Financial Statement Analysis: A Comprehensive Review

2. Review of Literature

So, financial statement analysis is a fundamental aspect of financial management and

investment decision-making. Over the years, scholars, financial analysts, and accounting
professionals have developed various models and techniques to evaluate financial
performance. The literature on financial statement analysis encompasses various
frameworks, principles, and methodologies that aid in understanding a company's financial
stability, operational efficiency, and profitability. Here, we’ll take a look at the theoretical
foundations and key analytical tools used in financial statement analysis, highlighting their
significance in corporate financial assessment.

2.1. Theoretical Framework

The theoretical foundation of financial statement analysis is built upon accounting and
financial theories that guide the preparation, interpretation, and evaluation of financial
data. The primary accounting standards—Generally Accepted Accounting Principles (GAAP)
and International Financial Reporting Standards (IFRS)—ensure consistency and
comparability across financial reports.

There are a bunch of financial theories that back up financial statement analysis:

- Efficient Market Hypothesis (EMH): Suggests that financial statements reflect all available
information, making it difficult for investors to gain excess returns solely through financial
analysis.
- Agency Theory: Highlights the conflicts between company management (agents) and
shareholders (principals), emphasizing the need for financial statement transparency.
- Stakeholder Theory: Proposes that financial analysis should consider not only
shareholders but also creditors, employees, and regulators, making it a broader evaluation
tool.

These theoretical perspectives provide a structured approach to analyzing financial

statements, ensuring that financial decision-making is based on sound economic principles.

2.2. Financial Statement Analysis Concepts

So, financial statement analysis involves key concepts that help assess a company's financial
position. These include:

- Liquidity and Solvency: Evaluates a company's ability to meet short-term and long-term
obligations.
- Profitability and Efficiency: Assesses how effectively a company generates profits and
utilizes its assets.
- Cash Flow Management: Analyzes the movement of cash within an organization to ensure
operational sustainability.
- Comparability and Consistency: Ensures that financial data can be analyzed across
different time periods and industry benchmarks.

When you actually use these ideas, financial analysts and investors can derive meaningful
insights from financial statements.

2.3. Ratio Analysis: Liquidity Ratios

Liquidity ratios measure a company’s ability to meet its short-term liabilities using available
assets. These ratios are crucial for assessing financial flexibility and short-term solvency:

- Current Ratio = Current Assets / Current Liabilities → Indicates whether a company has
sufficient assets to cover short-term debts.
- Quick Ratio = (Current Assets - Inventory) / Current Liabilities → Excludes inventory to
provide a stricter test of liquidity.
- Cash Ratio = Cash & Cash Equivalents / Current Liabilities → Measures the company’s
ability to cover short-term liabilities using only cash and cash equivalents.

High liquidity ratios indicate financial stability, while excessively high values may suggest
underutilization of assets.

2.4. Ratio Analysis: Solvency Ratios

Solvency ratios assess a company's ability to meet long-term financial obligations and
overall financial health. These ratios include:

- Debt-to-Equity Ratio = Total Debt / Total Equity → Evaluates the financial leverage of a
company.
- Interest Coverage Ratio = EBIT / Interest Expense → Indicates how easily a company can
pay interest on its outstanding debt.
- Debt-to-Assets Ratio = Total Debt / Total Assets → Measures the proportion of assets
financed by debt.

Too much debt? That’s risky business., while a balanced capital structure ensures
sustainability.

2.5. Ratio Analysis: Profitability Ratios

Profitability ratios help assess how effectively a company generates earnings in relation to
revenue, assets, or equity:

- Gross Profit Margin = (Gross Profit / Revenue) × 100 → Shows the percentage of revenue
that exceeds the cost of goods sold.
- Net Profit Margin = (Net Income / Revenue) × 100 → Indicates overall profitability after
accounting for all expenses.
- Return on Assets (ROA) = Net Income / Total Assets → Measures how efficiently a
company uses its assets to generate profit.
- Return on Equity (ROE) = Net Income / Shareholder’s Equity → Evaluates the profitability
of shareholder investments.

Higher profitability ratios reflect strong financial performance and operational efficiency.

2.6. Ratio Analysis: Activity Ratios

Activity ratios, also known as efficiency ratios, determine how effectively a company utilizes
its resources. These include:

- Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory → Measures how
quickly inventory is sold.
- Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable →
Indicates the efficiency of credit collection.
- Asset Turnover Ratio = Net Sales / Total Assets → Assesses how efficiently a company
generates revenue from its assets.

Efficient asset utilization enhances profitability and cash flow stability.

2.7. Trend Analysis

Trend analysis examines financial data over time to identify growth patterns, performance
trends, and financial risks. This method is useful for:

- Revenue Growth Analysis: Evaluates increases or declines in sales revenue over time.
- Expense Trend Evaluation: Identifies cost control effectiveness.
- Profitability Trends: Assesses improvements or declines in profit margins.

By analyzing trends, financial analysts can make informed predictions about a company's
future performance.

2.8. Comparative Analysis

Comparative analysis involves evaluating financial performance by comparing data across

different entities or time periods. This method helps:

- Benchmark Performance: Compare a company's financial health with industry peers.

- Assess Market Position: Identify competitive advantages and weaknesses.
- Analyze Year-over-Year Performance: Evaluate business growth and stability.

Comparative analysis provides a broader perspective on financial strength relative to

industry standards.
2.9. Common Size Analysis

Common size analysis expresses financial statements in percentage terms, making it easier
to compare companies of different sizes. Key benefits include:

- Standardized Comparison: Converts income statement figures into percentages of total

revenue.
- Identifies Cost Structure: Highlights how expenses impact profitability.
- Assesses Financial Stability: Evaluates whether revenue distribution is efficient.

This method is particularly useful for evaluating businesses within the same industry.

2.10. Limitations of Financial Statement Analysis

Despite its usefulness, financial statement analysis has several limitations:

- Historical Data Dependence: Financial statements reflect past performance, which may not
indicate future trends.
- Accounting Policy Differences: Variations in accounting methods affect comparability
across companies.
- Influence of External Factors: Economic conditions, inflation, and regulatory changes can
impact financial statements.
- Non-Financial Factors Exclusion: Employee satisfaction, brand value, and innovation are
not captured in traditional financial analysis.

To mitigate these limitations, financial analysis should be supplemented with qualitative

assessments and external market evaluations.