• A | Financial Statement Analysis
  • Why It Matters
  • 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
  • 1.2 Identify Users of Accounting Information and How They Apply Information
  • 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
  • 1.4 Explain Why Accounting Is Important to Business Stakeholders
  • 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
  • Multiple Choice
  • 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
  • 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
  • 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
  • Exercise Set A
  • Exercise Set B
  • Problem Set A
  • Problem Set B
  • Thought Provokers
  • 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
  • 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
  • 3.3 Define and Describe the Initial Steps in the Accounting Cycle
  • 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
  • 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
  • 3.6 Prepare a Trial Balance
  • 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
  • 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
  • 4.3 Record and Post the Common Types of Adjusting Entries
  • 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
  • 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
  • 5.1 Describe and Prepare Closing Entries for a Business
  • 5.2 Prepare a Post-Closing Trial Balance
  • 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
  • 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
  • 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
  • 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
  • 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
  • 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
  • 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
  • 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
  • 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
  • 7.1 Define and Describe the Components of an Accounting Information System
  • 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
  • 7.3 Analyze and Journalize Transactions Using Special Journals
  • 7.4 Prepare a Subsidiary Ledger
  • 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
  • 8.1 Analyze Fraud in the Accounting Workplace
  • 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
  • 8.3 Describe Internal Controls within an Organization
  • 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
  • 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
  • 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
  • 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
  • 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
  • 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
  • 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
  • 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
  • 9.5 Apply Revenue Recognition Principles to Long-Term Projects
  • 9.6 Explain How Notes Receivable and Accounts Receivable Differ
  • 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
  • 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
  • 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
  • 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
  • 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
  • 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
  • 11.1 Distinguish between Tangible and Intangible Assets
  • 11.2 Analyze and Classify Capitalized Costs versus Expenses
  • 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
  • 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
  • 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
  • 12.1 Identify and Describe Current Liabilities
  • 12.2 Analyze, Journalize, and Report Current Liabilities
  • 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
  • 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
  • 12.5 Record Transactions Incurred in Preparing Payroll
  • 13.1 Explain the Pricing of Long-Term Liabilities
  • 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
  • 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
  • 13.4 Appendix: Special Topics Related to Long-Term Liabilities
  • 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
  • 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
  • 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
  • 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
  • 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
  • 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
  • 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
  • 15.3 Compute and Allocate Partners’ Share of Income and Loss
  • 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
  • 15.5 Discuss and Record Entries for the Dissolution of a Partnership
  • 16.1 Explain the Purpose of the Statement of Cash Flows
  • 16.2 Differentiate between Operating, Investing, and Financing Activities
  • 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
  • 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
  • 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
  • 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
  • B | Time Value of Money
  • C | Suggested Resources

Financial Statement Analysis

Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of retained earnings, balance sheet, and statement of cash flows, among other financial information, can be analyzed. The information obtained from this analysis can benefit decision-making for internal and external stakeholders and can give a company valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital investments opportunities.

When considering the outcomes from analysis, it is important for a company to understand that data produced needs to be compared to others within industry and close competitors. The company should also consider their past experience and how it corresponds to current and future performance expectations. Three common analysis tools are used for decision-making; horizontal analysis, vertical analysis, and financial ratios.

For our discussion of financial statement analysis, we will use Banyan Goods. Banyan Goods is a merchandising company that sells a variety of products. The image below shows the comparative income statements and balance sheets for the past two years.

Keep in mind that the comparative income statements and balance sheets for Banyan Goods are simplified for our calculations and do not fully represent all the accounts a company could maintain. Let’s begin our analysis discussion by looking at horizontal analysis.

Horizontal Analysis

Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A company will look at one period (usually a year) and compare it to another period. For example, a company may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a company valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year.

The dollar change is found by taking the dollar amount in the base year and subtracting that from the year of analysis.

Using Banyan Goods as our example, if Banyan wanted to compare net sales in the current year (year of analysis) of $120,000 to the prior year (base year) of $100,000, the dollar change would be as follows:

The percentage change is found by taking the dollar change, dividing by the base year amount, and then multiplying by 100.

Let’s compute the percentage change for Banyan Goods’ net sales.

This means Banyan Goods saw an increase of $20,000 in net sales in the current year as compared to the prior year, which was a 20% increase. The same dollar change and percentage change calculations would be used for the income statement line items as well as the balance sheet line items. The image below shows the complete horizontal analysis of the income statement and balance sheet for Banyan Goods.

Depending on their expectations, Banyan Goods could make decisions to alter operations to produce expected outcomes. For example, Banyan saw a 50% accounts receivable increase from the prior year to the current year. If they were only expecting a 20% increase, they may need to explore this line item further to determine what caused this difference and how to correct it going forward. It could possibly be that they are extending credit more readily than anticipated or not collecting as rapidly on outstanding accounts receivable. The company will need to further examine this difference before deciding on a course of action. Another method of analysis Banyan might consider before making a decision is vertical analysis.

Vertical Analysis

Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments.

The company will need to determine which line item they are comparing all items to within that statement and then calculate the percentage makeup. These percentages are considered common-size because they make businesses within industry comparable by taking out fluctuations for size. It is typical for an income statement to use net sales (or sales) as the comparison line item. This means net sales will be set at 100% and all other line items within the income statement will represent a percentage of net sales.

On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities and stockholders’ equity. Total assets will be set at 100% and all assets will represent a percentage of total assets. Total liabilities and stockholders’ equity will also be set at 100% and all line items within liabilities and equity will be represented as a percentage of total liabilities and stockholders’ equity. The line item set at 100% is considered the base amount and the comparison line item is considered the comparison amount. The formula to determine the common-size percentage is:

For example, if Banyan Goods set total assets as the base amount and wanted to see what percentage of total assets were made up of cash in the current year, the following calculation would occur.

Cash in the current year is $110,000 and total assets equal $250,000, giving a common-size percentage of 44%. If the company had an expected cash balance of 40% of total assets, they would be exceeding expectations. This may not be enough of a difference to make a change, but if they notice this deviates from industry standards, they may need to make adjustments, such as reducing the amount of cash on hand to reinvest in the business. The image below shows the common-size calculations on the comparative income statements and comparative balance sheets for Banyan Goods.

Even though vertical analysis is a statement comparison within the same year, Banyan can use information from the prior year’s vertical analysis to make sure the business is operating as expected. For example, unearned revenues increased from the prior year to the current year and made up a larger portion of total liabilities and stockholders’ equity. This could be due to many factors, and Banyan Goods will need to examine this further to see why this change has occurred. Let’s turn to financial statement analysis using financial ratios.

Overview of Financial Ratios

Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability. Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions. (You will learn more about ratios, industry standards, and ratio interpretation in advanced accounting courses.)

Liquidity Ratios

Liquidity ratios show the ability of the company to pay short-term obligations if they came due immediately with assets that can be quickly converted to cash. This is done by comparing current assets to current liabilities. Lenders, for example, may consider the outcomes of liquidity ratios when deciding whether to extend a loan to a company. A company would like to be liquid enough to manage any currently due obligations but not too liquid where they may not be effectively investing in growth opportunities. Three common liquidity measurements are working capital, current ratio, and quick ratio.

Working Capital

Working capital measures the financial health of an organization in the short-term by finding the difference between current assets and current liabilities. A company will need enough current assets to cover current liabilities; otherwise, they may not be able to continue operations in the future. Before a lender extends credit, they will review the working capital of the company to see if the company can meet their obligations. A larger difference signals that a company can cover their short-term debts and a lender may be more willing to extend the loan. On the other hand, too large of a difference may indicate that the company may not be correctly using their assets to grow the business. The formula for working capital is:

Using Banyan Goods, working capital is computed as follows for the current year:

In this case, current assets were $200,000, and current liabilities were $100,000. Current assets were far greater than current liabilities for Banyan Goods and they would easily be able to cover short-term debt.

The dollar value of the difference for working capital is limited given company size and scope. It is most useful to convert this information to a ratio to determine the company’s current financial health. This ratio is the current ratio.

Current Ratio

Working capital expressed as a ratio is the current ratio. The current ratio considers the amount of current assets available to cover current liabilities. The higher the current ratio, the more likely the company can cover its short-term debt. The formula for current ratio is:

The current ratio in the current year for Banyan Goods is:

A 2:1 ratio means the company has twice as many current assets as current liabilities; typically, this would be plenty to cover obligations. This may be an acceptable ratio for Banyan Goods, but if it is too high, they may want to consider using those assets in a different way to grow the company.

Quick Ratio

The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses. The conversion of inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current assets. A company will want to know what they have on hand and can use quickly if an immediate obligation is due. The formula for the quick ratio is:

The quick ratio for Banyan Goods in the current year is:

A 1.6:1 ratio means the company has enough quick assets to cover current liabilities.

Another category of financial measurement uses solvency ratios.

Solvency Ratios

Solvency implies that a company can meet its long-term obligations and will likely stay in business in the future. To stay in business the company must generate more revenue than debt in the long-term. Meeting long-term obligations includes the ability to pay any interest incurred on long-term debt. Two main solvency ratios are the debt-to-equity ratio and the times interest earned ratio.

Debt to Equity Ratio

The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running. It is less risky and less costly to use equity sources for financing as compared to debt resources. This is mainly due to interest expense repayment that a loan carries as opposed to equity, which does not have this requirement. Therefore, a company wants to know how much debt and equity contribute to its financing. Ideally, a company would prefer more equity than debt financing. The formula for the debt to equity ratio is:

The information needed to compute the debt-to-equity ratio for Banyan Goods in the current year can be found on the balance sheet.

This means that for every $1 of equity contributed toward financing, $1.50 is contributed from lenders. This would be a concern for Banyan Goods. This could be a red flag for potential investors that the company could be trending toward insolvency. Banyan Goods might want to get the ratio below 1:1 to improve their long-term business viability.

Times Interest Earned Ratio

Time interest earned measures the company’s ability to pay interest expense on long-term debt incurred. This ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is:

The information needed to compute times interest earned for Banyan Goods in the current year can be found on the income statement.

The $43,000 is the operating income, representing earnings before interest and taxes. The 21.5 times outcome suggests that Banyan Goods can easily repay interest on an outstanding loan and creditors would have little risk that Banyan Goods would be unable to pay.

Another category of financial measurement uses efficiency ratios.

Efficiency Ratios

Efficiency shows how well a company uses and manages their assets. Areas of importance with efficiency are management of sales, accounts receivable, and inventory. A company that is efficient typically will be able to generate revenues quickly using the assets it acquires. Let’s examine four efficiency ratios: accounts receivable turnover, total asset turnover, inventory turnover, and days’ sales in inventory.

Accounts Receivable Turnover

Accounts receivable turnover measures how many times in a period (usually a year) a company will collect cash from accounts receivable. A higher number of times could mean cash is collected more quickly and that credit customers are of high quality. A higher number is usually preferable because the cash collected can be reinvested in the business at a quicker rate. A lower number of times could mean cash is collected slowly on these accounts and customers may not be properly qualified to accept the debt. The formula for accounts receivable turnover is:

Many companies do not split credit and cash sales, in which case net sales would be used to compute accounts receivable turnover. Average accounts receivable is found by dividing the sum of beginning and ending accounts receivable balances found on the balance sheet. The beginning accounts receivable balance in the current year is taken from the ending accounts receivable balance in the prior year.

When computing the accounts receivable turnover for Banyan Goods, let’s assume net credit sales make up $100,000 of the $120,000 of the net sales found on the income statement in the current year.

