Evaluating Financial Statements

There are a few techniques used to evaluate financial statements which would eventually help investors to evaluate a company’s performance in respect of its overall efficiency, profitability or company risk. Financial statement analysis helps you to project future performance by using information which is historical. Let’s understand these techniques one by one to evaluate financial statements.

Vertical Evaluation: This is used to classify where the company has used its resources and what is the amount of those resources distributed among the income statement and the balance sheet accounts. This evaluation will help you determine the weight of each account. It is a universal tool used to measure a company’s relative performance of profitability and cost year on year. It is also sometimes known as margin analysis. On the balance sheet front, it represents each line item concerning the percentage of total assets/liabilities. For example, it can be helpful to understand whether equity or debt from year to year has increased or decreased.

Horizontal Evaluation: To evaluate trends over a period, by calculating an increase or decrease in percentage when compared to a base year is a horizontal evaluation. This analysis guides and compares the evaluation over time. Horizontal evaluation can be used to measure the growth of an item from one year to another, i.e., by picking any line item like net profit in 2018 – net profit in 2017 (here a previous year is the base year). It is commonly known as Trend analysis which can help you show the number of changes in the corresponding financial statement’s items over a specific period.

Ratio Analysis: A change in the company’s financial situation can be identified with the help of ratio analysis. It is a combination of the ratios which may be analyzed together and then compared with prior-year ratios, or it can also be in comparison to other companies in the same industry. Ratio analysis can help measure the strength of a company’s financial statements, having said that it is only a parameter to evaluate and not an absolute measure. Most common ratios are:

Solvency ratio – These are of two major types which are further subdivided into:

1. Liquidity ratio – It shows the liquidity of the company’s assets concerning the company’s Types of liquidity ratios are current ratio, quick asset, and cash ratio.
2. Turnover ratio – This ratio helps to evaluate the time take to convert assets into cash or the time taken for the dollar amount to be paid to the suppliers. The most common types of ratios are accounts receivables days, receivables turnover, inventory turnover, payable days, payable turnover and cash conversion cycle.

Then there are operating performance ratios which measure more at the ground level, the performance of a business and its ability to generate returns given the number of assets deployed. Operating performance ratio can also be further subdivided into:

Operating efficiency ratio which includes asset turn over ratio, equity turnover ratio, net profit margin. And finally, the profitability ratio which includes return on assets and returns on equity. With the help of the above one can evaluate the financial statement and analyze them better.

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