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How to Analyze Financial Statements Understanding financial statements is essential for evaluating a company's financial health and making informed business decisions.
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.
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.
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.
✅ 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 |
Practical Insights -
Vertical Analysis helps in benchmarking and setting cost targets.
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Horizontal Analysis helps in tracking performance trends over time.
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KPI Tracking ensures focused improvement and better decision-making.
- Consistently monitoring KPIs allows quick corrective actions and better financial control.