An accounts receivable turnover of four times per year may be low for Banyan Goods. Given this outcome, they may want to consider stricter credit lending practices to make sure credit customers are of a higher quality. They may also need to be more aggressive with collecting any outstanding accounts.

Total Asset Turnover

Total asset turnover measures the ability of a company to use their assets to generate revenues. A company would like to use as few assets as possible to generate the most net sales. Therefore, a higher total asset turnover means the company is using their assets very efficiently to produce net sales. The formula for total asset turnover is:

Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year.

Banyan Goods’ total asset turnover is:

The outcome of 0.53 means that for every $1 of assets, $0.53 of net sales are generated. Over time, Banyan Goods would like to see this turnover ratio increase.

Inventory Turnover

Inventory turnover measures how many times during the year a company has sold and replaced inventory. This can tell a company how well inventory is managed. A higher ratio is preferable; however, an extremely high turnover may mean that the company does not have enough inventory available to meet demand. A low turnover may mean the company has too much supply of inventory on hand. The formula for inventory turnover is:

Cost of goods sold for the current year is found on the income statement. Average inventory is found by dividing the sum of beginning and ending inventory balances found on the balance sheet. The beginning inventory balance in the current year is taken from the ending inventory balance in the prior year.

Banyan Goods’ inventory turnover is:

1.6 times is a very low turnover rate for Banyan Goods. This may mean the company is maintaining too high an inventory supply to meet a low demand from customers. They may want to decrease their on-hand inventory to free up more liquid assets to use in other ways.

Days’ Sales in Inventory

Days’ sales in inventory expresses the number of days it takes a company to turn inventory into sales. This assumes that no new purchase of inventory occurred within that time period. The fewer the number of days, the more quickly the company can sell its inventory. The higher the number of days, the longer it takes to sell its inventory. The formula for days’ sales in inventory is:

Banyan Goods’ days’ sales in inventory is:

243 days is a long time to sell inventory. While industry dictates what is an acceptable number of days to sell inventory, 243 days is unsustainable long-term. Banyan Goods will need to better manage their inventory and sales strategies to move inventory more quickly.

The last category of financial measurement examines profitability ratios.

Profitability Ratios

Profitability considers how well a company produces returns given their operational performance. The company needs to leverage its operations to increase profit. To assist with profit goal attainment, company revenues need to outweigh expenses. Let’s consider three profitability measurements and ratios: profit margin, return on total assets, and return on equity.

Profit Margin

Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each $1 of sales is returned as profit. The larger the ratio figure (the closer it gets to 1), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is:

For Banyan Goods, the profit margin in the current year is:

This means that for every dollar of sales, $0.29 returns as profit. If Banyan Goods thinks this is too low, the company would try and find ways to reduce expenses and increase sales.

Return on Total Assets

The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is:

For Banyan Goods, the return on total assets for the current year is:

The higher the figure, the better the company is using its assets to create a profit. Industry standards can dictate what is an acceptable return.

Return on Equity

Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is:

Average stockholders’ equity is found by dividing the sum of beginning and ending stockholders’ equity balances found on the balance sheet. The beginning stockholders’ equity balance in the current year is taken from the ending stockholders’ equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid.

For Banyan Goods, we will use the net income figure and assume no preferred dividends have been paid. The return on equity for the current year is:

The higher the figure, the better the company is using its investments to create a profit. Industry standards can dictate what is an acceptable return.

Advantages and Disadvantages of Financial Statement Analysis

There are several advantages and disadvantages to financial statement analysis. Financial statement analysis can show trends over time, which can be helpful in making future business decisions. Converting information to percentages or ratios eliminates some of the disparity between competitor sizes and operating abilities, making it easier for stakeholders to make informed decisions. It can assist with understanding the makeup of current operations within the business, and which shifts need to occur internally to increase productivity.

A stakeholder needs to keep in mind that past performance does not always dictate future performance. Attention must be given to possible economic influences that could skew the numbers being analyzed, such as inflation or a recession. Additionally, the way a company reports information within accounts may change over time. For example, where and when certain transactions are recorded may shift, which may not be readily evident in the financial statements.

A company that wants to budget properly, control costs, increase revenues, and make long-term expenditure decisions may want to use financial statement analysis to guide future operations. As long as the company understands the limitations of the information provided, financial statement analysis is a good tool to predict growth and company financial strength.

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  • Authors: Mitchell Franklin, Patty Graybeal, Dixon Cooper
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The Beginner’s Guide to Reading & Understanding Financial Statements

Business professional reading financial statements

  • 10 Jun 2020

An ability to understand the financial health of a company is one of the most vital skills for aspiring investors, entrepreneurs, and managers to develop. Armed with this knowledge, investors can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.

Financial statements offer a window into the health of a company, which can be difficult to gauge using other means. While accountants and finance specialists are trained to read and understand these documents, many business professionals are not. The effect is an obfuscation of critical information.

If you’re new to the world of financial statements, this guide can help you read and understand the information contained in them.

Access your free e-book today.

Understanding Financial Statements

To understand a company’s financial position—both on its own and within its industry—you need to review and analyze several financial statements: balance sheets, income statements, cash flow statements, and annual reports. The value of these documents lies in the story they tell when reviewed together.

1. How to Read a Balance Sheet

A balance sheet conveys the “book value” of a company. It allows you to see what resources it has available and how they were financed as of a specific date. It shows its assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount invested by shareholders).

The balance sheet also provides information that can be leveraged to compute rates of return and evaluate capital structure, using the accounting equation: Assets = Liabilities + Owners’ Equity.

balance sheet equation

Assets are anything a company owns with quantifiable value.

Liabilities refer to money a company owes to a debtor, such as outstanding payroll expenses, debt payments, rent and utility, bonds payable, and taxes.

Owners’ equity refers to the net worth of a company. It’s the amount of money that would be left if all assets were sold and all liabilities paid. This money belongs to the shareholders, who may be private owners or public investors.

Alone, the balance sheet doesn’t provide information on trends, which is why you need to examine other financial statements, including income and cash flow statements, to fully comprehend a company’s financial position.

This article will teach you more about how to read a balance sheet .

2. How to Read an Income Statement

An income statement , also known as a profit and loss (P&L) statement, summarizes the cumulative impact of revenue, gain, expense, and loss transactions for a given period. The document is often shared as part of quarterly and annual reports, and shows financial trends, business activities (revenue and expenses), and comparisons over set periods.

Income statements typically include the following information:

  • Revenue: The amount of money a business takes in
  • Expenses: The amount of money a business spends
  • Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever a business sells
  • Gross profit: Total revenue less COGS
  • Operating income: Gross profit less operating expenses
  • Income before taxes: Operating income less non-operating expenses
  • Net income: Income before taxes less taxes
  • Earnings per share (EPS): Division of net income by the total number of outstanding shares
  • Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
  • EBITDA: Earnings before interest, taxes, depreciation, and amortization

Accountants, investors, and other business professionals regularly review income statements:

  • To understand how well their company is doing: Is it profitable? How much money is spent to produce a product? Is there cash to invest back into the business?
  • To determine financial trends: When are costs highest? When are they lowest?

This article will teach you more about how to read an income statement .

Related: Financial Terminology: 20 Financial Terms to Know

3. How to Read a Cash Flow Statement

The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified duration of time, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of it.

Cash flow statements are broken into three sections: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.

Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activity is cash flow from purchasing or selling assets—usually in the form of physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.

It’s important to note there’s a difference between cash flow and profit . While cash flow refers to the cash that's flowing into and out of a company, profit refers to what remains after all of a company’s expenses have been deducted from its revenues. Both are important numbers to know.

With a cash flow statement, you can see the types of activities that generate cash and use that information to make financial decisions .

Ideally, cash from operating income should routinely exceed net income, because a positive cash flow speaks to a company’s financial stability and ability to grow its operations. However, having positive cash flow doesn’t necessarily mean a company is profitable, which is why you also need to analyze balance sheets and income statements.

This article will teach you more about how to read a cash flow statement .

4. How to Read an Annual Report

An annual report is a publication that public corporations are required to publish annually to shareholders to describe their operational and financial conditions.

Annual reports often incorporate editorial and storytelling in the form of images, infographics, and a letter from the CEO to describe corporate activities, benchmarks, and achievements. They provide investors, shareholders, and employees with greater insight into a company’s mission and goals, compared to individual financial statements.

Beyond the editorial, an annual report summarizes financial data and includes a company's income statement, balance sheet, and cash flow statement. It also provides industry insights, management’s discussion and analysis (MD&A), accounting policies, and additional investor information.

In addition to an annual report, the US Securities and Exchange Commission (SEC) requires public companies to produce a longer, more detailed 10-K report, which informs investors of a business’s financial status before they buy or sell shares.

10-K reports are organized per SEC guidelines and include full descriptions of a company’s fiscal activity, corporate agreements, risks, opportunities, current operations, executive compensation, and market activity. You can also find detailed discussions of operations for the year, and a full analysis of the industry and marketplace.

Both an annual and 10-K report can help you understand the financial health, status, and goals of a company. While the annual report offers something of a narrative element, including management’s vision for the company, the 10-K report reinforces and expands upon that narrative with more detail.

This article will teach you more about how to read an annual report .

Which HBS Online Finance and Accounting Course is Right for You? | Download Your Free Flowchart

A Critical Skill

Reviewing and understanding these financial documents can provide you with valuable insights about a company, including:

  • Its debts and ability to repay them
  • Profits and/or losses for a given quarter or year
  • Whether profit has increased or decreased compared to similar past accounting periods
  • The level of investment required to maintain or grow the business
  • Operational expenses, especially compared to the revenue generated from those expenses

Accountants, investors, shareholders, and company leadership need to be keenly aware of the financial health of an organization, but employees can also benefit from understanding balance sheets, income statements, cash flow statements, and annual reports.

If you don’t have a financial background, the good news is that there are steps you can take to learn about finance and jumpstart your career . Building your financial literacy and skills doesn’t need to be difficult.

Are you interested in gaining a toolkit for making smarter financial decisions and communicating decisions to key stakeholders? Explore our online finance and accounting courses , and download our free course flowchart to determine which best aligns with your goals.

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accounting analysis of financial statements

How to Read (and Analyze) Financial Statements

Bryce Warnes

Reviewed by

Janet Berry-Johnson, CPA

June 8, 2022

This article is Tax Professional approved

There are three main types of financial statements: The balance sheet, the income statement, and the cash flow statement.

When you know how to read your financial statements, you can find ways to make more profit, expand your business, or catch problems before they grow.

What's Bench?

I am the text that will be copied.

Let’s walk through each of these statements piece by piece, using examples. Then, we can use some basic financial ratios to see how your business is performing.

What are financial statements?

There are three basic financial statements your business might use: the balance sheet, the income statement, and the cash flow statement. If you’re brand new to financial reporting, check out our comprehensive article on financial statements —then head back here to learn how to analyze them with financial ratios.

What are financial ratios?

Financial ratios represent your company’s financial performance in different categories—for instance, how well it can cover its debts, or how much profit it’s earning.

You use these ratios by plugging your financial information into formulas. There are different formulas—meaning, different ratios—you can use according to which financial statement you’re analyzing.

Financial advisors, investment gurus, CPAs, and authors of corporate annual reports may employ Einstein-level calculations to help their clients plan how to spend money. But in this guide, we’ll look at the most straightforward, essential ratios business owners use to analyze their companies’ financial statements and make day-to-day business decisions.

