Using Financial Statement Analysis to Evaluate Industry and Competitor Performance (2024)

Introduction

Financial statements are a rich source of financial data insights for an organization. By analyzing historical financial data and key metrics, trends, and ratios within financial statements, it’s possible to understand how well an organization has been performing, compared to industry peers and competitors. Through this evaluation process, CFOs and financial planning and analysis professionals can identify areas that require improvement or further exploration for better decision-making and improved organizational outcomes.

This blog post will explore the fundamentals of financial statement analysis along with its various applications in analyzing industries, competitors, and more.

Understanding Financial Statements

Financial statements help evaluate a company’s financial health through three primary financial statements, the balance sheet, income statement, and cash flow statement. Each financial statement provides different information about the company’s performance and financial professionals use it to make investment decisions.

At a specific moment, the balance sheet presents an overview of a company’s assets, liabilities, and equity. It shows what the company owns as an asset and what it owes in liabilities. Assets include accounts receivable, inventory, buildings, or equipment owned by the business; liabilities include loans from banks or other creditors. Equity represents an ownership interest in the firm—what would be left over if all debts were paid off?

The income statement furnishes a synopsis of the revenues earned during a designated reporting period and expenses sustained to generate those same revenues, helping investors ascertain whether profits were made over that time frame and how much money was generated from operations as opposed to investments or other activities outside regular business proceedings. Revenues stem from sales of goods or services while expenses include costs linked to producing these goods/services such as labor costs and materials acquired for production purposes along with administrative outlays like rent on office space or salaries paid out to employees who don’t directly contribute to revenue generation but still provide essential support functions within an organization.

Finally, the cash flow statement tracks inflows (cash coming into the business) versus outflows (cash going out). It also includes non-cash items such as depreciation which can help identify trends in liquidity so investors can better understand how much-working capital is available for day-to-day operations versus long-term investments like new equipment purchases needed for expansion plans down the line. By looking at these figures and profitability ratios like gross margin investors can get a complete picture when assessing potential risks associated with investing in any company.

Understanding financial statements are critical for CFOs, as it helps identify and assess risks and opportunities.

Industry Analysis

Financial experts use industry analysis to evaluate the financial performance of a sector and companies from that sector by looking at their income statements, balance sheet, and cash flow statements and financial metrics like debt-to-equity ratio, return on equity (ROE), current ratio, and gross margin percentage. This analysis helps identify trends in profitability, liquidity, and solvency ratios that can indicate how the business is doing as compared to competitors within its industry and assess the profitability, and growth potential.

In addition to the experts, investors evaluate the performance of various businesses operating in the same industry or market segment by using industry analysis. It allows them to determine how different companies stack up in terms of performance within a certain industry or market by analyzing their financials and assessing their competitiveness and riskiness.

Investors stand to gain the strategic advantage of macroeconomic conditions and can assess changes in consumer demand by analyzing the industry and its various players. It influences their decisions regarding buying, selling, holding, or using short stocks associated with these sectors.

Another source of data is the regulatory filings made with government agencies such as the Securities & Exchange Commission (SEC). Companies must regularly file certain documents with these organizations detailing their operations including financial details that are available publicly through EDGAR databases maintained by the SEC.

The industry analysis provides a comprehensive overview of the global regulatory reporting landscape, key trends, and challenges and how businesses are performing within those parameters.

Competitor Analysis

Competitor analysis is a critical component of financial statement analysis and involves analyzing the financial statements of a given company vis-a-vis its competitors. It provides insight into their respective performances by comparing metrics, such as income statements, balance sheets, cash flows, and investment analysis over various reporting periods.

Financial professionals use financial ratios to compare the performance of companies with each other. By analyzing the profitability ratios such as gross profit or return on assets (ROA), liquidity metrics like accounts receivable turnover and working capital ratio, debt-to-equity ratio, and others of different companies in an industry, financial professionals can gain valuable insights into which firms are outperforming their peers and what areas they may need to improve.

Businesses may use reports filed by competitors during M&A negotiations; investors may use them as examples of a competitor analysis when deciding whether to invest in stocks or funds related to publicly traded companies; and regulators may review company files before approving transactions between two parties suspected of collusion.

A comprehensive awareness of the market and the ways in which their rivals operate helps decision-makers make wise choices.

