Financial Statement Analysis
Overview of Financial Statement Analysis
Financial statement analysis involves the identification of the following items for a company's financial
statements over a series of reporting periods:
Trends. Create trend lines for key items in the financial statements over multiple time periods, to see
how the company is performing. Typical trend lines are for revenues, the gross margin,
net profits, cash, accounts receivable, and debt.
Proportion analysis. An array of ratios are available for discerning the relationship between the size of
various accounts in the financial statements. For example, you can calculate a company's quick
ratio to estimate its ability to pay its immediateliabilities, or its debt to equity ratio to see if it has
taken on too much debt. These analyses are frequently between the revenues and expenses listed on
the income statement and the assets, liabilities, and equity accounts listed on the balance sheet.
Financial statement analysis is an exceptionally powerful tool for a variety of users of financial
statements, each having different objectives in learning about the financial circumstances of the
entity.
Users of Financial Statement Analysis
There are a number of users of financial statement analysis. They are:
Creditors. Anyone who has lent funds to a company is interested in its ability to pay back the debt,
and so will focus on various cash flow measures.
Investors. Both current and prospective investors examine financial statements to learn about a
company's ability to continue issuing dividends, or to generate cash flow, or to continue growing at its
historical rate (depending upon their investment philisophies).
Management. The company controller prepares an ongoing analysis of the company's financial results,
particularly in relation to a number of operational metrics that are not seen by outside entities (such
as the cost per delivery, cost per distribution channel, profit by product, and so forth).
Regulatory authorities. If a company is publicly held, its financial statements are examined by the
Securities and Exchange Commission (if the company files in the United States) to see if its
statements conform to the various accounting standards and the rules of the SEC.
Methods of Financial Statement Analysis
There are two key methods for analyzing financial statements. The first method is the use of
horizontal and vertical analysis. Horizontal analysis is the comparison of financial information over a
series of reporting periods, while vertical analysis is the proportional analysis of a financial statement,
where each line item on a financial statement is listed as a percentage of another item. Typically, this
means that every line item on an income statement is stated as a percentage of gross sales, while
every line item on a balance sheet is stated as a percentage of total assets. Thus, horizontal analysis
is the review of the results of multiple time periods, whiile vertical analysis is the review of the
proportion of accounts to each other within a single period. The following links will direct you to more
information about horizontal and vertical analyis:
Horizontal analysis
Vertical analysis
The second method for analyzing financial statements is the use of many kinds of ratios. You use
ratios to calculate the relative size of one number in relation to another. After you calculate a ratio,
you can then compare it to the same ratio calculated for a prior period, or that is based on an industry
average, to see if the company is performing in accordance with expectations. In a typical financial
statement analysis, most ratios will be within expectations, while a small number will flag potential
problems that will attract the attention of the reviewer.
There are several general categories of ratios, each designed to examine a different aspect of a
company's performance. The general groups of ratios are:
1. Liquidity ratios. This is the most fundamentally important set of ratios, because they measure
the ability of a company to remain in business. Click the following links for a thorough review
of each ratio.
Cash coverage ratio. Shows the amount of cash available to pay interest.
Current ratio. Measures the amount of liquidity available to pay for current liabilities.
Quick ratio. The same as the current ratio, but does not include inventory.
Liquidity index. Measures the amount of time required to convert assets into cash.
2. Activity ratios. These ratios are a strong indicator of the quality of management, since they
reveal how well management is utilizing company resources. Click the following links for a
thorough review of each ratio.
Accounts payable turnover ratio. Measures the speed with which a company pays its suppliers.
Accounts receivable turnover ratio. Measures a company's ability to collect accounts
receivable.
Fixed asset turnover ratio. Measures a company's ability to generate sales from a certain base
of fixed assets.
Inventory turnover ratio. Measures the amount of inventory needed to support a given level of
sales.
Sales to working capital ratio. Shows the amount of working capital required to support a
given amount of sales.
Working capital turnover ratio. Measures a company's ability to generate sales from a certain
base of working capital.
3. Leverage ratios. These ratios reveal the extent to which a company is relying upon debt to
fund its operations, and its ability to pay back the debt. Click the following links for a thorough
review of each ratio.
Debt to equity ratio. Shows the extent to which management is willing to fund operations with
debt, rather than equity.
Debt service coverage ratio. Reveals the ability of a company to pay its debt obligations.
Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.
4. Profitability ratios. These ratios measure how well a company performs in generating a profit.
Click the following links for a thorough review of each ratio.
Breakeven point. Reveals the sales level at which a company breaks even.
Contribution margin ratio. Shows the profits left after variable costs are subtracted from sales.
Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of sales.
Margin of safety. Calculates the amount by which sales must drop before a company reaches
its breakeven point.
Net profit ratio. Calculates the amount of profit after taxes and all expenses have been
deducted from net sales.
Return on equity. Shows company profit as a percentage of equity.
Return on net assets. Shows company profits as a percentage of fixed assets and working
capital.
Return on operating assets. Shows company profit as percentage of assets utilized.
Problems with Financial Statement Analysis
While financial statement analysis is an excellent tool, there are several issues to be aware of that can
interfere with your interpretation of the analysis results. These issues are:
Comparability between periods. The company preparing the financial statements may have changed
the accounts in which it stores financial information, so that results may differ from period to period.
For example, an expense may appear in the cost of goods sold in one period, and in administrative
expenses in another period.
Comparability between companies. An analyst frequently compares the financial ratios of different
companies in order to see how they match up against each other. However, each company may
aggregate financial information differently, so that the results of their ratios are not really comparable.
This can lead an analyst to draw incorrect conclusions about the results of a company in comparison to
its competitors.
Operational information. Financial analysis only reviews a company's financial information, not its
operational information, so you cannot see a variety of key indicators of future performance, such as
the size of the order backlog, or changes in warranty claims. Thus, financial analysis only presents
part of the total picture.
Similar Terms
Horizontal analysis is also known as trend analysis.