How to read a balance sheet

Your balance sheet tells you how much value you have on hand ( assets ) and how much money you owe ( liabilities ). Assets can include cash, accounts receivable, equipment, inventory, or investments. Liabilities can include accounts payable, accrued expenses, and long-term debt such as mortgages and other loans.

Example balance sheet

chelsea-balance-sheet

Parts of a balance sheet

ASSETS include all the value you have on hand. Some of it is cold hard cash—like the business bank account line item in the example above, which holds $20,000. Some of it is less liquid, like equipment or inventory. And some may not even be in your hands yet— accounts receivable , or payments you’re due to receive.

LIABILITIES cost you money. Subtracting them from your assets gives you a rough idea of how much value your business really has to work with. In the example above, accounts payable —typically payments to vendors or contractors—could be considered a short term liability; you’ll probably pay them off each month. Other liabilities, like business loan debt, stick around longer.

OWNER’S EQUITY is the money that you, the owner, has sunk into the business. Capital is your initial investment, the money you used to get up and running. Retained earnings is the profit your business has held onto. And drawing, or owner’s draw , is the money you pay yourself from your business. (For the sake of tidy accounting and liability, you shouldn’t use your company’s retained earnings as a personal spending account.)

Analyzing a balance sheet with financial ratios

These three financial ratios let you do a basic analysis of your balance sheet.

  • Current ratio

The current ratio measures your liquidity —how easily your current assets can be converted to cash in order to cover your short-term liabilities. The higher the ratio, the more liquid your assets.

To calculate the current ratio, use this formula:

Current Ratio = Current Assets / Current Liabilities

If we use the example above, the calculation looks like this:

Current Ratio = 36,000 / 11,000 = 3.27

Meaning a ratio of 3.27:1 (assets:liabilities).

Your current ratio shouldn’t dip far below 2:1 ; if it’s less than 1:1, you don’t have enough current assets on hand to cover your short-term debts, and you’re in a tight position. The higher your ratio, the better able you are to cover liabilities.

  • Quick ratio

The quick ratio (also called the acid test ratio) is like the current ratio—it measures how well your business can pay off its debts. However, it only looks at highly liquid assets, such as cash or assets that can easily be converted to cash—that is, money you can get your hands on quickly.

To calculate the quick ratio, use this formula:

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

Using the example above, the total number of cash and cash equivalents, plus accounts receivable, is $24,000. (Chelsea’s Ceramics doesn’t have any marketable securities.)

We don’t include the equipment line item in these assets, because selling off equipment isn’t a quick way to raise cash.

So, the formula looks like:

Quick Ratio = 24,000 / 11,000 = 2.18

Or a ratio of 2.18:1 (quick assets:liabilities).

So long as your quick ratio is 1:1 or higher , you’re doing well; you’ve got enough easy-to-liquidate assets to cover all your debts.

  • Debt to equity ratio

The debt to equity ratio tells you how much your business depends on equity versus borrowed money.

To calculate your debt-to-equity ratio, use this formula:

Debt to Equity Ratio = Total Debt / Owner or Shareholders’ Equity

Using the example above, we include the long-term debt, but not accounts payable, in the calculation.

So, our formula looks like this:

Debt to Equity Ratio = 10,000 / 25,000 = 0.4

Or a ratio of 0.4:1 (debt:equity).

In this case, Chelsea’s doing well. A 4:1 debt:equity ratio is considered acceptable . With all her retained earnings, Chelsea is able to run her business largely using her own money.

How to read an income statement

Your income statement tells you how much money your business has spent, and how much it has earned, over a financial reporting period. That lets you calculate your net profit—the bottom line.

The reason it’s called the bottom line is because net profit is at the bottom of your income statement. As you work down your income statement, more and more expenses get applied to your revenue, meaning your income line item becomes more and more specific.

Example income statement

erin-aquarium-income-statement

Parts of an income statement

Sales revenue, the top line, is all the money that has come into the business during the month, before taking any expenses into account.

Cost of Goods Sold (COGS) is the money Erin spent in order to earn her sales revenue. For a retail business like Erin’s, that’s typically the wholesale cost of products.

Gross profit is Erin’s income, after subtracting COGS, but without taking general expenses into account.

General expenses includes money Erin has to spend on a monthly basis to keep her business running and making sales. Some of these, like rent, will be the same month to month. Others, like utilities and office supplies, may fluctuate.

Operating earnings (or EBITDA—Expenses Before Interest, Taxes, Depreciation, and Amortization)—equals the total amount Erin takes home after subtracting expenses from her revenue, but before taking into account any taxes or interest on debt she needs to pay.

Income tax expense is the cost of estimated income tax paid or owed for the reporting period. Along with interest payments (which Erin doesn’t have), this is part of the IT in EBITDA.

Net profit is the total amount the business has earned, after taking all expenses into account, including tax and interest.

Further reading: Gross Profit vs. Net Profit: Understanding Profitability

Analyzing an income statement with financial ratios

There are three key financial ratios you can use to analyze your income statements. All of them calculate different profit margins —the relationship between revenue and expenses.

  • Gross profit margin

Your gross profit margin is how much money your business makes per dollar earned, only taking into account COGS. You can increase this margin by lowering COGS—saving money on the wholesale cost of goods and services—or by raising prices…

To calculate gross profit margin, use this formula:

Gross Profit Margin = (Sales Revenue – COGS) / Sales Revenue

Using the example above, we get:

Gross Profit Margin = (9,000 – 4,000) / 9,000 = 0.55, or 55%

Erin’s gross profit margin is 55%, meaning she keeps $0.55 of every dollar earned as gross profit.

  • Operating profit margin

Your operating profit margin is similar to your gross profit margin, but taking general expenses into account as well. You can increase this profit margin by raising prices, lowering COGS, or lowering operating expenses and overhead .

To calculate operating profit margin, use this formula:

Operating Profit Margin = Operating Earnings (EBITDA) / Sales Revenue

For Erin, that looks like this:

Operating Profit Margin = 2,750 / 9,000 = 0.31, or 31%

So, for every dollar she earns, Erin takes home $0.31, after taking EBITDA into account.

Typically, it’s the operating profit margin that you’ll focus on increasing in order to earn more profit. Interest and tax expenses aren’t usually something you can control. After all, Congress sets tax rates and interest rates are set by lenders. But EBITDA is determined by your own day-to-day operations—so your operating profit margin is the ratio you have the greatest control over.

  • Net profit margin

The net profit margin is the relationship of your bottom line to your sales revenue; it’s the total amount you keep after taking every expense into account.

You calculate your net profit margin like this:

Net Profit Margin = Net Income / Sales Revenue

Net Profit Margin = 1,850 / 9,000 = 0.21, or 21%

So, for every dollar she earns, Erin takes home $0.21.

How to read a cash flow statement

Not every small business uses cash flow statements . But if you use the accrual method of accounting, a statement of cash flows is essential for measuring your financial health.

With the accrual method, expenses and income are recorded on the books when they’re incurred, not when the money actually changes hands. For instance, you may place a $1,000 order to a vendor; in that case, you’d immediately record it as a $1,000 expense—even if you won’t send money to the vendor until later, after you get an invoice.

Similarly, you may invoice a client $1,000, and record that as $1,000 accounts receivable, an asset. But you don’t actually have the money on hand yet—so, if you were to try and use it for a $1,000 purchase, the money wouldn’t be there.

A cash flow statement reverses those transactions where you don’t actually have cash on hand, so you get a real idea of how much cash you have to work with during a period of time.

Example cash flow statement

suraya-cash-flow-statement

Parts of a cash flow statement

Keep in mind that numbers in brackets are subtractions of cash—you can read them as negative numbers. Numbers without brackets are additions.

Cash, beginning of period is the cash Suraya had on hand at the beginning of the month.

Net income is her total income for the month. Some or all of that income may be subtracted on the cash flow statement, depending how much of it is in accounts receivable (not paid) or in the bank (paid).

Additions to cash reverse expenses that are listed on the books, but haven’t been paid out yet. For instance, the $500 in accounts payable is money Suraya owes, but hasn’t paid. And the $200 depreciation is symbolic, for accounting purchases—she already paid out that $200 as part of the total cost of the asset she’s depreciating.

Subtractions from cash reverse any transactions that were recorded as revenue for the month, but not actually received. In this case, it’s $1,000 in accounts receivable.

Suraya’s net cash from operating activities is $700, meaning $700 cash came into her business during the month.

Cash flow from investing activities covers assets like real estate, equipment, or securities. Suraya bought a $500 sewing machine this month—an investment. This is recorded on the books as a $500 increase to her equipment account. However, she spent $500 cash to get it—meaning, the total cost needs to be subtracted.

Cash flow from financing activities lists money earned collecting interest on loans, credit, and other debt. It can also include draws or additional capital contributions from the business owner.

Cash flow for month ending March 31, 2020 is $200. That’s Suraya’s total cash flow from operations ($700) minus the cash she spent on equipment ($500). In total, she had $200 cash come into her business this month.

Cash at end of period is $2,200—her starting cash amount, plus the money she earned this month.

Analyzing a cash flow statement with financial ratios

Financial ratios for cash flow can tell you how much cash you have on hand to cover debt, as well as how much of your income you earned during the month was in the form of cash. Here are three formulas to help you do that.

  • Current liability coverage ratio

The current liability coverage ratio tells you how much cash flow you have for a specific period versus how much debt you need to pay in the near future—typically, within one year’s time.

To use this formula, you need to calculate your current average liability. Your current liability can change month to month as you pay down the principle on a debt; calculating an average takes that into account, so you can get a ballpark figure.

Do that by taking all your current liabilities at the beginning of an accounting period, all your current liabilities at the end of a period, adding them together and dividing by 2.

Let’s say Suraya’s balance sheet shows total current liabilities of $1,000 at the beginning of March, and $900 at the end.

(1,000 + 900) / 2 = 950

So, her current average liability is $950.

Here’s the formula for calculating your current average liability ratio:

Current Average Liability Ratio =

Net Cash from Operating Activities / Average Current Liabilities

For Suraya, that would look like this:

Current Average Liability Ratio = 200 / 950 = 0.21, or 21%

A current liability coverage ratio of less than 1:1 shows the business isn’t generating enough cash to pay for its immediate obligations… In this case, Suraya’s business has room for improvement.

  • Cash flow coverage ratio

Similar to the current liability coverage ratio, the cash flow coverage ratio measures how well you’re able to pay off debt with cash. However, this ratio takes into account all debt, both long term and short term.

It’s important for bringing on investors, getting a loan, or selling your company—a good cash flow coverage ratio shows your business is financially healthy and able to cover its debts.

Cash flow coverage is calculated on a large scale—yearly, rather than monthly. So, Suraya would add up operating cash flow from all her monthly cash flow statements for the year in order to get her annual cash flow.

For the sake of simplicity, we’ll say Suraya’s cash flow from operations was exactly $700 every month. So her total cash flow for the year is $8,400.

The formula looks like this:

Cash Flow Coverage Ratio = Net Cash Flow from Operations / Total Debt

Let’s say that, in addition to $1,200 credit card debt, Suraya has $5,000 left on a loan she took out to start her business. That’s $6,200 total debt.

For her, the equation would be:

8,400 / 6,200 = 1.35

Generally, experts recommend you keep your cash flow coverage ratio above 1.0 to attract investors.

  • Cash flow margin ratio

The cash flow margin ratio tells you how much cash you earned for every dollar in sales for a reporting period.

