Financial Statement Analysis

Financial statement analysis involves a detailed evaluation of a company’s three primary financial reports: the Income Statement (also known as the Profit & Loss or P&L Statement), the Balance Sheet, and the Cash Flow Statement. This analysis equips stakeholders, such as investors, creditors, and company management, with insights needed to make informed decisions, especially in the context of the prevailing economic environment.

What is Financial Statement Analysis?

Financial statement analysis involves reviewing a company’s three primary financial reports: the Income Statement, the Balance Sheet, and the Cash Flow Statement. These reports are typically available in annual and quarterly filings, known as 10-K and 10-Q filings respectively, in the US. By analyzing the company’s primary financial reports, one can determine if a company is growing, how it earns profits, where it spends money, and how stable its finances are. A solid financial statement analysis can reveal trends, for example consistent growth or looming trouble, ensure that companies remain compliant with regulations, and instill confidence in investors by demonstrating transparency and strong performance.

What is the Purpose of Financial Statement Analysis?

The core objective of financial statement analysis is to assess a company’s profitability, liquidity, solvency, and overall financial health. This enables different stakeholders to make decisions aligned with their goals:

• Equity Investors: Use financial analysis to evaluate the company’s valuation based on projected cash flows, earnings potential, and return on investment.
• Debt Investors / Creditors: Assess creditworthiness by evaluating profitability, cash flows, and the company’s ability to meet financial obligations.
• Company Management: Monitor operational performance, identify areas of improvement, and benchmark against industry peers for strategic planning.
• Regulators: Use it to assess the company’s compliance and financial transparency.

How to Analyze Financial Statements?

Financial statement analysis involves several techniques to extract insights from the raw numbers presented in financial filings:

Horizontal Analysis (also known as Trend Analysis)

This technique looks at financial data across multiple periods (side by side) to identify trends and growth patterns. For example, comparing a company’s revenue in financial years 2022, 2023, and 2024 to assess year-over-year growth trends. Horizontal analysis often involves calculating the percentage change for each line item from one year to the next. This helps highlight which items grew rapidly or declined. For instance, if sales increased 10% but operating expenses increased 20% from last year, it could signal worsening cost management. Examining changes over time helps spot trends such as accelerating growth, consistent declines, or cyclical patterns. Horizontal analysis is essential for evaluating performance over time and checking if a company’s results are improving or deteriorating year by year.​

Vertical Analysis

Vertical analysis looks up and down a single financial statement to understand the proportion of each item relative to a base figure. For example, in an income statement, expressing each expense line as a percentage of revenue. This shows what percentage of sales is consumed by cost of goods sold, administrative expenses, and other components. This standardizes the statements and makes it easier to compare companies of different sizes and to spot structural changes within a company. For instance, if in one year the cost of goods sold is 60% of sales and in the next year it is 70%, vertical analysis immediately flags a decline in the gross margin. The output from vertical analysis is useful for comparing a company’s composition to industry benchmarks or peers.

Ratio Analysis

Ratio analysis involves calculating key financial ratios from the statements to assess specific aspects of performance. There are various categories of ratios, each highlighting a different dimension of the company’s financial health:

• Liquidity ratios (for example, current ratio and quick ratio) measure the company’s ability to meet short-term obligations, i.e., whether the company has sufficient current assets to cover its current liabilities.
• Solvency or leverage ratios (for example, debt-to-equity and debt-to-assets) evaluate long-term stability and how much the company relies on debt financing. A rising debt-to-equity ratio might indicate the company is becoming more leveraged and potentially riskier to creditors.
• Profitability ratios (for example, gross margin, EBIT margin, net profit margin, return on assets, and return on equity) gauge the company’s ability to generate earnings relative to sales, assets, or equity​. These ratios help determine if the company is efficient at turning revenue into profit and rewarding its shareholders.
• Asset management ratios (for example, inventory turnover and days sales outstanding) show how efficiently the company uses its assets. A higher inventory turnover ratio means the company carries little inventory and is able to rotate it multiple times, saving on inventory carrying costs. A low inventory turnover ratio may indicate overstocking or sluggish sales.
• Valuation ratios (for example, the price-to-earnings ratio) help assess whether a company’s stock is over-valued or under-valued.

By computing these ratios, an analyst can benchmark the company against peers or track its performance against prior periods. For instance, a current ratio of 2.0 indicates the company has twice as many current assets as current liabilities, suggesting comfortable levels of short-term liquidity. However, if peers in the industry average a current ratio of 3.0, the company might be less liquid than competitors.

How to Analyze Financial Statements Using Ratios Effectively?

Always look at the context: compare ratios to industry averages, to management targets, and watch their trend over time. An isolated ratio rarely provides meaningful insight, it’s the patterns and comparisons that deliver true analytical value.

Adjusting for One-time Items

While companies report results using GAAP, analyzing non-GAAP (adjusted) figures is often helpful, especially for operating income and net income. These adjustments typically remove one-time charges or gains (for example, legal settlements and restructuring costs), providing a clearer view of the core business performance. This ensures an apples-to-apples comparison among peers by focusing on recurring earnings and cash flows.

In practice, a combination of these methods is typically used. A thorough financial statement analysis might start with horizontal analysis to spot big changes year-over-year, use vertical analysis to understand the composition of financials in a given year, and delve into ratio analysis to evaluate specific strengths and weaknesses. The goal is to interpret the numbers in a way that explains the company’s financial condition and supports sound forecasting or decision-making.

