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Financial statement analysis

Financial statement analysis involves reviewing a company's financial statements, including the income statement, balance sheet, and statement of cash flows, to assess its financial health and future prospects. This process helps various stakeholders—such as investors, creditors, and decision-makers—make informed economic decisions. Techniques like horizontal and vertical analysis, along with financial ratios, are commonly used to evaluate risks, performance, and valuations. Historical data combined with forecasts guide these assessments. Professional analysts may pursue the Chartered Financial Analyst designation to gain expertise in this field, supporting better investment and credit decisions.

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History

Benjamin Graham and David Dodd first published their influential book "Security Analysis" in 1934.2 3 A central premise of their book is that the market's pricing mechanism for financial securities such as stocks and bonds is based upon faulty and irrational analytical processes performed by many market participants. This results in the market price of a security only occasionally coinciding with the intrinsic value around which the price tends to fluctuate.4 Investor Warren Buffett is a well-known supporter of Graham and Dodd's philosophy.

The Graham and Dodd approach is referred to as Fundamental analysis and includes: 1) Economic analysis; 2) Industry analysis; and 3) Company analysis. The latter is the primary realm of financial statement analysis. On the basis of these three analyses the intrinsic value of the security is determined.5

Horizontal and vertical analysis

Horizontal analysis compares financial information over time, typically from past quarters or years. Horizontal analysis is performed by comparing financial data from a past statement, such as the income statement. When comparing this past information one will want to look for variations such as higher or lower earnings.6

Vertical analysis is a percentage analysis of financial statements. Each line item listed in the financial statement is listed as the percentage of another line item. For example, on an income statement each line item will be listed as a percentage of gross sales. This technique is also referred to as normalization7 or common-sizing.8

Financial ratio analysis

Main article: Financial ratio

Financial ratios are very powerful tools to perform some quick analysis of financial statements. There are four main categories of ratios: liquidity ratios, profitability ratios, activity ratios and leverage ratios. These are typically analyzed over time and across competitors in an industry.

  • Liquidity ratios are used to determine how quickly a company can turn its assets into cash if it experiences financial difficulties or bankruptcy. It essentially is a measure of a company's ability to remain in business. A few common liquidity ratios are the current ratio and the liquidity index. The current ratio is current assets/current liabilities and measures how much liquidity is available to pay for liabilities. The liquidity index shows how quickly a company can turn assets into cash and is calculated by: (Trade receivables x Days to liquidate) + (Inventory x Days to liquidate)/Trade Receivables + Inventory.
  • Profitability ratios are ratios that demonstrate how profitable a company is. A few popular profitability ratios are the breakeven point and gross profit ratio. The breakeven point calculates how much cash a company must generate to break even with their start up costs. The gross profit ratio is equal to gross profit/revenue. This ratio shows a quick snapshot of expected revenue.
  • Activity ratios are meant to show how well management is managing the company's resources. Two common activity ratios are accounts payable turnover and accounts receivable turnover. These ratios demonstrate how long it takes for a company to pay off its accounts payable and how long it takes for a company to receive payments, respectively.
  • Leverage ratios depict how much a company relies upon its debt to fund operations. A very common leverage ratio used for financial statement analysis is the debt-to-equity ratio. This ratio shows the extent to which management is willing to use debt in order to fund operations. This ratio is calculated as: (Long-term debt + Short-term debt + Leases)/ Equity.9

DuPont analysis uses several financial ratios that multiplied together equal return on equity, a measure of how much income the firm earns divided by the amount of funds invested (equity).

A Dividend discount model (DDM) may also be used to value a company's stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value.10 In other words, it is used to value stocks based on the net present value of the future dividends.

Financial statement analyses are typically performed in spreadsheet software — or specialized accounting software — and summarized in a variety of formats.

Recasting financial statements

An earnings recast is the act of amending and re-releasing a previously released earnings statement, with specified intent.11

Investors need to understand the ability of the company to generate profit. This, together with its rate of profit growth, relative to the amount of capital deployed and various other financial ratios, forms an important part of their analysis of the value of the company. Analysts may modify ("recast") the financial statements by adjusting the underlying assumptions to aid in this computation. For example, operating leases (treated like a rental transaction) may be recast as capital leases (indicating ownership), adding assets and liabilities to the balance sheet. This affects the financial statement ratios.12

Recasting is also known as normalizing accounts.13

Certifications

Financial analysts typically have finance and accounting education at the undergraduate or graduate level. Persons may earn the Chartered Financial Analyst (CFA) designation through a series of challenging examinations. Upon completion of the three-part exam, CFAs are considered experts in areas like fundamentals of investing, the valuation of assets, portfolio management, and wealth planning.

