Financial Statement Analysis

Financial statement analysis (or financial analysis) the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports.

Financial statement analysis consists of 1) reformulating reported financial statements, 2) analysis and adjustments of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted financial statements. The two first steps are often dropped in practice, meaning that financial ratios are just calculated on the basis of the reported numbers, perhaps with some adjustments. Financial statement analysis is the foundation for evaluating and pricing credit risk and for doing fundamental company valuation.

1) Financial statement analysis typically starts with reformulating the reported financial information. In relation to the income statement, one common reformulation is to divide reported items into recurring or normal items and non-recurring or special items. In this way, earnings could be separated in to normal or core earnings and transitory earnings. The idea is that normal earnings are more permanent and hence more relevant for prediction and valuation. Normal earnings are also separated into net operational profit after taxes (NOPAT) and net financial costs. The balance sheet is grouped, for example, in net operating assets (NOA), net financial debt and equity.

2) Analysis and adjustment of measurement errors question the quality of the reported accounting numbers. The reported numbers can for example be a bad or noisy representation of invested capital, for example in terms of NOA, which means that the return on net operating assets (RNOA) will be a noisy measure of the underlying profitability (the internal rate of return, IRR). Expensing of R&D is an example when such investment expenditures are expected to yield future economic benefits, suggesting that R&D creates assets which should have been capitalized in the balance sheet. An example of an adjustment for measurement errors is when the analyst removes the R&D expenses from the income statement and put them in the balance sheet. The R&D expenditures are then replaced by amortization of the R&D capital in the balance sheet. Another example is to adjust the reported numbers when the analyst suspects earnings management.

3) Financial ratio analysis should be based on regrouped and adjusted financial statements. Two types of ratio analysis are performed: 3.1) Analysis of risk and 3.2) analysis of profitability:

3.1) Analysis of risk typically aims at detecting the underlying credit risk of the firm. Risk analysis consists of liquidity and solvency analysis. Liquidity analysis aims at analyzing whether the firm has enough liquidity to meet its obligations when they should be paid. A usual technique to analyze illiquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also useful. Solvency analysis aims at analyzing whether the firm is financed so that it is able to recover from a loss or a period of losses. A usual technique to analyze insolvency risk is to focus on ratios such as the equity in percentage of total capital and other ratios of capital structure. Based on the risk analysis the analyzed firm could be rated, i.e. given a grade on the riskiness, a process called synthetic rating.

Ratios of risk such as the current ratio, the interest coverage and the equity percentage have no theoretical benchmarks. It is therefore common to compare them with the industry average over time. If a firm has a higher equity ratio than the industry, this is considered less risky than if it is above the average. Similarly, if the equity ratio increases over time, it is a good sign in relation to insolvency risk.

3.2) Analysis of profitability refers to the analysis of return on capital, for example return on equity, ROE, defined as earnings divided by average equity. Return on equity, ROE, could be decomposed: ROE = RNOA + (RNOA - NFIR) * NFD/E, where RNOA is return on net operating assets, NFIR is the net financial interest rate, NFD is net financial debt and E is equity. In this way, the sources of ROE could be clarified.

Unlike other ratios, return on capital has a theoretical benchmark, the cost of capital - also called the required return on capital. For example, the return on equity, ROE, could be compared with the required return on equity, kE, as estimated, for example, by the capital asset pricing model. If ROE < kE (or RNOA > WACC, where WACC is the weighted average cost of capital), then the firm is economically profitable at any given time over the period of ratio analysis. The firm creates values for its owners.

Insights from financial statement analysis could be used to make forecasts and to evaluate credit risk and value the firm's equity. For example, if financial statement analysis detects increasing superior performance ROE - kE > 0 over the period of financial statement analysis, then this trend could be extrapolated into the future. But as economic theory suggests, sooner or later the competitive forces will work - and ROE will be driven toward kE. Only if the firm has a sustainable competitive advantage, ROE - kE > 0 in "steady state".