Financial Statement Analysis: A Comprehensive Guide for Beginners & Professionals

The main task of an analyst is to perform an extensive analysis of financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are.  In this free guide, we will break down the most important methods, types, and approaches to financial analysis.

This guide is designed to be useful for both beginners and advanced finance professionals, with the main topics covering: (1) income statement, (2) balance sheet, (3) cash flow, and (4) rates of return.

Image: Example financial analysis template.

#1 Income statement analysis

Most analysts start their analysis of financial statements with the income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or.  Intuitively, this is usually the first thing we think about with a business…we often ask questions such as, “how much revenue does it have, is it profitable, what are the margins like?”

In order to answer these questions, and much more, we will dive into the income statement to get started.

There are two main types of analysis we will perform: vertical analysis and horizontal analysis.

Vertical analysis

With this method of analysis of financial statements, we will look up and down the income statement (hence, “vertical” analysis) to see how every line item compares to revenue, as a percentage.

For example, in the income statement shown below, we have the total dollar amounts and the percentages, which make up the vertical analysis.

As you see in the above example, we do a thorough analysis of the income statement by seeing each line item as a proportion of revenueSales RevenueSales revenue is the income received by a company from its sales of goods or the provision of services. In accounting, the terms "sales" and.

The key metrics we look at are:

• Cost of Goods Sold (COGS) as a percent of revenue
• Gross profitGross ProfitGross profit is the direct profit left over after deducting the cost of goods sold, or cost of sales, from sales revenue. It's used to calculate the gross profit margin. as a percent of revenue
• DepreciationDepreciation ExpenseWhen a long-term asset is purchased, it should be capitalized instead of being expensed in the accounting period it is purchased in. as a percent of revenue
• Selling General & Administrative (SG&ASG&ASG&A includes all non-production expenses incurred by a company in any given period. It includes expenses such as rent, advertising, marketing) as a percent of revenue
• InterestInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also as a percent of revenue
• Earnings Before Tax (EBT) as a percent of revenue
• Tax as a percent of revenue
• Net earnings Net IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at throughas a percent of revenue

To learn how to perform this analysis step-by-step please check out our Financial Analysis Fundamentals Course.

Horizontal Analysis

Now it’s time to look at a different way to evaluate the income statement.  With horizontal analysis, we look across the income statement at the year-over-yearYoY (Year over Year)YoY stands for Year over Year and is a type of financial analysis used for comparing time series data. It is useful for measuring growth and detecting trends. (YoY) change in each line item.

In order to perform this exercise, you need to take the value in Period N and divide it by the value in Period N-1 and then subtract 1 from that number to get the percent change.

For example, revenue in 2017 was $4,000 and in 2016 it was $3,000.  The YoY change in revenue is equal to $4,000 / $3,000 minus one, which equals 33%.

To see exactly how to perform this horizontal analysis of financial statements please enroll in our Financial Analysis Fundamentals Course now!

#2 Balance sheet and leverage ratios

Let’s move on to the balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting..  In this section of financial statement analysis, we will evaluate the operational efficiency of the business.  We will take several items on the income statement, and compare them to the company’s capital assets on the balance sheet.

The balance sheet metrics can be divided into several categories, including liquidity, leverage, and operational efficiency.

The main liquidity ratios for a business are:

• Quick ratio
• Current ratio
• Net working capitalNet Working CapitalNet Working Capital (NWC) is the difference between a company's current assets (net of cash) and current liabilities (net of debt) on its balance sheet.

The main leverage ratios are:

• Debt to equityFinanceCFI's Finance Articles are designed as self-study guides to learn important finance concepts online at your own pace. Browse hundreds of articles!
• Debt to capital
• Debt to EBITDA
• Interest coverage
• Fixed charge coverage ratio

The main operating efficiency ratios are:

• Inventory turnoverInventory TurnoverInventory turnover, or the inventory turnover ratio, is the number of times a business sells and replaces its stock of goods during a given period. It considers the cost of goods sold, relative to its average inventory for a year or in any a set period of time.
• Accounts receivable days
• Accounts payable days
• Total asset turnoverAsset TurnoverAsset turnover measures the value of revenue generated by a business relative to its average total assets for a given fiscal year.
• Net asset turnover

Using the above financial ratios, we can determine how efficiently a company is generating revenue and how quickly it’s selling inventory.

