A financial statement analysis is an appropriate method by which to evaluate a business. The analysis can provide helpful insights – such as, if the business has been profitable, what the cash flows have been and how much capital has been invested into the business. However, the results of the financial statement analysis won’t necessarily provide insights into the future operations or profitability of the business.
There are some distinct advantages of performing a financial statement analysis. If the financial statements have been audited and an unqualified opinion has been issued by the auditor, additional comfort can be gained that the financial statements have been prepared in accordance with Generally Accepted Accounting Principles (“GAAP”) – that the accounting rules have been followed and that there is a good basis for performing the analysis. A financial statement analysis also provides a historical and factual perspective. The results will represent facts - not assumptions or future projections. Multiple year financial results provide valuable trends as a basis for analyzing a business. And in some cases, the past results may be a good indicator of future results – if a company has a track record of generating profits, it may continue to do so.
While the apparent disadvantages of a financial statement analysis are few, there are disadvantages of performing ONLY a financial statement analysis. If a company is operating in an ever- changing or highly competitive environment, its past results, as reflected in historical financial statements, may not be an indicator of future results. Analysis of historical financial statements will not identify operational issues or inefficiencies or any favorable or unfavorable changes in the environment. There are other non-GAAP measures (such as EBITDA – earnings before interest, taxes, depreciation and amortization), which are excluded from audited financial statements but may provide valuable insights into the financial results of a business.
Financial statement analysis is only one tool in evaluating a business. Supplementing the financial statement review with other analytical tools can overcome the limitations of only using one method of analysis. The review and analysis of financial projections, of the competitive or regulatory environment and of the market factors in which the company operates are additional tools for evaluating a business. These analyses, when combined with the historical financial statement analysis, will provide a more holistic approach as to where the company has been and to where it is headed.