You calculate the cash flow margin ratio with this formula:

Cash Flow Margin = Net Cash from Operating Activities / Net Sales

Let’s say Suraya made $1,200 net sales for the month of March. Her cash flow margin ratio would look like this:

700 / 1,200 = 0.58, or 58%.

So, for every dollar Suraya earned in sales revenue during March, she got $0.58 in cash.

Further reading: Financial Statements 101

  • Owner’s Equity: What It Is and How to Calculate It
  • How to Calculate and Use Year-Over-Year (YOY) Growth
  • What Are Liabilities in Accounting? (With Examples)
  • What is a Chart of Accounts? A How-To with Examples
  • Owner’s Draw vs. Salary: How to Pay Yourself
  • How to Calculate Net Income (Formula and Examples)
  • Cash Flow Statement: Explanation and Example
  • The Best Apps for Managing Receipts [2023]

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Financial Statement Analysis

True Tamplin, BSc, CEPF®

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

Fact Checked

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Table of Contents

What is financial statement analysis.

Financial statement analysis is one of the most fundamental practices in financial research and analysis.

In layman’s terms, it is the process of analyzing financial statements so that decision-makers have access to the right data.

Financial statement analysis is also used to take the pulse of a business. Since statements center on a company’s key financial details, they are useful for evaluating activities.

This is essential to understanding the firm’s overall performance.

What Are Financial Statements?

According to the American Institute of Public Accounts, financial statements are prepared for the following purposes:

  • Presenting a periodical review or report on the progress made by the management
  • Dealing with the status of investments in the business and the results achieved during the period under review

Financial statements reflect a combination of recorded facts, accounting conventions, and personal judgments.

The judgments and conventions that are applied are dependent on the competence and integrity of those who make them and on their adherence to generally accepted accounting principles (GAAP) and conventions.

Public companies are forced to keep track of their financial statements in very specific ways through a balance sheet, income statement, and cash flow statement.

However, private companies often underestimate the importance of these statements because they are not required to keep track of them. It’s not that they don’t create them, but they typically don’t use them to their full benefit.

Let’s consider the following important financial documents:

  • Balance Sheet: Details a company’s value based on its assets , liabilities , and shareholder equity . We can learn a lot about the efficiency of a business’s operations from its short-term cash flow and accounts receivable.
  • Income Statement: An income statement breaks down a company’s earnings by comparing expenses and revenue . It is broken down into separate categories that businesses can use to help them identify profitable areas.
  • Cash Flow Statement : This report shows a company’s cash flow in terms of operational activities, financial ventures, and investments .

Tools and Techniques Used For Financial Statement Analysis

Financial statement analysis is centered on the balance sheet, income statement, and cash flow statement. It is the best way to gauge the overall health of a business.

There are several tools and techniques with which this is done, including:

  • Fundamental Analysis: This analytical practice is used on a company’s most basic financial levels. It shows the health of the business on a financial level and helps provide insight into the overall value.
  • DuPont Analysis: This tool is used to help companies prevent conclusions that are misleading. Sometimes, looking at sheer profitability doesn’t tell the whole story, so DuPont Analysis is used to create a detailed assessment.
  • Horizontal Analysis: Here, we compare financial ratios, a specified benchmark, and a specified line item over a specific period. This allows firms to examine changes that have been made and compare them with other behaviors.
  • Vertical Analysis: This financial analytical practice shows items within the financial statement as a percentage of the base figure. It’s simple, so it’s the method that most businesses prefer.

Value of Financial Statement Analysis When Analyzing and Reporting Financial Statements

Now that we’ve gone over some of the basics, let’s dive deeper into financial research and analysis. Here’s what makes financial statement analysis such a powerful tool.

Identifying the Industry’s Economic Characteristics

Financial statement analysis can identify several important factors in a business’s marketplace, sometimes finding smaller niches that are other methods miss.

We can use financial statement analysis to determine market size, compare competitors , and investigate the growth rate of a market as it relates to a variable such as spending.

It’s also possible to look beyond your own company and find out how others are faring in new markets before you decide to invest in them.

Another powerful tool that a lot of brands are using is product differentiation analysis. This method crunches financial numbers to see how well a brand’s products and prices are holding up against others in the same market.

There are several factors at play here, including distribution, purchasing, and advertising costs .

Identifying Company Strategies

All entrepreneurs understand the importance of finding the right strategy to meet the needs of their business. They spend a lot of time searching for the perfect one.

When you break it all down, the blueprint is usually the same, whether it’s developing a business plan or developing advanced strategies. That blueprint is defined by data.

The only difference between the two is that a business strategy is focused more on the future and the development of the business.

Once a strategy is established, then it has to be measured. The only true way to get accurate results is to compare financials.

Most strategies evolve, and financial analysis helps steer us in the right direction. For example, a detailed financial statement analysis will reveal the direction your company is moving. It will be the first indicator if growth is not where you want it to be.

Assessing the Quality of a Company’s Financial Statements

All businesses must have a method of efficiently analyzing their financial statements. This process requires three key points of understanding that must always be accounted for.

These can all be found through a sound financial statement analysis.

  • Businesses must identify the economic characteristics of their industry and compare their finances to the average.
  • Companies must be able to identify which strategies are profitable and which are not.
  • Businesses must be able to gauge the quality of their financial statements.

Inaccurate financial statements are common in small businesses. If left unchecked, this will lead down a path of ruin.

Financial research and analysis are the best way to ensure that these valuable reports are steering your growth in the right direction.

Analyzing Profitability and Identifying Potential Business Risks

Every business strategy has risks, and the majority of those risks are felt on a financial level. Therefore, it’s important for businesses to devise ways to identify and mitigate these risks.

While it’s not possible to avoid every risk, we can identify them before they cause too much damage. This is done by keeping a close eye on profitability.

Noteworthily, then, financial statement analysis helps you to keep track of profitability ratios, enabling you to truly measure the overall value of a strategy moving forward.

Preparing Financial Statement Forecasts

Forecasts are how companies predict the direction in which their business is heading. These forecasts need to be aligned with the company’s overall goals.

Income , cash flow, and balance sheets must all be closely monitored to ensure that they are aligned with the organization’s overall growth objectives.

Financial statement analysis is the practice that the world’s leading businesses engage in to stay ahead of their competitors.

Financial Statement Analysis FAQs

What is financial statement analysis.

Financial Statement Analysis is the process of analyzing a company’s financial statements and using this information to gauge its performance over time, assess its current condition, and make predictions about future performance.

Why is Financial Statement Analysis important?

Financial Statement Analysis is an essential tool for investors and financial professionals as it can help them better understand a company’s financial health and improve their decision-making processes when making investments or loan decisions.

What types of Financial Statements are analyzed?

The three main financial statements used in Financial Statement Analysis are the Balance Sheet, Income Statement, and Cash Flow statement.

What analysis techniques are used to review Financial Statements?

Common analysis techniques used in Financial Statement Analysis include trend analysis, vertical and horizontal analyses, ratio analysis, and cash flow statement analysis.

What information can be gathered through Financial Statement Analysis?

Financial Statement Analysis can provide insights into a company’s financial position, performance over time, liquidity and solvency, profitability, the efficiency of operations, and more. It can also be used to assess the quality of accounting practices and risk levels.

accounting analysis of financial statements

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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accounting analysis of financial statements

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Chapter 12: Financial Statement Analysis

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  • Page ID 98050

  • Henry Dauderis and David Annand
  • Athabasca University via Lyryx Learning

Learning Objectives

  • LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.
  • LO2 – Describe horizontal and vertical trend analysis, and explain how they are used to analyze financial statements.

Financial statements can be used by shareholders, creditors, and other interested parties to analyze a corporation's liquidity, profitability, and financial structure compared to prior years and other similar companies. As part of this analysis, financial evaluation tools are used. Some of these tools are discussed in this chapter.

  • 12.1: Introduction to Ratio Analysis
  • 12.2: Liquidity Ratios- Analyzing Short-term Cash Needs
  • 12.3: Profitability Ratios- Analyzing Operating Activities
  • 12.4: Leverage Ratios - Analyzing Financial Structure
  • 12.5: Market Ratios- Analysis of Financial Returns to Investors
  • 12.6: Overall Analysis of Big Dog's Financial Statements
  • 12.7: Horizontal and Vertical Trend Analysis
  • 12.8: Summary of Chapter 12 Learning Objectives
  • 12.9: Exercises

Concept Self-Check

Use the following as a self-check while working through Chapter 12.

  • What is working capital?
  • What is meant by liquidity?
  • What are some ratios commonly used to evaluate liquidity?
  • What is a company's revenue operating cycle and how is it measured?
  • What profitability ratios can be used to evaluate a corporation?
  • How is the amount of shareholder claims against a corporation's assets compared to the amount of creditor claims?
  • What are the relative advantages of short-term and long-term debt?
  • What are some measures used to evaluate the future financial prospects of a company for investors?
  • What is a horizontal analysis? How does it differ from a vertical analysis?
  • What is a common-size analysis?

NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.

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Home » Explanations » Financial statement analysis » What is financial statement analysis?

What is financial statement analysis?

Definition and explanation, techniques of financial statement analysis.

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Financial statement analysis is a function that involves the evaluation of reported financial statements of an entity, to aid stakeholders and users of those statements in their decision making. It seeks to establish relationships between various financial parameters so as to gain a better understanding of the entity’s financial health and performance. Financial statement analysis benefits both internal stakeholders (like management and existing shareholders) as well as external stakeholders (like potential investors, lenders and suppliers).

Financial statements typically include income statement , cash and fund flow statements and balance sheet . They record detailed financial transactions of the entity for a specific time period and thus reveal both financial performance and financial position of its business. A further analysis of these financial statements facilitates stakeholders with a lot of information which works as a key in their decision making process.

On the part of management, financial statement analysis reveals and identify areas of the organization that call for corrective actions, from investors’ perspective, it is a tool for gauging financial outlook and deciding upon the viability of their investment in the entity, and for vendors and suppliers, it helps dig into the entity’s creditworthiness and guides them in deciding whether or not they should consider providing goods and/or services to the entity on credit.

While there are several techniques of financial statement analysis, the three most widely used techniques are briefly discussed below:

1. Horizontal analysis

Horizontal analysis involves evaluation of financial statements on a historical basis. Under this technique, financial data is compared across time periods. For example, the progression of sales is evaluated over the years to evaluate the sales growth rate of the entity.

Horizontal analysis uses a base period and one or more comparison periods. The result of this analysis is generally expressed as a percentage with reference to the specified base period. The formula used to calculate percentages in a horizontal analysis is given below:

accounting analysis of financial statements

To understand the practical working of horizontal analysis, click here .

Benefits of horizontal analysis technique:

This technique of financial statement analysis offers the following advantages:

  • Horizontal analysis helps identify and analyze trends and patterns in entity’s financial performance.
  • By analyzing the progression of various financial parameters over the years, it helps in identifying areas of the strengths and weaknesses in the entity’s financial operations. For example, management can analyze the growth in entity’s profitability in relation to the growth in sales revenue over the years which may reveal actions needed to be taken towards cost control.
  • This analysis provides a basis for estimating the entity’s future performance as well as assists in setting benchmarks or standards for forthcoming years.

Drawbacks of horizontal analysis technique:

Horizontal analysis technique also suffers from certain drawbacks; such as:

  • It only compares relative financial performance without considering performance in absolute terms.
  • Under this type of analysis, a change in classification of reported accounts can lead to misleading results.
  • It can be manipulated to indicate desired but misleading results; for example, a comparison of line items amongst different quarters of the same year can lead to significantly different results when compared to the same quarter of different years.

