How to Analyze Financial Statements
 
Understanding financial statements is essential for evaluating a company's financial health and making informed business decisions. 

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3 TYPES OF ANALYSIS 

1. Vertical Analysis 
Vertical analysis compares each line item to a baseline number. 
- For example, a manufacturer might set a target of 60% of revenue for Cost of Goods Sold (COGS). 
- If COGS exceeds 60%, corrective action is needed. 

Formula: 
(Line Item ÷ Revenue) × 100 

Example: 
- Revenue = $1,000,000 
- COGS = $650,000 
COGS Percentage = ($650,000 ÷ $1,000,000) × 100 = 65% 

If COGS exceeds 60%, you could: 
- Raise prices 
- Change suppliers 
- Renegotiate supplier contracts 

Action Example (Cable Factory): 
- If the cost of copper cables exceeds the target rate, the company could renegotiate contracts with copper suppliers or seek alternative materials. 

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2. Horizontal Analysis 
Horizontal analysis compares each line item to prior year values. 
- Evaluates growth or decline over time. 
- Identifies trends and performance changes. 

Formula: 
(Current Year Value – Previous Year Value) ÷ Previous Year Value × 100 

Example: 
- Revenue in 2022 = $900,000 
- Revenue in 2023 = $1,000,000 
Revenue Growth = ($1,000,000 – $900,000) ÷ $900,000 × 100 = 11.1% 

Key Questions: 
- Did it increase/decrease proportionally? 
- What conditions changed that would affect expenses? 

Variables Affecting Performance: 
- Restructuring costs 
- Product launch expenses 

Action Example (Cable Factory): 
- If revenue increased due to a new product launch, the company could allocate more budget toward R&D and marketing. 
- If expenses increased due to higher raw material costs, the company could explore new suppliers or increase prices. 

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3. KPI Tracking 
Key Performance Indicators (KPIs) measure specific aspects of financial health and performance. 
- Choose 3 to 5 key KPIs per statement. 
- Focus on KPIs that: 
   - Directly impact results 
   - Are easy to collect/report on 

Best KPIs for Financial Statements: 
- Current Ratio – Measures short-term liquidity. 
Current Ratio = Current Assets ÷ Current Liabilities 

- Gross Profit Margin – Measures how much profit remains after COGS. 
Gross Profit Margin = (Gross Profit ÷ Revenue) × 100 

- Revenue Growth – Measures increase in revenue over time. 
Revenue Growth = (Current Revenue – Previous Revenue) ÷ Previous Revenue × 100 

- Operating Cash Flow – Measures how much cash a company generates from core operations. 
Operating Cash Flow = Cash from Operations 

- Net Profit Margin – Measures how much of each dollar of revenue translates to profit. 
Net Profit Margin = (Net Income ÷ Revenue) × 100 

- Return on Equity (ROE) – Measures how efficiently a company uses shareholder's equity to generate income. 
ROE = (Net Income ÷ Shareholder's Equity) × 100 

Example: 
- Current Assets = $500,000 
- Current Liabilities = $250,000 
Current Ratio = $500,000 ÷ $250,000 = 2.0 

- Revenue = $1,000,000 
- Gross Profit = $400,000 
Gross Profit Margin = ($400,000 ÷ $1,000,000) × 100 = 40% 

KPI Strategy: 
- Review KPIs monthly. 
- Track major KPIs quarterly and annually. 
- Adjust operational and strategic plans based on KPI performance. 

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✅ Summary Example (Cable Factory): 

Category	Example	Action
Vertical Analysis	COGS exceeded 60% of revenue	Renegotiate supplier contracts
Horizontal Analysis	Revenue increased by 11.1%	Allocate more budget to product launch
Current Ratio	2.0	Healthy liquidity position
Gross Profit Margin	40%	Good operational efficiency

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Practical Insights 
- Vertical Analysis helps in benchmarking and setting cost targets. 
- Horizontal Analysis helps in tracking performance trends over time. 
- KPI Tracking ensures focused improvement and better decision-making. 
- Consistently monitoring KPIs allows quick corrective actions and better financial control. 

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