strategic decisions, such as expanding operations, investing in new projects, or cutting costs.

• Performance Evaluation

  Company leadership and investors can track their business’s financial performance over time. Thus, recognising strengths and areas for improvement depends on the company’s financial position.

• Risk Management

  By understanding financial vulnerabilities and current liabilities, company leadership can take assertive steps to mitigate risks. Operating activities, such as cash flow issues or excessive debt.

• Risk Management

  By understanding financial vulnerabilities and current liabilities, company leadership can take assertive steps to mitigate risks. Operating activities, such as cash flow issues or excessive debt.

• Investor Confidence

  Detailed financial analysis helps attract and retain investors by demonstrating transparency and the company’s ability to generate return on assets or return on equity.

• Regulatory Compliance

  Regular financial analysis and reporting guarantee that businesses meet legal and regulatory requirements. This leads to reducing the risk of penalties, fines, or reputational damage by using modern financing activities that convert debt to equity ratios for profitability ratios.

Techniques of Financial Statement Analysis

Horizontal Analysis

Horizontal analysis involves the evaluation of financial statements on a historical basis. Under this technique, financial data is compared across time periods. For example, the progression of sales is evaluated over the years to evaluate the sales growth rate of the entity. Horizontal analysis uses a base period and one or more comparison periods. The result of this analysis is generally expressed as a percentage with reference to the specified base period, with the help of leverage ratios on working capital and financial strength.

Vertical Analysis

As the name suggests, vertical analysis involves assessing various line items of a financial statement as a percentage of a specific baseline item. For example, various expenses in the financial information on an income statement are expressed as a percentage of sales and the share of each type of asset is expressed as a percentage of total assets and the net income of the company’s financial performance.

Ratio Analysis

Ratio analysis involves evaluating the relationship between various line items of financial statements like income statement and the balance sheet. This is done by calculating various financial ratios and comparing them with some set standards. On the basis of this comparison, management can take corrective steps, and other stakeholders can make informed decisions according to their specific situations.

Trend Analysis

Trend analysis examines changes in financial statement accounts and ratios over time to identify positive or negative trends. Analysing multiple reporting periods highlights growing or declining momentum that impacts future performance. Financial analysts compile comparative data across at least three reporting periods to conduct trend analysis. The data is plotted on a graph with time on the horizontal axis and the financial metric on the vertical axis. A trend line is added to show the general direction of the financial indicator. An upward-sloping trend signals increases over time, while a downward-sloping trend line indicates declines.

Limitations of Financial Statement Analysis

While financial statement analysis is an important and useful exercise, it does suffer from certain limitations. These can include:

• High dependency on accuracy of financial statements:

  A financial statement analysis can be inaccurate and, in fact, can even be manipulated if the base forecasting financial statements are inaccurate.

• Change in accounting policies:

  Any change in accounts payable, accounts receivable or presentation can result in erroneous results, hampering the efficacy of inter-period or inter-firm comparison with corporate finance.

• Focus on quantitative analysis:

  While exercising a financial statement analysis, the primary focus is on quantitative data. The non-monetary and qualitative aspects that impact financial performance are often sidelined.

• Only a tool, not a solution:

  The analysis of financial statements is only a means to an end of current ratio among free cash flow, common size and net profit margin. The actual success of the analysis requires expert analysts to meaningfully interpret, analyse, and then take appropriate and timely decisions about the matters involved.

Conclusion

Financial statement analysis is a function that involves the evaluation of reported financial statements of an entity to aid stakeholders and users of those statements in their decision-making. It seeks to establish relationships between various financial parameters so as to gain a better understanding of the entity’s financial health and performance. Financial statement analysis is benefiting from both internal stakeholders, like management and existing shareholders, as well as external stakeholders such as potential investors, lenders and suppliers. Financial statements typically include an income statement, cash and fund flow statements and a balance sheet. They record detailed financial transactions of the entity for a specific time period and thus reveal both financial performance and the financial position of its business. A further analysis of these financial statements facilitates stakeholders with a lot of information, which works as a key in their decision-making process.

All in all, financial statement analysis is an extremely vital function as it has utility for both internal and external stakeholders. Generally, a large part of this financial analysis is presented in annual reports along with the reported financial statements. This is done so that the information is easily accessible by all stakeholders. However, a leader is only as good as his team; thus, for financial statement analysis to be meaningful, the financial statements themselves must be accurate, and the interpretations applied must be meaningful.

FAQs about Financial Statement Analysis

• How do you analyse financial statements?

  The first step in analysing a company’s financials is accumulating the latest financial statements, including its balance sheet, income statement, cash flow statement, and accompanying notes. Accessing the investor relations section of the company’s website is another way to obtain the latest financial reports. Focus on consolidated financial statements, which reflect total company results, rather than individual segment results. Also, gather financial statements from prior fiscal years for comparison.

• What are the benefits of financial statement analysis?

  Financial statement analysis allows investors, creditors, and management to evaluate past performance and current position. Trend analysis offers insight into historical trajectories, while ratio analysis quantifies key metrics such as profitability, efficiency, and leverage for comparison across companies and industries.

• What Are the Advantages of Financial Statement Analysis?

  The main point of financial statement analysis is to evaluate a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company’s financial profile.

• What Are the Different Types of Financial Statement Analysis?

  Most often, analysts will use three main techniques for analysing a company’s financial statements. First, horizontal analysis involves comparing historical data. Usually, the purpose of horizontal analysis is to detect growth trends across different time periods. Second, vertical analysis compares items on a financial statement in relation to each other. For instance, an expense item could be expressed as a percentage of company sales. Finally, ratio analysis, a central part of fundamental equity analysis, compares line-item data. Price-to-earnings (P/E) ratios, earnings per share, or dividend yield are examples of ratio analysis.

• What Is an Example of Financial Statement Analysis?

  An analyst may first look at several ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit margin will show the difference between revenues and the cost of goods sold. If the company has a higher gross profit margin than its competitors, this may indicate a positive sign for the company. At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s operating trends.