2. Vertical analysis

As the name suggests, vertical analysis involves the assessment of various line items of a financial statement as a percentage of a specific base line item. For example, various expenses on an income statement are expressed as a percentage of sales and the share of each type of asset is expressed as a percentage of total assets. The percentages under a vertical analysis are derived by the following formula:

accounting analysis of financial statements

To understand the practical working of vertical analysis, click here .

Benefits of vertical analysis technique:

  • It is an easy representation of relationship between various line items of the financial statement.
  • It helps understand the relative share of each line item. For example, if direct material is a significant percentage of sales in relation to say, direct labor , the management can understand its impact on profitability and can thus focus a greater attention towards any possibility of reducing or controlling it.
  • Since a vertical analysis converts absolute numbers to percentage terms, It can be employed for inter-firm comparison with other entities within the industry by equating companies of different scales.
  • It helps in identifying trends to aid comparison over time periods.

Drawbacks of vertical analysis technique:

  • It requires a standard benchmark percentage defined for the analysis to be meaningful and to actually assist in decision making. For example, a company may know that its marketing expenses are 10% of its sales; however without a defined standard percentage, it may not be able to decide on the reasonableness of this derived percentage.
  • Need for consistency in base – for an appropriate comparison from year to year or company to company, the base used for comparison must be the same.

3. Ratio analysis

Ratio analysis involves evaluating relationship between various line items of financial statements like income statement and balance sheet. This is done by calculating various financial ratios and comparing them with some set standards. On the basis of this comparison, management can take corrective steps and other stakeholders can make informed decisions according to their specific situations.

The ratios that are derived to perform a financial statement analysis are typically categorized as follows:

  • Liquidity ratios: measure an entity’s ability to service its near-term debts as well as to meet its near-term fund requirements. A typical set of liquidity ratios includes current ratio , quick or liquid ratio, absolute liquid ratio , and current cash debt coverage ratio etc.
  • Solvency ratios: measure the long-term stability of a business entity by evaluating its ability to meet its fund requirements over a long period of time. These typically include debt to equity ratio , fixed assets to equity ratio , current assets to equity ratio , and capital gearing ratio etc.
  • Profitability ratios: measure the ability of a commercial entity to generate profits for its stockholders or owners. These ratios can include gross and net profit ratio , P/E ratio, EPS ratio , and return on capital employed ratio etc.
  • Activity ratios: measure the efficiency of a business entity to utilize or convert its assets into sales revenue or liquid funds. These ratios can include inventory turnover ratio , receivables turnover ratio , and fixed assets turnover ratio etc.

Benefits of ratios analysis technique:

  • Ratios analysis indicates an entity’s financial health as well as its operational efficiency through various parameters (e.g., liquidity and solvency) which other analysis techniques may not address.
  • This analysis indicates the entity’s current position and any necessary remedial actions that it needs to take. It, thus, helps management in financial activity planning of the entity.
  • Ratios analysis provides a standard for inter-firm comparison.

Drawbacks of ratios analysis technique:

  • Ratios analysis can give erroneous results if there is a difference in accounting presentation of different entities compared or different periods considered in the analysis.
  • Its results are often limited to quantitative analysis only, and not qualitative analysis. For example, balance sheet may exhibit a healthy current ratio but will not reveal the level of obsolescence present in the inventory considered in the calculation.

Purpose of financial statement analysis

Financial statement analysis has considerable utility for all stakeholders of an entity. Some of its salient purposes are mentioned below:

  • The primary purpose: The primary purpose of performing a financial statement analysis is to dig into financial health as well as operational efficiency of the entity through its various analysis techniques.
  • Aids industry comparison: It helps stakeholders gauge where the entity’s financial performance stands as compared to its peers in the industry. This is possible even when other entities operate at materially different scales.
  • Aids historical comparison: It helps identify trends in financial performance as well as understand the financial progression of the entity over the years.
  • Forecasting and budgeting: The interpretation of financial statement analysis can help management take budgeting decisions. Stakeholders can also estimate and project future performance based on results of financial analysis.
  • Basis for decision making: The ultimate goal of the analysis is to provide stakeholders with a means to evaluate financial performance giving them a basis for comprehensive decision making.

Limitations of financial statement analysis

While financial statement analysis is an important and useful exercise, it does suffer from certain limitations. These can include:

  • High dependency on accuracy of financial statements: A financial statement analysis can be inaccurate and in fact can even be manipulated if the base financial statements are inaccurate.
  • Change in accounting policies: Any change in accounting methodology or presentation can result in erroneous results, hampering the efficacy of inter-period or inter-firm comparison.
  • Focus on quantitative analysis: While exercising a financial statement analysis, the primary focus is on quantitative data. The non-monetary and qualitative aspects that impact financial performance are often side-lined under.
  • Only a tool not a solution: The analysis of financial statements is only a means to an end. The actual success of the analysis requires expert analysts to meaningfully interpret, analyze and then take appropriate and timely decisions about the matters involved.

All in all, financial statement analysis is an extremely vital function as it has utility for both internal and external stakeholders. Generally, a large part of this financial analysis is presented in annual reports along with the reported financial statements. This is done so that the information is easily accessible by all stakeholders. However, a leader is only as good as his team; thus for financial statement analysis to be meaningful, the financial statements themselves must be accurate and the interpretations applied must be meaningful.

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Introduction to Financial Analysis

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Kenneth S. Bigel, New York City, New York

Copyright Year: 2022

Publisher: Open Touro

Language: English

Formats Available

Conditions of use.

Attribution

Table of Contents

  • About the Author
  • Author's Acknowledgements
  • Open Touro Acknowledgements
  • Chapter 1: Introduction
  • Chapter 2: Financial Statement Analysis: The Balance Sheet
  • Chapter 3: Financial Statements Analysis: The Income Statement
  • Chapter 4: Financial Statements and Finance
  • Chapter 5: Financial Ratios and Forecasting; Liquidity and Solvency Ratios
  • Chapter 6: Profitability and Return Ratios, and Turnover
  • Chapter 7: Market Ratios
  • Chapter 8: Cash Flow, Depreciation, and Financial Projections
  • Chapter 9: Corporate Forecasting Models
  • Chapter 10: The Time Value of Money: Simple Present- and Future-Values
  • Chapter 11: The Time Value of Money: Annuities, Perpetuities, and Mortgages
  • Chapter 12: Fixed Income Valuation
  • Chapter 13:  Interest Rates
  • Chapter 14: Equity Valuation and Return Measurement

Ancillary Material

About the book.

This Open Textbook is a dynamic guide incorporating the essential skills needed to build a foundation in  Financial Analysis . Students and readers will learn how to insightfully read a Financial Statement, utilize key financial ratios in order to derive forward-looking investment-related inferences from the accounting data, engage in elementary forecasting and modeling, master the theory of the  Time Value of Money , and learn to price stocks and bonds in an environment in which interest rates constantly change. Ample problems and solutions, and review questions are provided to the student so that s/he can gauge his/her progress. This text will be continually updated in order to provide novel information and enhance students’ experiences.  

About the Contributors

Dr. Bigel was formerly a fixed income analyst in the International Banking Department of the Bankers Trust Company (now DeutscheBank), analyzing international wholesale loans and debt instruments, and a graduate of its Institutional Credit Training Program. He later was affiliated with the Ford Motor Company, conducting investment analysis and planned car profits analysis, annual budgeting, and strategic planning. Subsequently, he worked as a senior portfolio manager attached to the wealth management division of Prudential Securities. He was formerly registered under Series 3, 7, 15, 24, 63, and 65.

As an independent consultant, he was involved in numerous high-profile cases including Enron. Dr. Bigel has conducted executive education programs for Morgan Stanley Capital Markets, Merrill Lynch Capital Markets, UBS, Lehman Brothers, CIBC, G.X. Clarke & Co. (now part of Goldman Sachs), and China CITIC Bank. He currently serves on the Financial Industry Regulatory Association’s Board of Arbitrators.

His extensive published research relates to Financial Ethics and Moral Development, Behavioral Finance, and Political Economy. He has been teaching college and graduate level finance courses since 1989.

Dr. Bigel has been interviewed on American radio, was a visiting scholar at Sichuan University and at Xi’an Jiaotong University in China, and appeared on Chinese television. At Touro University, he is a member of the Faculty Senate, The Touro Academy of Leadership and Management, The Assessments Committee, and The Promotions Committee. He chairs the Integrity Committee at LCM.

His wife and their three children reside in New York City. He enjoys reading, playing 60’s guitar, seeing his students succeed professionally, and watching his kids grow.

Educational Background:

  • Ph.D., (high honors) New York University, Steinhardt School of Culture, Education, and Human Development (Business Education and Financial Ethics)
  • M.B.A., New York University, Stern School of Business (Finance)
  • B.A. (honors), Brooklyn College of the City University of New York (Philosophy and Mathematics)
  • CFP™, International Board of Standards and Practices for Certified Financial Planners
  • Hebrew University of Jerusalem (one-year program)

Dr. Bigel welcomes questions and constructive suggestions. He can be reached at <[email protected]>.

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Module 15: Financial Statement Analysis

Why it matters: financial statement analysis.

A group of coworkers sitting around a table.

Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization and  to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques include horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical effects line items have on other parts of the business and also the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships.

What we will study in this module are indicators, similar to watching the dashboard on your car.  The speedometer gives you information, as does the temperature gauge and the gas gauge.  Even if the car seems to be running fine, a sudden spike in engine temperature could give you a heads up to coming trouble, and at the garage, a mechanic may run further diagnostics using more sophisticated tools.

What you’ll be learning to do in this Module is run diagnostics on companies using the financial statements.

  • Why It Matters: Financial Statement Analysis. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution
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  • Financial Statement Analysis: An Introduction

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accounting analysis of financial statements

Financial Statement Analysis is a method of reviewing and analyzing a company’s accounting reports (financial statements) in order to gauge its past, present or projected future performance. This process of reviewing the financial statements allows for better economic decision making.

Globally, publicly listed companies are required by law to file their financial statements with the relevant authorities. For example, publicly listed firms in America are required to submit their financial statements to the Securities and Exchange Commission (SEC). Firms are also obligated to provide their financial statements in the annual report that they share with their stakeholders. As financial statements are prepared in order to meet requirements, the second step in the process is to analyze them effectively so that future profitability and cash flows can be forecasted.

Therefore, the main purpose of financial statement analysis is to utilize information about the past performance of the company in order to predict how it will fare in the future. Another important purpose of the analysis of financial statements is to identify potential problem areas and troubleshoot those.

Financial Statement Analysis: An Introduction

© Shutterstock.com | samui

Here, we will look at 1) the users of financial statement analysis , 2) the methods of financial statement analysis , 3) key accounting reports (the balance sheet, income statement, and statement of cash flows) and how they are analyzed , 4) other financial statement information , and 5) problems with financial statement analysis .

USERS OF FINANCIAL STATEMENT ANALYSIS

There are different users of financial statement analysis. These can be classified into internal and external users. Internal users refer to the management of the company who analyzes financial statements in order to make decisions related to the operations of the company. On the other hand, external users do not necessarily belong to the company but still hold some sort of financial interest. These include owners, investors, creditors, government, employees, customers, and the general public. These users are elaborated on below:

1. Management

The managers of the company use their financial statement analysis to make intelligent decisions about their performance. For instance, they may gauge cost per distribution channel, or how much cash they have left, from their accounting reports and make decisions from these analysis results.

