Writing Financial Statement Analysis

Overview of Financial Statement Analysis

Financial statement analysis involves gaining an understanding of an organization's financial situation by reviewing
its financial reports. The results can be used to make investment and lending decisions. This review involves
identifying 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 revenue, 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, one can calculate a company's quick ratio to
estimate its ability to pay its immediate liabilities, 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 philosophies).

 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, while vertical analysis is the review of the
proportion of accounts to each other within a single period.

The second method for analyzing financial statements is the use of many kinds of ratios. Ratios are used to calculate
the relative size of one number in relation to another. After a ratio is calculated, 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.

o Cash coverage ratio. Shows the amount of cash available to pay interest.

o Current ratio. Measures the amount of liquidity available to pay for current liabilities.

o Quick ratio. The same as the current ratio, but does not include inventory.

o 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.

o Accounts payable turnover ratio. Measures the speed with which a company pays its suppliers.

o Accounts receivable turnover ratio. Measures a company's ability to collect accounts receivable.

o Fixed asset turnover ratio. Measures a company's ability to generate sales from a certain base of
fixed assets.

o Inventory turnover ratio. Measures the amount of inventory needed to support a given level of
sales.

o Sales to working capital ratio. Shows the amount of working capital required to support a given
amount of sales.

o 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.

o Debt to equity ratio. Shows the extent to which management is willing to fund operations with
debt, rather than equity.

o Debt service coverage ratio. Reveals the ability of a company to pay its debt obligations.

o 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.

o Breakeven point. Reveals the sales level at which a company breaks even.

o Contribution margin ratio. Shows the profits left after variable costs are subtracted from sales.

o Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of sales.

o Margin of safety. Calculates the amount by which sales must drop before a company reaches its
break even point.

o Net profit ratio. Calculates the amount of profit after taxes and all expenses have been deducted
from net sales.
o Return on equity. Shows company profit as a percentage of equity.

o Return on net assets. Shows company profits as a percentage of fixed assets and working capital.

o Return on operating assets. Shows company profit as percentage of assets utilized.