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What is the purpose of analysing financial statements?
Every company aims to increase its profitability and generate more income. Owing to financial statements, we are able to understand its business model and verify whether it’s making a profit or loss. We are able to see how the company is spending, investing and earning money. We can notice whether a company is growing, is stagnant or is collapsing. Knowing how the company is performing, we are able to make better economic decisions in the future.
Financial statement performance
Financial statement performance analysis is a process of analyzing a company’s financial position. It focuses on reviewing, assessing, and comparing financial statements - a collection of data and figures organised according to recognized accounting principles. It may also include calculating and analysing financial ratios.
There are two main financial statements: income statement and balance sheet.
Fig. 1 - Financial statements
How to analyse the financial performance of a company?
Income statement, in other words, profit and loss account. It shows the profit earned and loss sustained by a business entity over a particular period (usually 12 months) and how this figure is arrived at. Into the Income Statement, we place revenues earned during the period and we match them against expenses incurred during the period.
Company A is selling jeans. It bought 2000 pairs of jeans during 2019 at a price of £20 each and sold all of them for £45 each. No other inventory was traded that year.
Other payments were: rent and rates £6,000, heat and light £4,000, fixtures and fittings £30,000 (expected to last 5 years), staff wages £18,000. Moreover, the owner withdrew from the business a total of £15,000. Based on the information, we know that:
- Turnover (total revenue) is £90,000 (£45 x 2000).
- The cost of sales is £40,000 (£20 x 2000).
- Gross profit is £50,000 (£90,000 - £40,000).
- Other expenses are rent and rates, heat and light, fixtures and fittings, staff wages, and they equal £34,000 (£6,000 + £4,000 + £6,000 + £18,000). Net profit is £16,000 (£50,000 - £34,000).
The Income Statement of company A for the year ended 31.12.2019 would look as follows:
| Turnover | £90,000 |
| Cost of sales | £40,000 |
| Gross profit | £50,000 |
| Rent and rates | £6,000 |
| Heat and light | £4,000 |
| Depreciation of fixtures and fittings | £6,000 |
| Staff wages | £18,000 |
| Other expenses | £34,000 |
| Net profit | £16,000 |
Important points arising out of the above:
The full cost of fixtures and fittings does not appear because it is a capital expenditure. Instead, the depreciation represents this years’ revenue expenditure.
The money which the owner withdrew from the business does not appear because it represents a reduction in the capital, rather than an expense.
The balance sheet, in other words, a statement of financial position (abbreviations: BS, SFP), shows the assets and liabilities of a business at a specific point in time (usually the end of the financial period). Here, the assets are resources controlled by the business and the liabilities are present obligations of the business.
Financial performance analysis example
Let’s have a look at the balance sheet of a company B:
| Tangible asset | £140,000 |
| Intangible assets | £80,000 |
| Non-current assets | £220,000 |
| Inventory | £20,000 |
| Receivables | £90,000 |
| Bank | £15,000 |
| Cash | £5,000 |
| Current assets | £130,000 |
| Payables | £30,000 |
| Corporation owing tax | £25,000 |
| Short-term liabilities | £55,000 |
| Net current assets | £75,000 |
| Total assets less current liabilities | £295,000 |
| Long-term liabilities | £110,000 |
| Net assets | £185,000 |
| Financed by: | |
| Ordinary shares | £100,000 |
| Share premium | £50,000 |
| Retained earnings | £35,000 |
| Total equity | £185,000 |
Important points arising out of the above:
Assets and liabilities can be short term and long term (current and non-current).
Net current assets are current assets minus current liabilities.
Net assets are total assets minus total liabilities.
Intangible non-current assets might be for example IPR, goodwill licences.
Tangible non-current assets might be for example equipment, plants, buildings.
Receivables is money owed to the company by credit customers.
Payables denote money owed by the company to credit suppliers.
Net assets equal total equity.
Liabilities are being deducted from the assets.
Income Statement vs. Balance Sheet
Both income statements and balance sheets are used by company owners, banks and investors, because they provide a good indication of the current and future financial position of a company. However, there are some key differences regarding the statements (see the table below).
| Income Statement | Balance Sheet | |
| Performance | It shows exactly how a company was earning and spending money. | It shows only what a company owns. |
| Timing | A period of time | A moment in time |
| Reporting | It presents revenue and expenses. | It presents assets, liabilities, and equity. |
| Usage | Evaluating performance | Determining whether a company has enough assets to meet financial obligations. |
Financial Performance ratio and report analysis
We have written a separate article “Financial Ratios” introducing you to financial ratios and methods of calculating them. However, there are the most important ratios to analyze the financial performance:
Return on capital employed,
Net profit margin,
Gross profit margin,
Current ratio.
Fig. 2 - Financial performance ratios
Financial Report
A financial report is a document that emphasises the strengths and weaknesses of a company. It is useful both for shareholders and potential investors since it examines the financial position of a business.
How to make a financial report?
Gather information from financial statements.
Calculate ratios.
Conduct a risk assessment.
Determine the value of a company.
Fig. 3 - How to make a financial report?
Sections of the financial report
Company overview - description of the business.
Investment - advantages and disadvantages of investing in the business.
Valuation - a value of the business.
Risk Analysis - factors that might prevent the business from growing.
Details - financial statements and ratios.
Summary - a brief recapitulation of all the sections.
Analysing Financial Performance - Key takeaways
Financial Performance analysis is the process of reviewing and analysing a company's financial statements.
The analysis’ purpose is to measure the financial performance of a company to make better economic decisions to earn income in the future.
There are two most commonly used financial statements: income statements and balance sheets.
Both of these statements are extremely useful, but they indicate different elements.
There are four most important financial ratios: return on capital employed, net profit margin, gross profit margin and current ratio.
A financial report examines the financial position of a company highlighting its strengths and weaknesses.
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Frequently Asked Questions about Analysing Financial Performance
How to analyze a company's financial performance?
Financial performance analysis is a process of analyzing a company’s financial position. It focuses on reviewing, assessing and comparing financial statements - a collection of data and figures organised according to recognized accounting principles. It may also include calculating and analysing financial ratios.
What are the four financial performance ratios?
The four financial performance ratios are as follows:
Return on capital employed,
Net profit margin,
Gross profit margin,
Current ratio.
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