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Lesson 1 of 6 · 11 min
The role of financial statement analysis
Financial statement analysis combines a company's reports with other information to judge its past and present performance and position, so the analyst can form expectations about the future and make investment, credit and other economic decisions.
In short
- The role of financial statement analysis: use company reports plus other information to evaluate past, current and potential performance and financial position for investment, credit and other economic decisions.
- The aim is forward-looking. History is studied to form expectations about future performance and position, and about the risks around them.
- Equity investors focus on profitability and per-share value; debt investors focus on the ability to pay interest and repay principal.
- A central question: can the company earn a return on capital at least equal to its cost of capital, grow profitably and generate enough cash?
- Performance covers profitability (earning a profit) and cash flow generation (receipts exceeding disbursements). Financial position matters most for credit decisions.
- Managers also analyse their company, but they have nonpublic information, so they do not depend only on published statements.
What the analysis is for
Financial analysis means interpreting and evaluating a company's performance and position in the context of its economic environment. Financial statement analysis is the part that starts from the company's own reports: audited statements, extra disclosures required by regulators and management's (unaudited) commentary.
The analysis always serves a decision. An analyst rarely reads a set of accounts out of curiosity; there is a portfolio to build, a loan to price or a rating to assign. The decision decides which parts of the reports matter most.
Managers inside the company analyse results too, to make operating, investing and financing decisions. They are not limited to the published statements, because they can see internal, nonpublic data. External analysts must work with what is disclosed plus outside research.
- Deciding whether to add a company's shares to a portfolio.
- Valuing a security in order to recommend it to others.
- Judging creditworthiness before lending, and setting the loan terms.
- Assigning a credit rating to a company or a bond issue.
- Deciding on a venture capital or other private equity investment.
- Assessing a merger or acquisition target.
Looking back to look forward
All of these decisions share one theme. The analyst examines past and current performance and financial position in order to form expectations about the future, and pays close attention to the factors that could make the future riskier than it looks.
Performance has two sides. Profitability is the ability to earn a profit from selling goods and services. Cash flow generation is the ability to bring in more cash than goes out. A company can report profits and still run short of cash, so analysts look at both.
Financial position (what the company owns and owes, and how it is financed) is especially important for credit analysis. Rating agencies typically upgrade a company when leverage is falling and free cash flow is rising, and downgrade it when the reverse happens.
The ultimate test of a business: does it earn at least its cost of capital? A company with a 7% return on capital and a 9% cost of capital is profitable on paper but is not creating value for its owners.
Equity and credit perspectives
Equity and credit analysts read the same statements but ask different questions. The shareholder owns the upside, so profit growth and value per share matter most. The lender's upside is capped at interest and principal, so the downside, meaning the ability to keep paying, matters most.
Markets judge results against expectations. When a company releases earnings, the news coverage usually compares revenue and earnings per share with analysts' consensus forecasts. A share price can fall on a day the company beats its earnings forecast if revenue disappoints or management withdraws its guidance.
Earnings are also a key valuation input. An analyst may compare a company's price-to-earnings ratio (P/E) with those of its peers, or feed forecast earnings into a discounted cash flow model.
| Equity analyst | Credit analyst | |
|---|---|---|
| Main question | Is the share attractive, and at what price? | Should we lend, on what terms, or what rating fits? |
| Focus | Profitability, growth, value per share | Ability to pay interest and repay principal |
| Typical output | Buy, hold or sell recommendation with a value estimate | Lending decision, loan terms or credit rating |
| Key statements | Earnings and their quality, cash flows | Financial position, leverage, cash flows |
Formula
- Earnings or revenue surprise
Positive = a 'beat', negative = a 'miss'. Results are judged relative to what the market expected, not in isolation.
Worked examples
Example 1 Beat or miss?
Kestrel Freight ASA reports quarterly revenue of NOK 4.85 billion against a consensus forecast of NOK 4.95 billion, and earnings per share of NOK 3.40 against a consensus of NOK 3.10. Management also withdraws its full-year revenue guidance. How did results compare with expectations, and why might the share price still fall?
Example 2 Profitable, but is it creating value?
Arlberg Tools AG earns after-tax operating profit of EUR 14 million on EUR 200 million of capital. Its investors require a 9% return. Is Arlberg meeting the central test of financial analysis?
Example 3 Same company, two readers
Calder Shipping plc wants to issue new shares and also refinance a bank loan. An equity analyst and the bank's credit analyst both receive its annual report. What will each concentrate on?
On the exam
Expect definition questions on the role of financial statement analysis (evaluating a company to make economic decisions, forming expectations about future performance and position), and questions contrasting equity and debt investors' focus.
- Describing the role as merely 'providing information'. Providing information is the role of financial reporting; analysis uses that information to make decisions.
- Thinking the analysis is backward-looking. Past results matter only as a basis for expectations about the future.
- Assuming a profitable company is creating value. The return must at least equal the cost of capital.
- Forgetting that the statements analysts use are prepared by the company, not by analysts.
Check yourself
Q1The role of financial statement analysis is best described as:
Q2Compared with an equity investor, a debt investor in a company is most likely to focus on the company's:
Q3A company reports EPS of EUR 2.10. The consensus forecast was EUR 2.00. The earnings surprise is closest to:
Q4Managers do not rely only on published financial statements when analysing their own company, most likely because they:
Q5Analysts examine a company's past and current financial results mainly in order to:
Answer the 5 questions: +10 XP for each one you get right first time.
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