Small business owners need financial information from their operations to determine whether the business is profitable. It helps in making decisions like whether to continue operating the business, whether to improve business strategies or whether to give up on the business altogether.

3. Investors

People who have purchased stock or shares in a company need financial information to analyze the way the company is performing. They use financial statement analysis to determine what to do with their investments in the company. So depending on how the company is doing, they will either hold onto their stock, sell it or buy more.

4. Creditors

Creditors are interested in knowing if a company will be able to honor its payments as they become due. They use cash flow analysis of the company’s accounting records to measure the company’s liquidity , or its ability to make short-term payments.

5. Government

Governing and regulating bodies of the state look at financial statement analysis to determine how the economy is performing in general so they can plan their financial and industrial policies. Tax authorities also analyze a company’s statements to calculate the tax burden that the company has to pay.

6. Employees

Employees need to know if their employment is secure and if there is a possibility of a pay raise. They want to be abreast of their company’s profitability and stability. Employees may also be interested in knowing the company’s financial position to see whether there may be plans for expansion and hence, career prospects for them.

7. Customers

Customers need to know about the ability of the company to service its clients into the future. The need to know about the company’s stability of operations is heightened if the customer (i.e. a distributor or procurer of specialized products) is dependent wholly on the company for its supplies.

8. General Public

Anyone in the general public, like students, analysts and researchers, may be interested in using a company’s financial statement analysis. They may wish to evaluate the effects of the firm on the environment, or the economy or even the local community. For instance, if the company is running corporate social responsibility programs for improving the community, the public may want to be aware of the future operations of the company.

METHODS OF FINANCIAL STATEMENT ANALYSIS

There are two main methods of analyzing financial statements: horizontal or trend analysis, and vertical analysis. These are explained below along with the advantages and disadvantages of each method.

Horizontal Analysis

Horizontal analysis is the comparison of financial information of a company with historical financial information of the same company over a number of reporting periods. It could also be based on the ratios derived from the financial information over the same time span. The main purpose is to see if the numbers are high or low in comparison to past records, which may be used to investigate any causes for concern. For example, certain expenditures that are high currently, but were well under budget in previous years may cause the management to investigate the cause for the rise in costs; it may be due to switching suppliers or using better quality raw material.

This method of analysis is simply grouping together all information, sorting them by time period: weeks, months or years. The numbers in each period can also be shown as a percentage of the numbers expressed in the baseline (earliest/starting) year. The amount given to the baseline year is usually 100%. This analysis is also called dynamic analysis or trend analysis.

Advantages and Disadvantages of Horizontal Analysis

When the analysis is conducted for all financial statements at the same time, the complete impact of operational activities can be seen on the company’s financial condition during the period under review. This is a clear advantage of using horizontal analysis as the company can review its performance in comparison to the previous periods and gauge how it’s doing based on past results.

A disadvantage of horizontal analysis is that the aggregated information expressed in the financial statements may have changed over time and therefore will cause variances to creep up when account balances are compared across periods.

Horizontal analysis can also be used to misrepresent results. It can be manipulated to show comparisons across periods which would make the results appear stellar for the company. For instance, if the profits for this month are only compared with those of last month, they may appear outstanding but that may not be the case if compared with the same month the previous year. Using consistent comparison periods can address this problem.

Vertical Analysis

Vertical analysis is conducted on financial statements for a single time period only. Each item in the statement is shown as a base figure of another item in the statement, for a given time period, usually for year. Typically, this analysis means that every item on an income and loss statement is expressed as a percentage of gross sales, while every item on a balance sheet is expressed as a percentage of total assets held by the firm.

Vertical analysis is also called static analysis because it is carried out for a single time period.

Advantages and Disadvantages of Vertical Analysis

Vertical analysis only requires financial statements for a single reporting period. It is useful for inter-firm or inter-departmental comparisons of performance as one can see relative proportions of account balances, no matter the size of the business or department.

Because basic vertical analysis is constricted by using a single time period, it has the disadvantage of losing out on comparison across different time periods to gauge performance. This can be addressed by using it in conjunction with timeline analysis, which shows what changes have occurred in the financial accounts over time, such as a comparative analysis over a three-year period. For instance, if the cost of sales comes out to be only 30 percent of sales each year in the past, but this year the percentage comes out to be 45 percent, it would be a cause for concern.

KEY FINANCIAL STATEMENTS & HOW THEY ARE ANALYZED

The main types of financial statements are the balance sheet, the income statement and the statement of cash flows. These accounting reports are analyzed in order to aid economic decision-making of a firm and also to predict profitability and cash flows.

I. The Balance Sheet

PEF_D122_balance_sheet_for_the_year_ending_1893-12-31(1)

© Wikimedia Commons

The balance sheet shows the current financial position of the firm, at a given single point in time. It is also called the statement of financial position. The structure of the balance sheet is laid out such that on one side assets of the firm are listed, while on the other side liabilities and shareholders’ equity is shown. The two sides of the balance sheet must balance as follows:

Assets = Liabilities + Shareholders’ Equity

The main items on the balance sheet are explained below:

Current Assets

Current assets held by the firm refer to cash and cash equivalents. These cash equivalents are assets that can be easily converted into cash within one year. Current assets include marketable securities, inventory and accounts receivable.

Long-term Assets

Long-term assets are also called non-current assets and include fixed assets like plant, equipment and machinery, and property, etc.

A firm records depreciation of its fixed, long-term assets every year. It is not an actual expense of cash paid, but is only a reduction in the book value of the asset. The book value is calculated by subtracting the accumulated depreciation of prior years from the price of the assets.

Total Assets = Current Assets + Book Value of Long-Term Assets

Current Liabilities

Current liabilities of the firm are obligations that are due in less than one year. These include accounts payable, deferred expenses and also notes payable.

Long-term Liabilities

Long-term liabilities of the firm are financial payments or obligations due after one year. These include loans that the firm has to repay in more than a year, and also capital leases which the firm has to pay for in exchange for using a fixed asset.

Shareholders’ Equity

Shareholders’ equity is also known as the book value of equity or net worth of the firm. It is the difference between total assets owned by a firm and total liabilities outstanding. It is different from the market value of equity (stock market capitalization) which is calculated as follows: number of shares outstanding multiplied by the current share price.

Balance Sheet Analysis

The balance sheet is analyzed to obtain some key ratios that help explain the health of the firm at a given point in time. These metrics are as follows:

Debt-Equity Ratio = Total Debt / Total Equity

The debt-equity ratio is also called a leverage ratio. It is calculated to assess the leverage, or gearing, of a firm to show how much it relies on debt to finance its activities. This ratio has pertinent implications for the financial health of the firm and the risk and return of its shares.

Market-to-Book Ratio = Market Value of Equity / Book Value of Equity

The market-to-book ratio is used to reflect any changes in a firm’s characteristics. The variations in this ratio also show any value added by the management and its growth prospects.

Enterprise Value = Market Value of Equity + Debt – Cash

The enterprise value of a firm shows the underlying value of the business. It reflects the true value of the firm’s assets, not including any cash or cash equivalents, while unencumbered by the debt the firm carries.

II. The Income Statement

Microsoft_10-K_Fiscal_2010_Selected_Financial_Data - Income statement

© Wikimedia Commons | Microsoft

The purpose of an income statement is to report the revenues and expenditures of a firm over a specific period of time. It was previously also called a profit and loss account. The general structure of the income statement with major components is as follows:

Sales revenue

– Cost of goods sold (COGS)

= Gross profit

– Selling, general and administrative costs (SG&A)

– Research and development (R&D)

= Earnings before interest, taxes, depreciation and amortization (EBITDA)

– Depreciation and amortization

= Earnings before interest and taxes (EBIT)

– Interest expense

= Earnings before taxes (EBT)

= Net income

The net income on the income statement, if positive, shows that the company has made a profit. If the net income is negative, it means the company incurred a loss.

Earnings per share can be derived from knowing the total number of shares outstanding of the company:

Earnings per Share = Net Income / Shares Outstanding

Income statement Analysis

Some useful metrics based on the information provided in the income statement and the balance sheet are as follows:

Profitability Ratios:

1. Net profit margin: This ratio calculates the amount of profit that the company has earned after taxes and all expenses have been deducted from net sales.

Net profit Margin =Net Income / Net Sales

2. Return on Equity: This ratio is used to calculate company profit as a percentage of total equity.

Return on Equity = Net Income / Book Value of Equity

Valuation Ratios:

Price to earnings ratios (P/E ratio)

The P/E ratio is used to evaluate whether the value of a stock is proportional to the level of earnings it can generate for its stockholders. It assesses whether the stock is overvalued or undervalued.

(P/E) Ratio = Market Capitalization / Net Income = Share Price / Earnings per Share

III. The Statement of Cash Flows

The statement of cash flows shows explicitly the sources of the firm’s cash and where the cash is utilized. It is essentially a statement whereby the net income is adjusted for non-cash expenses and any changes to the net working capital. It also reflects changes in cash coming from, or being used by, investing and financing activities of the firm. The structure and main components of the cash flow statement are as follows:

Cash from operating activities = Net income + Depreciation ± Changes in net working capital

Cash from financing activities = New debt + New shares – Dividends – Shares repurchased

Cash from investment activities = Capital expenditure – Proceeds from sales of long-term assets

All three of the above determine the bottom line: changes in cash flows.

Cash Flows Statement Analysis

In order to measure how much cash is available to the company for investments without outside financing or money diverting from operations, it is useful to conduct a simple cash flow statement analysis. The free cash flow, as the name suggests, allows a company to be able to pay dividends, repay its debts, buy back its stock and also make new investments to facilitate future growth. The excess cash produced by the company, free cash flow, is calculated as follows:

+ Amortization/Depreciation

– Changes in Working Capital

– Capital Expenditures

= Free Cash Flow

Some analysts also study the cash flow from operating activities to see if the company is earning “quality” income. In order for the company to be doing extremely well, the cash from operating activities must be consistently greater than the net income earned by the company.

OTHER FINANCIAL STATEMENT INFORMATION

Apart from the key financial statements, complete financial reporting statements also include the following:

Business and Operating Review

The business and operating review is also called “management discussion and analysis”. It serves as a preface to all the complete reporting statements in which the management talks about recent events, discloses essential information regarding expansion and future plans, and discusses significant developments in the business industry.

The business and operating review is a good place for the company to share any good news with the general public. They have room to elaborate on plans that would help enhance the company’s image and address any unpleasant events that may have occurred, to show the customers that they truly care about talking openly to their customers.

Statement of Change in Shareholders’ Equity

The statement of change in shareholders’ equity is also known as equity analysis. It provides information about all the changes in the company’s equity value over a certain time period. It reconciles the opening balances of the equity accounts with the closing balances. There are two types of changes expressed in the statement of change in shareholders’ equity:

  • Changes arising from any transactions conducted with shareholders of the company. For example, issuing new shares, paying dividends, purchasing treasury stock, and issuing bonus shares, etc.
  • Changes that are a result of alterations in the comprehensive income of the company. These changes might include revaluation of fixed assets, net income for the period and fair value of for-sale investments, etc.

Notes to the Financial Statements

Notes to the financial statements are basically additional information provided in a company’s financial statements. These notes provide details and information that are left out of the main reporting documents. They are important for the sake of clarity on many points as they outline the accounting methodology used for recording certain transactions. The notes to the financial statements are essentially footnotes because if included in the main statements, they would obscure the important information, as they are generally quite elaborate and detailed.

