What financial statement analysis is for

What is financial statement analysis for?

It is for forming expectations. The analyst takes a company’s reports, adds industry and economic information, and works out what is likely to happen to its performance, its financial position and its risk. Someone then makes a decision with that expectation.

Financial analysis means reading a company’s results and balance sheet against the backdrop of its industry and the economy, and judging what they say. The reports describe the past; what the analyst produces is a view of the future.

The decision decides what the analyst looks for:

• an investor weighing a share purchase or a valuation is doing equity analysis : will profit and per-share value grow?
• a lender, a bond investor or a rating agency is doing credit analysis : can the company pay interest and repay principal?
• others use the same tools to judge a private equity stake, a merger candidate or a subsidiary.

Financial statement analysisreports in, expectations out, then a decision

• Equity analyst Use it is the price right for the shares?
  • Profitability ability to earn a profit
  • Per-share value what each share is worth
• Credit analyst Use it will interest and principal be paid?
  • Cash generation cash receipts above cash payments
  • Leverage and liquidity debt load and short-term cover
• Other users Know the idea same reports, different decision
  • Private equity and venture capital investor whether to back a business
  • Acquirer whether a merger candidate is worth its price
  • Rating agency what grade a borrower earns

Whatever the decision, three questions keep coming back. Does the business earn more on its capital than that capital costs? Can it grow without destroying that return? Does it bring in enough cash to pay what it owes?

User	Main question	Leans on
Equity investor	Will profits and cash flows grow enough to justify the price?	Income statement, cash flow statement
Lender or bond investor	Can the company pay interest and repay principal on time?	Balance sheet, cash flow statement
Supplier or customer	Will this counterparty still be around and able to pay?	Balance sheet (liquidity)

Exam tip Match the user to the question. Shares: profit and value per share. Debt: cash and ability to repay.

What is the difference between performance and position?

Financial performance is what happened over a period: how much revenue and profit the company earned and how much cash it generated. Financial position is what the company owns and owes on one date.

The statements split along that line. Names under International Financial Reporting Standards (IFRS) are used on the exam alongside the familiar ones.

• The statement of comprehensive income is the income statement plus other comprehensive income. It shows performance over a period.
• The statement of cash flows shows cash received and paid over a period, grouped into operating, investing and financing activities.
• The statement of financial position is the balance sheet. It shows assets, liabilities and equity on one date.
• The statement of changes in equity reconciles opening equity to closing equity: profit, dividends, share issues and buybacks, and other comprehensive income.

The financial statementsplus the notes that explain them

• Financial performance Use it what happened over a period
  • Statement of comprehensive income Memorize income statement plus other comprehensive income
  • Statement of cash flows Memorize operating, investing and financing cash movements
• Financial position Use it what is owned and owed on one date
  • Statement of financial position Memorize the balance sheet: assets, liabilities, equity
• Links the two Know the idea opening equity to closing equity
  • Statement of changes in equity profit, dividends, share issues and buybacks

Now sort real analyst questions into the right statement, then switch the buckets to performance and position.

Why is profit not enough?

Because accrual accounting records revenue when it is earned and costs when they are incurred, not when cash moves. A company can report rising profit while its operations bring in less and less cash, so both the income statement and the cash flow statement matter.

Go deeper Other users and the non-financial picture

Rating agencies turn credit analysis into a grade, regulators check compliance, and acquirers compare a target’s earnings with its price. Analysts also add information that is not in the statements: the industry’s outlook, the economy, the quality of management and competitors’ results. Numbers get their meaning from that context. Markets react to the information in reports, as when a company beats or misses expected earnings, or when a rating agency upgrades its debt.

Go deeper Why managers do not rely on analysis alone

Insiders analyze their own company too, when they plan operations, capital spending and funding. They see internal data no outsider gets, so the published statements are only part of their picture. An outside analyst has little beyond what is published, which is why the quality of disclosure gets so much attention in the next lessons.