Automation

In November 2023, research conducted by Patronus AI, an artificial intelligence startup company, compared performance of GPT-4, GPT-4-Turbo, Claude 2, and LLaMA-2 on two versions of a 150-question test about information in financial statements (e.g., Form 10-K, Form 10-Q, Form 8-K, earnings reports, earnings call transcripts) submitted by public companies to the U.S. Securities and Exchange Commission. One version of the test required the generative AI models to use a retrieval system to find the specific SEC filing to answer the questions; the other gave the models the specific SEC filing to answer the question (i.e., in a long context window). On the retrieval system version, GPT-4-Turbo and LLaMA-2 both failed to produce correct answers to 81% of the questions, while on the long context window version, GPT-4-Turbo and Claude-2 failed to produce correct answers to 21% and 24% of the questions, respectively.1415

See also

Associations

  • SFAF - French Society of Financial Analysts
  • ACIIA - Association of Certified International Investment Analysts
  • EFFAS - European Federation of Financial Analysts Societies

References

  1. White, Gerald I.; Sondhi, Ashwinpaul; Fried, Dov (1998). The Analysis and Use of Financial Statements. John Wiley & Sons, Inc. ISBN 0-471-11186-4. 0-471-11186-4 ↩

  2. New York Times, August 16, 1998 Gretchen Morgenson – Market Watch MARKET WATCH; A Time To Value Words of Wisdom“ … Security Analysis by Benjamin Graham and David Dodd, the 1934 bible for value investors.” ↩

  3. New York Times, January 2, 2000 Business Section Humbling Lessons From Parties Past By BURTON G. MALKIEL “BENJAMIN GRAHAM, co-author of "Security Analysis," the 1934 bible of value investing, long ago put his finger on the most dangerous words in an investor's vocabulary: "This time is different." Burton G. Malkiel is an economics professor at Princeton University and the author of "A Random Walk Down Wall Street" (W.W. Norton). ↩

  4. Dodd, David; Graham, Benjamin (1998). Security Analysis. John Wiley & Sons, Inc. ISBN 0-07-013235-6. 0-07-013235-6 ↩

  5. Dodd, David; Graham, Benjamin (1998). Security Analysis. John Wiley & Sons, Inc. ISBN 0-07-013235-6. 0-07-013235-6 ↩

  6. "Accountingtools.com - Financial Statement Analysis". Archived from the original on 2014-08-11. Retrieved 2014-08-01. https://web.archive.org/web/20140811125748/http://www.accountingtools.com/financial-statement-analysis ↩

  7. Perceptual Edge-Jonathan Koomey-Best practices for understanding quantitative data-February 14, 2006 http://www.perceptualedge.com/articles/b-eye/quantitative_data.pdf ↩

  8. "Accountingtools.com - Financial Statement Analysis". Archived from the original on 2014-08-11. Retrieved 2014-08-01. https://web.archive.org/web/20140811125748/http://www.accountingtools.com/financial-statement-analysis ↩

  9. Investopedia Staff (2010-08-12). "Financial Statement Analysis". Investopedia. Retrieved 2018-07-14. http://www.investopedia.com/terms/f/financial-statement-analysis.asp ↩

  10. McClure, Ben (2004-04-12). "Digging Into The Dividend Discount Model". Investopedia. Retrieved 2018-07-14. http://www.investopedia.com/articles/fundamental/04/041404.asp ↩

  11. "Earnings Recast". https://www.investopedia.com/terms/e/earningsrecast.asp ↩

  12. "Recasting". Archived from the original on 2020-01-21. Retrieved 2019-03-15. https://web.archive.org/web/20200121202708/http://www.bytestart.co.uk/maximise-price-selling-business.html ↩

  13. Schenck, Barbara Findlay; Davies, John (3 November 2008). Selling Your Business For Dummies. ISBN 9780470381892. 9780470381892 ↩

  14. Leswing, Kif (December 19, 2023). "GPT and other AI models can't analyze an SEC filing, researchers find". CNBC. Archived from the original on December 19, 2023. Retrieved December 19, 2023. https://www.cnbc.com/2023/12/19/gpt-and-other-ai-models-cant-analyze-an-sec-filing-researchers-find.html ↩

  15. "Patronus AI Launches Industry-first LLM Benchmark for Finance to Address Hallucinations" (Press release). PR Newswire. November 16, 2023. Archived from the original on December 19, 2023. Retrieved December 19, 2023. https://www.prnewswire.com/news-releases/patronus-ai-launches-industry-first-llm-benchmark-for-finance-to-address-hallucinations-301990858.html ↩