The following notes are usually used to impart important disclosures for explaining the numbers on the financial statements:

  • Notes that show the basis for presentation
  • Notes that advise on significant accounting policies
  • Notes about valuing inventory
  • Notes about depreciating assets
  • Notes about intangible assets
  • Notes that disclose subsequent events
  • Notes about employee benefits
  • Notes that reveal contingency plans

PROBLEMS WITH FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is a brilliant tool to gauge the past performance of a company and predict future performance, but there are several issues that one should be aware of before using the financial statement analysis results blindly, as these issues can interfere with how the results are interpreted. Some of the issues are:

Comparability between Companies

This is a big issue for analysts because they can seemingly compare financial statement analyses between different companies on the basis of ratios used, but in reality it may not paint an accurate picture. The financial ratios of two different companies may be compared to see how they match up against each other, but each company may aggregate all their information different from each other in order to draw up their accounting statements. This may lead to incorrect conclusions drawn about a company in relation to other companies in the industry.

Comparability between Periods

The change in accounts where financial information is stored may skew the results of the financial statement analysis, from one period to the next. For example, if a company records an expense in one period as cost of goods sold , while in another period, it is recorded as a selling and distribution expense, the analysis between those two periods would not be comparable.

Operational Information

Analysts do not take into account operational information of a company, as only financial information is analyzed and reviewed. There may be several indicators in operational information of the company which may be predictors of future performance, for example, the number of backlogged orders, any changes in licenses or warranty claims submitted to the company or even changes in the culture and work environment. Therefore, analysis of financial information may only relay half the story.

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What Is Ratio Analysis?

  • What Does It Tell You?
  • Application

The Bottom Line

  • Corporate Finance
  • Financial Ratios

Financial Ratio Analysis: Definition, Types, Examples, and How to Use

accounting analysis of financial statements

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis .

Key Takeaways

  • Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
  • Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
  • Ratio analysis may also be required by external parties that set benchmarks often tied to risk.
  • While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company's financial health.
  • Examples of ratio analysis include current ratio, gross profit margin ratio, inventory turnover ratio.

Investopedia / Theresa Chiechi

What Does Ratio Analysis Tell You?

Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can also compare a company's financial standing with industry averages while measuring how a company stacks up against others within the same sector.

Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a company's financial statements.

Ratios are comparison points for companies. They evaluate stocks within an industry. Likewise, they measure a company today against its historical numbers. In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make it's stock and company ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red flags.

A ratio is the relation between two amounts showing the number of times one value contains or is contained within the other.

Types of Ratio Analysis

The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:

1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of profitability ratios .

4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.

5. Coverage Ratios

Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio .

6. Market Prospect Ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield , P/E ratio , earnings per share (EPS), and dividend payout ratio . Investors use these metrics to predict earnings and future performance.

For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.

Most ratio analysis is only used for internal decision making. Though some benchmarks are set externally (discussed below), ratio analysis is often not a required aspect of budgeting or planning.

Application of Ratio Analysis

The fundamental basis of ratio analysis is to compare multiple figures and derive a calculated value. By itself, that value may hold little to no value. Instead, ratio analysis must often be applied to a comparable to determine whether or a company's financial health is strong, weak, improving, or deteriorating.

Ratio Analysis Over Time

A company can perform ratio analysis over time to get a better understanding of the trajectory of its company. Instead of being focused on where it is today, the company is more interested n how the company has performed over time, what changes have worked, and what risks still exist looking to the future. Performing ratio analysis is a central part in forming long-term decisions and strategic planning .

To perform ratio analysis over time, a company selects a single financial ratio, then calculates that ratio on a fixed cadence (i.e. calculating its quick ratio every month). Be mindful of seasonality and how temporarily fluctuations in account balances may impact month-over-month ratio calculations. Then, a company analyzes how the ratio has changed over time (whether it is improving, the rate at which it is changing, and whether the company wanted the ratio to change over time).

Ratio Analysis Across Companies

Imagine a company with a 10% gross profit margin. A company may be thrilled with this financial ratio until it learns that every competitor is achieving a gross profit margin of 25%. Ratio analysis is incredibly useful for a company to better stand how its performance compares to similar companies.

To correctly implement ratio analysis to compare different companies, consider only analyzing similar companies within the same industry . In addition, be mindful how different capital structures and company sizes may impact a company's ability to be efficient. In addition, consider how companies with varying product lines (i.e. some technology companies may offer products as well as services, two different product lines with varying impacts to ratio analysis).

Different industries simply have different ratio expectations. A debt-equity ratio that might be normal for a utility company that can obtain low-cost debt might be deemed unsustainably high for a technology company that relies more heavily on private investor funding.

Ratio Analysis Against Benchmarks

Companies may set internal targets for their financial ratios. These calculations may hold current levels steady or strive for operational growth. For example, a company's existing current ratio may be 1.1; if the company wants to become more liquid, it may set the internal target of having a current ratio of 1.2 by the end of the fiscal year.

Benchmarks are also frequently implemented by external parties such lenders. Lending institutions often set requirements for financial health as part of covenants in loan documents. Covenants form part of the loan's terms and conditions and companies must maintain certain metrics or the loan may be recalled.

If these benchmarks are not met, an entire loan may be callable or a company may be faced with an adjusted higher rate of interest to compensation for this risk. An example of a benchmark set by a lender is often the debt service coverage ratio which measures a company's cash flow against it's debt balances.

Examples of Ratio Analysis in Use

Ratio analysis can predict a company's future performance — for better or worse. Successful companies generally boast solid ratios in all areas, where any sudden hint of weakness in one area may spark a significant stock sell-off. Let's look at a few simple examples

Net profit margin , often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It's calculated by dividing a company's net income by its revenues. Instead of dissecting financial statements to compare how profitable companies are, an investor can use this ratio instead. For example, suppose company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.

Using the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An average investor concludes that investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.

What Are the Types of Ratio Analysis?

Financial ratio analysis is often broken into six different types: profitability, solvency, liquidity, turnover, coverage, and market prospects ratios. Other non-financial metrics may be scattered across various departments and industries. For example, a marketing department may use a conversion click ratio to analyze customer capture.

What Are the Uses of Ratio Analysis?

Ratio analysis serves three main uses. First, ratio analysis can be performed to track changes to a company over time to better understand the trajectory of operations. Second, ratio analysis can be performed to compare results with other similar companies to see how the company is doing compared to competitors. Third, ratio analysis can be performed to strive for specific internally-set or externally-set benchmarks.

Why Is Ratio Analysis Important?

Ratio analysis is important because it may portray a more accurate representation of the state of operations for a company. Consider a company that made $1 billion of revenue last quarter. Though this seems ideal, the company might have had a negative gross profit margin, a decrease in liquidity ratio metrics, and lower earnings compared to equity than in prior periods. Static numbers on their own may not fully explain how a company is performing.

What Is an Example of Ratio Analysis?

Consider the inventory turnover ratio that measures how quickly a company converts inventory to a sale. A company can track its inventory turnover over a full calendar year to see how quickly it converted goods to cash each month. Then, a company can explore the reasons certain months lagged or why certain months exceeded expectations.

There is often an overwhelming amount of data and information useful for a company to make decisions. To make better use of their information, a company may compare several numbers together. This process called ratio analysis allows a company to gain better insights to how it is performing over time, against competition, and against internal goals. Ratio analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-financial data.

  • Valuing a Company: Business Valuation Defined With 6 Methods 1 of 37
  • What Is Valuation? 2 of 37
  • Valuation Analysis: Meaning, Examples and Use Cases 3 of 37
  • Financial Statements: List of Types and How to Read Them 4 of 37
  • Balance Sheet: Explanation, Components, and Examples 5 of 37
  • Cash Flow Statement: How to Read and Understand It 6 of 37
  • 6 Basic Financial Ratios and What They Reveal 7 of 37
  • 5 Must-Have Metrics for Value Investors 8 of 37
  • Earnings Per Share (EPS): What It Means and How to Calculate It 9 of 37
  • P/E Ratio Definition: Price-to-Earnings Ratio Formula and Examples 10 of 37
  • Price-to-Book (PB) Ratio: Meaning, Formula, and Example 11 of 37
  • Price/Earnings-to-Growth (PEG) Ratio: What It Is and the Formula 12 of 37
  • Fundamental Analysis: Principles, Types, and How to Use It 13 of 37
  • Absolute Value: Definition, Calculation Methods, Example 14 of 37
  • Relative Valuation Model: Definition, Steps, and Types of Models 15 of 37
  • Intrinsic Value of a Stock: What It Is and Formulas to Calculate It 16 of 37
  • Intrinsic Value vs. Current Market Value: What's the Difference? 17 of 37
  • The Comparables Approach to Equity Valuation 18 of 37
  • The 4 Basic Elements of Stock Value 19 of 37
  • How to Become Your Own Stock Analyst 20 of 37
  • Due Diligence in 10 Easy Steps 21 of 37
  • Determining the Value of a Preferred Stock 22 of 37
  • Qualitative Analysis 23 of 37
  • How to Choose the Best Stock Valuation Method 24 of 37
  • Bottom-Up Investing: Definition, Example, Vs. Top-Down 25 of 37
  • Financial Ratio Analysis: Definition, Types, Examples, and How to Use 26 of 37
  • What Book Value Means to Investors 27 of 37
  • Liquidation Value: Definition, What's Excluded, and Example 28 of 37
  • Market Capitalization: How Is It Calculated and What Does It Tell Investors? 29 of 37
  • Discounted Cash Flow (DCF) Explained With Formula and Examples 30 of 37
  • Enterprise Value (EV) Formula and What It Means 31 of 37
  • How to Use Enterprise Value to Compare Companies 32 of 37
  • How to Analyze Corporate Profit Margins 33 of 37
  • Return on Equity (ROE) Calculation and What It Means 34 of 37
  • Decoding DuPont Analysis 35 of 37
  • How to Value Private Companies 36 of 37
  • Valuing Startup Ventures 37 of 37

accounting analysis of financial statements

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3 Financial Statements to Measure a Company's Strength

accounting analysis of financial statements

When the stock market boomed in the 1920s, investors essentially had to fly blind in deciding which companies were sound investments because, at the time, most businesses had no legal obligation to reveal their finances. After the 1929 market crash, the government enacted legislation to help prevent a repeat disaster. To this day these reforms require publicly traded companies to regularly disclose certain details about their operations and financial position.

The income statement, balance sheet, and statement of cash flows are required financial statements. These three statements are informative tools that traders can use to analyze a  company's financial strength  and provide a quick picture of a company's financial health and underlying value.

This article will provide a quick overview of the information that you can glean from these important financial statements without requiring you to be an accounting expert.

Statement #1: The income statement

The income statement makes public the results of a company's business operations for a particular quarter or year. Through the income statement, you can witness the inflow of new assets into a business and measure the outflows incurred to produce revenue.

Profitability is measured by revenues (what a company is paid for the goods or services it provides) minus expenses (all the costs incurred to run the company) and taxes paid.

The income statement is read from top to bottom, starting with revenues, sometimes called the "top line." Expenses and costs are subtracted, followed by taxes. The end result is the company's net income—or profit—before paying any dividends. This is where the term "bottom line" comes from.

* YYZ Corp. is a hypothetical example used for illustrative purposes only.

As you can see in this example, net income for YYZ Corp. declined from $75 million to $50 million.

The next line in the income statement, after net income, displays the average number of common shares of the company's stock that are held by investors. Next comes the firm's earnings per share, which is calculated by dividing net income by the number of shares.

