Learn about the common financial statement analysis techniques used in preparing annual reports, such as horizontal, vertical, ratio, cash flow, and common size analysis.

From a historical perspective, the importance of the cash flow surge during the 80s is closely related to Shareholder value theory; during this period, Cash flow started to be incorporated within the financial statement. Accordingly, Free Cash Flow Analysis is the primary link to valuation practices. For obvious reasons, cash flow analysis is paramount in a high-interest rate environment like the one we are currently experiencing. In my experience, I found it particularly useful to utilize the cash flow to income ratio to assess the sustainability of earnings.

What are the most common financial statement analysis techniques used in preparing annual reports?

If you are a corporate finance professional, you probably spend a lot of time analyzing financial statements of companies. Financial statements are the primary source of information about the financial performance, position, and cash flows of a business. They are also essential for preparing annual reports, which are documents that summarize the financial and operational highlights of a company for its shareholders, investors, regulators, and other stakeholders. In this article, we will discuss some of the most common financial statement analysis techniques used in preparing annual reports, and how they can help you evaluate and communicate the financial health and value of a company.

1 Horizontal analysis

Horizontal analysis is a technique that compares the financial data of a company over a period of time, usually a year or a quarter. It shows how the financial items have changed in absolute and percentage terms from one period to another. Horizontal analysis can help you identify trends, patterns, and growth rates in the financial performance of a company. For example, you can use horizontal analysis to calculate the revenue growth rate, the profit margin, and the return on equity of a company over several years, and compare them with the industry averages or the competitors.

Add your perspective

Davide Massone

Finance Director| Financial Management| Financial Planning |Real Estate|EPC
Report contribution
Horizontal analysis is beneficial to find patterns that occurred in the past; starting from this, the financial management should use critical research to determine if these trends/potential volatility could continue by identifying the underlying reason for this trend. According to my experience, it is always essential to benchmark horizontal analysis with the competitors in the commodity industry to evaluate the performances, as volatility is usual in this industry and typically depends on exogenous factors.

Like

2 Vertical analysis

Vertical analysis is a technique that expresses the financial data of a company as a percentage of a common base, usually total assets, total liabilities, or total revenue. It shows how the financial items are distributed and proportioned within a single period. Vertical analysis can help you assess the financial structure, efficiency, and profitability of a company. For example, you can use vertical analysis to calculate the asset turnover, the debt-to-equity ratio, and the gross margin of a company, and compare them with the industry benchmarks or the targets.

Add your perspective

Davide Massone

Finance Director| Financial Management| Financial Planning |Real Estate|EPC
Report contribution
Vertical analysis has two advantages that immediately lead to a concise value that can be used as a starting point to make inferences and eliminate the size effect when comparing the internal ratio with data across the industry. In my experience, vertical analysis is instrumental in providing information about balance sheet performance regarding liquidity, solvency, and operational efficiency. On the P & L side, while this kind of analysis is only up to Gross profit margin, linking metrics such as EBIT affected by fixed cost with revenue could be misleading as an increase/decrease in sales can have a significant effect. In an expansion scenario, there is room for inefficiency of budgetary slack.

Like

3 Ratio analysis

Ratio analysis is a technique that calculates the relationships between different financial data of a company, using various formulas and categories. It shows how the financial items are related and affect each other in terms of liquidity, solvency, profitability, efficiency, and valuation. Ratio analysis can help you measure and evaluate the financial performance, position, and potential of a company. For example, you can use ratio analysis to calculate the current ratio, the interest coverage ratio, the return on assets, the inventory turnover, and the price-to-earnings ratio of a company, and compare them with the industry standards or the expectations.

Add your perspective

Davide Massone

Finance Director| Financial Management| Financial Planning |Real Estate|EPC
Report contribution
The ratio that can immediately snap a picture of the firm performance is the Return on Investment ratio in all the sophisticated varieties such as ROIC, RONA etc , as this metrics considers the company's overall performance in terms of capital and operational efficiency. On the other hand, ROI metrics should be decomposed further to understand "how" the firm produces the overall result according to the Dupont scheme; for instance, Company X is doing well in terms of profitability as it controls the cost well but has an idle capacity that inflates the fixed asset value. As a result, the overall return might not be satisfactory.

Like

4 Cash flow analysis

Cash flow analysis is a technique that examines the sources and uses of cash in a company, using the statement of cash flows and other supplemental information. It shows how the cash inflows and outflows are generated and allocated by the operating, investing, and financing activities of a company. Cash flow analysis can help you understand and forecast the cash position, liquidity, and solvency of a company. For example, you can use cash flow analysis to calculate the free cash flow, the cash conversion cycle, the operating cash flow margin, and the cash flow to income ratio of a company, and compare them with the industry norms or the goals.

Add your perspective

Davide Massone

Finance Director| Financial Management| Financial Planning |Real Estate|EPC
Report contribution
From a historical perspective, the importance of the cash flow surge during the 80s is closely related to Shareholder value theory; during this period, Cash flow started to be incorporated within the financial statement. Accordingly, Free Cash Flow Analysis is the primary link to valuation practices. For obvious reasons, cash flow analysis is paramount in a high-interest rate environment like the one we are currently experiencing. In my experience, I found it particularly useful to utilize the cash flow to income ratio to assess the sustainability of earnings.

Like

5 Common size analysis

Common size analysis is a technique that converts the financial data of different companies into a common scale or unit, usually a percentage or a ratio. It shows how the financial items are comparable and standardized across different companies, regardless of their size, currency, or accounting methods. Common size analysis can help you benchmark and analyze the financial performance, position, and efficiency of different companies. For example, you can use common size analysis to compare the revenue mix, the expense structure, the asset composition, and the profitability of different companies in the same industry or sector.

These are some of the most common financial statement analysis techniques used in preparing annual reports. By applying these techniques, you can gain valuable insights and insights into the financial health and value of a company, and communicate them effectively to the relevant stakeholders. You can also use these techniques to identify the strengths, weaknesses, opportunities, and threats of a company, and provide recommendations for improvement and growth.

Add your perspective

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

Add your perspective

What are the most common financial statement analysis techniques used in preparing annual reports?

1

2

3

4

5

6

1 Horizontal analysis

2 Vertical analysis

3 Ratio analysis

4 Cash flow analysis

5 Common size analysis

6 Here’s what else to consider

Corporate Finance

Rate this article

Thanks for your feedback

More articles on Corporate Finance

More relevant reading