Financial statement analysis is an invaluable skill for any financial professional. It helps to arrive at a baseline understanding of a firm’s position while also providing insights valuable during due diligence and advisory engagements.
To perform a financial analysis you need to have a good understanding and knowledge of the following:
- The financial statements and their structure
- The industry’s (of which the company is a part) economic features.
- The company’s strategies and how they are different from the competitors.
This guide is intended as a resource for financial professionals. It will help you understand how to analyse the financial statements of a firm and will give you some experience in applying this information.
So here are the 6 essential steps of any kind of financial analysis:
- Identifying the characteristics of the industry of which the company is a part of
Value chain analysis looks at the flows of economic value within an industry—from a firm’s perspective. The goal is to identify where an organization can add value or gain advantages over its competitors. In this analysis, the series of activities that are a part of the creation, manufacture and distribution of the products and services are analysed. In this step you should also be aware of the legal and governmental mandates for your industry like GST registration, GST certificate download. This website offers great checklist for all of these.
Some of the techniques used for Value chain analysis include Porter’s five forces or economic attributes analysis.
Note: Porter’s Five Forces is a framework for analysis of the level of competition based on five forces that determine the profit potential of an industry.
- Company strategy analysis
Next, find out the nature of the product or service being offered by the firm. Specifically, are there any qualities that make it unique; is it a product people will get great satisfaction from using and is it easy to use? Is the company making many sales compared to its competitors? Is there brand loyalty among consumers? What costs do the company’s employees incur as part of their jobs?
Other factors for consideration include supply chain integration, geographic diversification and industry diversification.
- Firms financial statements and their qualities
Analyse the financial statements to check if they follow all the accounting standards. While reviewing balance sheets lookout for problems in valuations, recognition and classification. The balance sheet should honestly and truly reflect the company’s accurate economic position. When assessing the income statement, the quality of income and earnings should be reviewed. The cash flow statement review tells should tell about the company’s liquidity that is possible from its investments, operations and other financial activities. Essentially this should tell the source and destination of funds. For successfully doing this you could use several resources like invoices since the GST bill format itself gives a lot of information that could be useful in an audit.
- Analysing the risk and current profitability
For this primarily the financial statement ratio is calculated. This will give an idea about the profitability, debt, coverage and risk market valuation. Additionally, it could be used for comparison with previous rations and the ratios of the competitors.
- Making forecasts
This is probably the most difficult step however, it is crucial for a successful financial analysis. It could tell a lot about the company’s future and the effects of funding and cash flow.
- Valuation of the firm
For this evaluation generally, the approach followed is to calculate the discounted cash flow. These cash flows can be in the form of forecasting dividends or estimating free cash flows. In some cases instead of discounted cash flow, the economic value-added methodology is also used.