Financial statement analysis (or financial analysis) is the process of reviewing and analyzing a company's financial statements to make better economic decisions. These statements include the income statement, balance sheet, statement of cash flows, and a statement of retained earnings. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.
Financial statements can reveal much more information when comparisons are made with previous statements, rather than when considered individually. Horizontal analysis compares financial data, such as an income statements, over a period of several quarters or years. When comparing past and present financial information, one will want to look for variations such as higher or lower earnings. Moreover, it is often useful to compare the financial statements of companies in related industries.
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 below the average. Similarly, if the equity ratio increases over time, it is a good sign in relation to insolvency risk.
The main purpose of conducting financial analysis is to measure a business's profitability and solvency. The actual metrics tracked and methods applied vary from stakeholder to stakeholder, depending on his or her interests and needs. For example, equity investors are interested in the long-term earnings power of the organization and perhaps the sustainability and growth of dividend payments. Creditors want to ensure the interest and principal is paid on the organizations debt securities (e.g., bonds) when due.
Most analytical measures are expressed as percentages or ratios, which allows for easy comparison with other businesses in the industry regardless of absolute company size. Vertical analysis, which is a proportional analysis of financial statements, lists each line item in the financial statement as the percentage of another line time. For example, on an income statement each line item will be listed as a percentage of gross sales. This technique is also referred to as normalization or common-sizing.
When using these analytical measures, one should take the following factors into consideration:
- Industry trends;
- Changes in price levels;
- Future economic conditions.
Ratios must be compared with other firms in the same industry to see if they are in line .
Refining Operation
Ratio analyses can be used to compare between companies within the same industry. For example, comparing the ratios of BP and Exxon Mobil would be appropriate, whereas comparing the ratios of BP and General Mills would be inappropriate.