Example of Financial Statement Analysis (Real-World Scenario)

Scenario: Analyze Kroger, which is one of the largest supermarket operators in the US.

Below are snippets of its financial data from the 10K for the fiscal year ended February 1, 2025.

Income Statement:

Adjustments to Income Statement:

Balance Sheet:

Cash Flow Statement:

Horizontal Analysis

Based on the Income Statement:

Insights From Horizontal Analysis

• Net sales slightly declined by (0.1%), essentially remaining flat year-over-year.
• Cost of sales declined by (0.7%), indicating modest efficiency improvements in managing direct product and operational expenses relative to the slight drop in sales. This favorable trend supports profit margins.
• Operating income (GAAP) increased significantly by 26.7%, primarily driven by substantial reductions in one-time costs (notably, opioid settlement charges) compared to FY 2023.
• Adjusted EBIT (non-GAAP), however, decreased slightly by (2.3%). This decline indicates that after removing the effects of special charges and benefits which are one-time in nature, core profitability modestly weakened.
• Net income (GAAP) grew strongly by 25.5%, reflecting the same factors as operating income.
• Adjusted net income (non-GAAP) declined by (2.7%), aligned with the adjusted EBIT trend.

Vertical Analysis

Based on the Income Statement:

Insights From Horizontal Analysis

• Cost of sales slightly decreased from 77.8% of sales to 77.3% of sales in FY 2024. This reflects Kroger’s improved efficiency in managing product costs and related operational expenses.
• Gross margin correspondingly improved from 22.2% to 22.7% of sales.
• Operating income margin (GAAP) saw a meaningful improvement from 2.1% to 2.6%, suggesting improved operational efficiencies or reduced one-time charges.
• Adjusted EBIT margin (non-GAAP) slightly declined from 3.2% to 3.1%, indicating mild underlying pressures or operational headwinds excluding non-recurring charges.
• Net income margin (GAAP) notably increased from 1.4% to 1.8%. This improvement was strongly influenced by fewer extraordinary expenses, such as lower opioid settlement costs.
• Adjusted net income margin (non-GAAP) slightly declined from 2.3% to 2.2%, aligned with the adjusted EBIT margin trend, signaling modest pressure on underlying profitability when excluding special charges and benefits.

Ratio Analysis

Liquidity Ratios

Current ratio improved from 0.8x to 1.0x, indicating a better ability to meet short-term obligations.

When subtracting inventories and prepaid assets from current assets, the quick ratio remains weak but improved from 0.3x to 0.5x.

A slight decrease in the operating cash flow ratio indicates a reduced ability to cover current liabilities through operating cash flows, suggesting a slight weakening in short-term liquidity.

Solvency or Leverage Ratios

Debt-to-equity ratio remained nearly flat, indicating stable leverage relative to the market value of equity. Note: Market data is as of April 15^th, 2025. Share price for FY 2023-24 is as of April 15^th 2024.

Debt-to-assets remained nearly flat, indicating stable balance sheet leverage.

EBIT slightly declined, and interest expense rose marginally, reducing interest coverage from 10.7x to 10.2x, though it remains strong.

Profitability Ratios

Gross margin, EBIT margin, net profit margin – these ratios were analyzed above

Return on assets (ROA) stands at 6.3%, indicating that for every dollar of assets the company holds, it generates 6.3 cents in profit. ROA measures the efficiency with which a company uses its total assets to produce net income, regardless of how the assets are financed

Return on equity (ROE), on the other hand, is higher at 7.5%, signifying that the company earns 7.5 cents in profit for every dollar of shareholder equity. ROE specifically assesses profitability from the viewpoint of shareholders, emphasizing returns generated from equity investments

The difference between ROA and ROE (6.3% vs. 7.5%) is primarily driven by the company’s capital structure. A higher ROE relative to ROA often indicates the use of cheaper debt in financing the company’s assets. Since debt financing increases returns to shareholders without affecting total assets, it tends to amplify ROE compared to ROA. In this scenario, the higher ROE implies the company is effectively using financial leverage to enhance returns for equity holders

Asset Management Ratios

Inventory turnover is high at 16.1x, meaning the company sells and replaces its inventory approximately 16 times during the financial year. A high inventory ratio generally indicates efficient inventory management because it suggests that the company maintains the optimal inventory levels, minimizing carrying costs such as capital expenses, warehousing, insurance and potential shrinkage

Days sales outstanding increased marginally from 5.2 to 5.4 days, a slight slowdown in collections

Valuation Ratio

EPS improved from $4.55 to $4.83, indicating earnings strength despite lower net income, largely due to a reduction in diluted shares from share repurchases

P/E ratio increased from 12.2x to 14.1x, suggesting increased market optimism about company’s future prospects. A higher P/E ratio reflects a valuation premium, meaning investors are willing to pay more for each dollar of earnings. This often occurs when investors expect higher future growth in earnings or reduced risk volatility with respect to industry peers or historical performance

Note: Note: Market data is as of April 15^th, 2025. Share price for FY 2023-24 is as of April 15^th, 2024

Conclusion

Financial statement analysis helps evaluate a company’s financial health, performance, and value. Leveraging horizontal, vertical, and ratio analysis, along with adjustments for non-recurring items, helps uncover trends, assess operational efficiency, and benchmark against peers. A well-rounded analysis goes beyond the numbers to reveal the story behind a company’s financials, enabling informed decision-making for all stakeholders.

Additional Resources

Investment Banking Courses

M&A Explained

Income Statement Analysis

Balance Sheet

Cash Flow Statement

What is Ratio Analysis