Using the financial ratios derived from the balance sheet and comparing them historically versus industry averages or competitors will help you assess the solvency and leverage of a business.

In our course on analysis of financial statements, we explore all the above metrics and ratios in great detail.

#3 Cash flow statement analysis

With the income statement and balance sheet under our belt, let’s look at the cash flow statementCash Flow Statement​A cash flow Statement contains information on how much cash a company generated and used during a given period. and all the insights it tells us about the business.

The cash flow statement will help us understand the inflows and outflows of cash over the time period we’re looking at.

Cash flow statement overview

The cash flow statement, or statement of cash flow, consist of three components:

• Cash from operationsFFO - Funds From OperationsFFO or Funds From Operations is a measure of cash flow generated from business operations that is often used by Real Estate Investment Trusts - REITS. Funds from operations (FFO) is the actual amount of cash flow generated from core business operations. Guide to FFO
• Cash used in investing
• Cash from financing

Each of these three sections tells us a unique and important part of the company’s sources and uses of cash during the time period being evaluated.

Many investors consider the cash flow statement the most important indicator of a company’s performance and it’s hard to imagine that until only recently companies didn’t even have to file a cash flow statement.

Today, investors quickly flip to this section to see if the company is actually making money or not, and what its funding requirements are.

It’s important to understand how different ratios can be used to properly assess the operation of an organization from a cash management standpoint.

Below is an example of the cash flow statement and its three main components. Linking the 3 statementsHow the 3 Financial Statements are LinkedHow are the 3 financial statements linked together? We explain how to link the 3 financial statements together for financial modeling and together in Excel is the building block of financial modeling.  To learn more, please see our online courses to learn the process step by step.

#4 Rates of return and profitability analysis

In this part of our analysis of financial statements, we unlock the drivers of financial performance. By using the pyramid of ratios, we are able to demonstrate how you can determine the profitability, efficiency, and leverage drivers for any business.

This is the most advanced section, and we recommend that you watch a demonstration of how professionals perform this analysis.

The course includes a hands-on case study and Excel templatesExcel & Financial Model TemplatesDownload free financial model templates - CFI's spreadsheet library includes a 3 statement financial model template, DCF model, debt schedule, depreciation schedule, capital expenditures, interest, budgets, expenses, forecasting, charts, graphs, timetables, valuation, comparable company analysis, more Excel templates that can be used to calculate individual ratios and a pyramid of ratios from any set of financial statements.

The key insights to be derived from the pyramid of ratios include:

• Return on equity ratioReturn on Equity (ROE)Return on Equity (ROE) is a measure of a company’s profitability that takes a company’s annual return (net income) divided by the value of its total shareholders' equity (i.e. 12%). ROE combines the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity. (ROE)
• Profitability, efficiency, and leverage ratios
• Primary, secondary, and tertiary ratios
• Dupont analysisDuPont AnalysisIn the 1920s, the management at DuPont Corporation developed a model called DuPont Analysis for a detailed assessment of the company’s profitability

By constructing the pyramid of ratios, you will gain an extremely solid understanding of the business and its financial statements.

Enroll in our financial analysis course to get started now!

More analysis of financial statements

We hope this guide on the analysis of financial statements has been a valuable resource for you.  If you’d like to keep learning with free CFI resources, we highly recommend these additional guides to improve your financial statement analysis:

• How to Link the 3 Financial StatementsHow the 3 Financial Statements are LinkedHow are the 3 financial statements linked together? We explain how to link the 3 financial statements together for financial modeling and
• Guide to Financial ModelingFree Financial Modeling GuideThis financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
• How to be a World-class Financial AnalystThe Analyst Trifecta® GuideThe ultimate guide on how to be a world-class financial analyst. Do you want to be a world-class financial analyst?  Are you looking to follow industry-leading best practices and stand out from the crowd? Our process, called The Analyst Trifecta® consists of analytics, presentation & soft skills
• Interactive Career Map