Financial Ratios for Industry and Competitor Analysis

It’s crucial to comprehend each category separately to obtain a thorough understanding of how these financial measures interact when used for competition and industry analysis.

Liquidity ratios measure a company’s ability to pay short-term obligations such as accounts payable and debt payments. Common liquidity ratios include the current ratio (current assets divided by current liabilities) and quick ratio (cash plus near cash items divided by current liabilities). A higher value indicates better liquidity while lower values suggest potential difficulty in meeting short-term obligations.

Profitability ratios measure how well a company is performing in terms of generating profits from sales revenue. These measures often involve comparing net income with sales or total assets over time to determine trends in operating performance. Examples include gross profit margin (gross profit divided by sales), return on equity (net income divided by shareholder’s equity), return on assets (net income divided by total assets), etc.

By analyzing these figures for both their organization as well as competitors, companies can identify areas where they may need improvement or strategies that have been successful for others that could be applied internally.

Efficiency ratios enable finance executives to ascertain how effectively a company utilizes its resources when producing goods or services for sale, generally expressed as an asset turnover rate (total revenue generated per dollar invested in fixed assets).

Other metrics include inventory turnover rate (cost of goods sold/average inventory) that gauges the speed at which products pass through stock levels; days receivable outstanding (accounts receivable/daily credit sales); days payable outstanding ((purchases – purchases returns)/daily average purchases); etc. Analyzing these figures offers insight into whether operations are running optimally or if there is room for improvement within the organization compared to others in the same sector.

Leverage ratios provide insight into the proportion of capital which comes from debt versus equity sources such as shareholders’ funds or retained earnings, giving finance executives an idea of the risk associated with investing in a particular entity. Higher leverage typically implies greater risk due to increased exposure should something go awry financially down the line. Leverage ratio examples include a debt-to-equity ratio ((total liabilities/shareholders’ equity)) and an interest coverage ratio ((earnings before interest & taxes /interest expense)).

Financial ratios provide invaluable insights into industry analysis and competitor comparison, so CFOs must understand them thoroughly before making decisions regarding investments or strategic planning initiatives.

Limitations of Financial Statement Analysis

Financial statement analysis is a useful tool for evaluating the performance of an industry or competitor. Still, when employing it to make choices, one must bear in mind certain restrictions.

First, financial statements are documents that reflect backward and do not predict future performance. Financial ratios produced from these statements can only offer insight into the historical operational trends of a business and cannot forecast future outcomes. To entirely assess possible opportunities and dangers related to investing in a company or industry additional data sources, such as market research and consumer surveys should also be considered.

Second, due to accounting practices and standards that allow businesses to manipulate their results by changing assumptions made about depreciation rates, inventory valuation methodologies, etc., financial statements may not always accurately depict the true economic realities of a corporation.

Some companies may decide to adopt accelerated depreciation techniques, which provide larger profits that are reported on their income statement but lower cash flows over time due to higher capital expenditures needed for asset replacement.

Leverage sensitivity and the failure to capture intangible value are two major limitations of financial statement analysis. ROE gets significantly impacted by even minor changes in leverage, while intangible assets such as brand recognition or customer loyalty remain unaccounted for. To ensure a comprehensive assessment, it is essential to employ multiple methods when evaluating industry and competitor performance.

Finally, most financial ratios rely heavily on historical data which makes them less useful when analyzing rapidly changing industries where traditional metrics may no longer apply (e.g., the technology sector). In such cases, alternative approaches such as discounted cash flow analysis might be more appropriate for assessing value creation potential over time given different scenarios related to growth prospects and competitive dynamics within the sector being evaluated

Despite its limitations, financial statement analysis can still yield useful insights into a company’s fiscal performance.

Conclusion

Ultimately, regular financial statement analysis provides CFOs with an invaluable resource for understanding their business environment and staying ahead of the competition. By utilizing this tool, companies can identify areas of strength, weaknesses, opportunities, and threats that can be used to inform strategic decision-making. Additionally, by analyzing financial ratios such as liquidity, profitability, solvency, and efficiency ratios businesses gain valuable insights into their own operations as well as those of competitors in the same industry.

However, when making strategic choices, it is essential to remember that financial reports are merely one element of the data accessible for conducting an industry or competitor analysis. Other aspects like customer reviews and market trends should also be considered.