Finally, the last line shows the dividends declared per common share, which is the cash payment per share (if any) the company makes to stockholders. The amount of any dividend payment is at the discretion of the company's board of directors.

Statement #2: The balance sheet

While the income statement is a record of the funds flowing in and out of a company over a given time period, the consolidated balance sheet is a snapshot of a company's financial position at a given point in time. In other words, the balance sheet shows what a company owns (its assets) and owes (its liabilities) and the difference between the two (stockholders' equity). This difference represents the book value of the stockholders' stake in the company. It's called a balance sheet because both sides of the equation must balance: assets equal liabilities plus stockholders' equity.

The balance sheet displays:

  • The portion of those assets financed with debt (liability)
  • The portion of equity (retained earnings and stock shares)
  • Assets listed in order from most liquid to least liquid (in other words, assets that can be most quickly converted to cash are listed first)
  • Liabilities listed in order of immediacy (those that have the most senior claim on a firm's assets are listed first)

Balance sheet example for YYZ Corp. for the year ending Dec. 31, 2022 (in millions)

Chart showing the Balance sheet for the hypothetical YYZ Corp, showing their assets and liabilities and owners’ equity.

The amount by which assets exceed liabilities is listed as total shareholders' equity, and this represents the net worth of a company, or the book value of the stock. Shareholders' equity includes common stock, additional paid-in capital, and retained earnings.

Statement #3: The statement of cash flows

As with an income statement, the statement of cash flows reflects a company's financial activity over a period of time. It shows where a company's cash comes from and how it's used to pay for operations and/or to invest in the future. By showing how a company has managed the inflow and outflow of cash, the statement of cash flows may paint a more complete picture of a company's liquidity (the ability to pay bills and creditors and fund future growth) than the income statement or the balance sheet.

Statement of cash flows example for YYZ Corp. for the year ending Dec. 31, 2022 (in millions)

A chart showing an example Statement of cash flow for the hypothetical YYZ Corp.

Cash flow from operations

Income and expenses on the income statement are recorded when a company earns revenue or incurs expenses, not necessarily when cash is received or paid. Similarly, the depreciation of owned assets is added back to net income, as this expense is not a cash outflow.

Analysts often look to cash flow from operations   as the most important measure of performance, as it's the most transparent way to gauge the health of the underlying business. A decrease in cash flow due to a sharp increase in inventory or receivables can signal that a company is having trouble selling products or collecting money from customers.

Cash flow from investing and financing

Cash flow from investing includes cash received from or used for investing activities, such as buying stock in other companies or purchasing additional property or equipment. Cash flow from financing activities includes cash received from borrowing money or issuing stock, and cash spent to repay loans.

Measuring a company's financial strength

The stock price for a given company can advance or decline based on a wide variety of factors. However, companies that perform well financially by increasing their earnings, net worth and cash flow are typically rewarded with a higher stock price over time. When it comes to trading, knowledge is power. Even traders who generally rely on  technical  factors to make their trading decisions may benefit from learning to use standard financial statements to home in on companies that are experiencing strong or improving fundamentals.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk including loss of principal.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

Past performance is no guarantee of future results.

2 year ratio analysis comparison   Review the Statement of Income...

2 year ratio analysis comparison

  • Review the Statement of Income (the Income Statement or Profit & Loss Statement) and the Statement of Financial Position (or the Balance Sheet) of the annual report from the link: https://www.annualreports.com/HostedData/AnnualReports/PDF/TSX_FFH_2022.pdf
  • include a table with the name of the Ratio, the Equation, the calculation for the Current year, the calculation for the Previous year, and then a space allowing the team to interpret the trend from the results and the implications for the company.
  • Provide the formula and explanation for the following Liquidity Ratios (including Current Ratio and Quick Ratio),  Efficiency Ratios (including Inventory Turnover, Days Sales Inventory, Account Receivable Turnover, and Days Sales Outstanding),  Leverage Ratios (including Total Debt Ratio, and Debt to Equity Ratio),  Coverage Ratios (including Times Interest Earned and Cash Coverage), Profitability Ratios (including Gross Profit Margin, Net Profit Margin, Return on Assets, and Return on Equity), and finally Market Value Indicators (including EPS and EPR).   Look to show the calculations, whether the company is stronger (or in a better position) than the previous year.

Look to see if the improvement is due to the market moving, the company's superior management decision-making or both.  

Answer & Explanation

  • To conduct a ratio analysis for Fairfax Financial Holdings Limited for the years 2022 and 2021, we'll focus on various categories of ratios including Liquidity Ratios, Efficiency Ratios, Leverage Ratios, Coverage Ratios, Profitability Ratios, and Market Value Indicators. The formulas and calculations for each ratio are provided below along with an interpretation of the trend and implications for the company.
  •  Liquidity Ratios:
  • 1. **Current Ratio:**   - Formula: Current Ratio = Current Assets / Current Liabilities   - Calculation for 2022: $54,322.9M / $5,215.2M = 10.42   - Calculation for 2021: $51,697.4M / $4,985.4M = 10.38   - **Interpretation:** The current ratio has increased slightly from 10.38 in 2021 to 10.42 in 2022, indicating a slight improvement in short-term liquidity. The company is in a better position to cover its short-term obligations.
  • 2. **Quick Ratio:**   - Formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities   - Calculation for 2022: ($54,322.9M - $2,338.0M) / $5,215.2M = 10.07   - Calculation for 2021: ($51,697.4M - $2,405.9M) / $4,985.4M = 9.89   - **Interpretation:** The quick ratio has also improved, from 9.89 in 2021 to 10.07 in 2022. This indicates an enhancement in the company's ability to meet short-term obligations, excluding inventory.
  •  Efficiency Ratios:
  • 3. **Inventory Turnover:**   - Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory   - Calculation for 2022: Not provided in the data.   - Calculation for 2021: Not provided in the data.   - **Interpretation:** The absence of data prevents the calculation of inventory turnover. It would be helpful to have cost of goods sold information to assess inventory management.
  • 4. **Days Sales Inventory:**   - Formula: Days Sales Inventory = 365 / Inventory Turnover   - Calculation for 2022: Not applicable without inventory turnover.   - Calculation for 2021: Not applicable without inventory turnover.   - **Interpretation:** Unable to interpret without inventory turnover data.
  • 5. **Account Receivable Turnover:**   - Formula: AR Turnover = Net Sales / Average Accounts Receivable   - Calculation for 2022: Not provided in the data.   - Calculation for 2021: Not provided in the data.   - **Interpretation:** The absence of data prevents the calculation of accounts receivable turnover.
  • 6. **Days Sales Outstanding (DSO):**   - Formula: DSO = 365 / AR Turnover   - Calculation for 2022: Not applicable without AR turnover.   - Calculation for 2021: Not applicable without AR turnover.   - **Interpretation:** Unable to interpret without accounts receivable turnover data.
  • Leverage Ratios:
  • 7. **Total Debt Ratio:**   - Formula: Total Debt Ratio = (Total Assets - Total Equity) / Total Assets   - Calculation for 2022: ($92,125.1M - $20,335.8M) / $92,125.1M = 0.78   - Calculation for 2021: ($86,645.4M - $21,315.3M) / $86,645.4M = 0.75   - **Interpretation:** The total debt ratio has increased from 0.75 in 2021 to 0.78 in 2022, suggesting a higher proportion of assets financed by debt.
  • 8. **Debt to Equity Ratio:**   - Formula: Debt to Equity Ratio = Total Debt / Total Equity   - Calculation for 2022: $71,789.3M / $20,335.8M = 3.52   - Calculation for 2021: $65,330.1M / $21,315.3M = 3.06   - **Interpretation:** The debt to equity ratio has increased from 3.06 in 2021 to 3.52 in 2022, indicating higher financial leverage and potentially increased financial risk.
  •  Coverage Ratios:
  • 9. **Times Interest Earned:**   - Formula: Times Interest Earned = Earnings Before Interest and Taxes (EBIT) / Interest Expense   - Calculation for 2022: $4,392.6M / $452.8M = 9.71   - Calculation for 2021: $1,712.0M / $513.9M = 3.33   - **Interpretation:** The times interest earned ratio has significantly improved from 3.33 in 2021 to 9.71 in 2022. This suggests the company is in a better position to cover interest expenses.
  • 10. **Cash Coverage:**   - Formula: Cash Coverage = (EBIT + Depreciation) / Interest Expense   - Calculation for 2022: ($4,392.6M + $683.6M) / $452.8M = 11.37   - Calculation for 2021: ($1,712.0M + $930.4M) / $513.9M = 5.36   - **Interpretation:** The cash coverage ratio has also improved significantly from 5.36 in 2021 to 11.37 in 2022. This indicates a higher ability to cover interest expenses with operating cash flow.
  •  Profitability Ratios:
  • 11. **Gross Profit Margin:**   - Formula: Gross Profit Margin = (Net Sales - Cost of Goods Sold) / Net Sales   - Calculation for 2022: Not provided in the data.   - Calculation for 2021: Not provided in the data.   - **Interpretation:** The absence of data prevents the calculation of gross profit margin.
  • 12. **Net Profit Margin:**   - Formula: Net Profit Margin = Net Income / Net Sales   - Calculation for 2022: $1,286.8M / $28,050.0M = 4.58%   - Calculation for 2021: $3,666.6M / $26,467.9M = 13.81%   - **Interpretation:** The net profit margin has decreased from 13.81% in 2021 to 4.58% in 2022, indicating lower profitability as a percentage of sales.
  • 13. **Return on Assets (ROA):**   - Formula: ROA = Net Income / Average Total Assets   - Calculation for 2022: $1,286.8M / (($92,125.1M + $86,645.4M) / 2) = 1.46%   - Calculation for 2021: $3,666.6M / (($86,645.4M + $92,125.
  • 1M) / 2) = 4.24%   - **Interpretation:** The return on assets has decreased from 4.24% in 2021 to 1.46% in 2022, indicating a lower return on the company's assets.
  • 14. **Return on Equity (ROE):**   - Formula: ROE = Net Income / Average Shareholders' Equity   - Calculation for 2022: $1,286.8M / (($16,676.2M + $20,335.8M) / 2) = 6.48%   - Calculation for 2021: $3,666.6M / (($16,385.1M + $21,315.3M) / 2) = 17.55%   - **Interpretation:** The return on equity has decreased from 17.55% in 2021 to 6.48% in 2022, indicating a lower return on shareholders' equity.
  • ### Market Value Indicators:
  • 15. **Earnings Per Share (EPS):**   - Formula: EPS = Net Income / Weighted Average Shares Outstanding   - Calculation for 2022: $1,286.8M / 23,638,000 shares = $54.40   - Calculation for 2021: $3,666.6M / 25,953,000 shares = $141.09   - **Interpretation:** The EPS has decreased from $141.09 in 2021 to $54.40 in 2022, indicating a lower earning per share.
  • 16. **Earnings Price Ratio (EPR):**   - Formula: EPR = EPS / Market Price Per Share   - Calculation for 2022: Not provided in the data.   - Calculation for 2021: Not provided in the data.   - **Interpretation:** The absence of market price per share data prevents the calculation of EPR.
  • Overall Interpretation:
  • - **Liquidity:** The company has slightly improved its liquidity position, as indicated by higher current and quick ratios.   - **Efficiency:** Lack of data on inventory turnover and accounts receivable turnover makes it challenging to assess efficiency in managing these assets.
  • - **Leverage:** The company has taken on more debt as evidenced by higher total debt ratios and debt to equity ratios.
  • - **Coverage:** The company has significantly improved its ability to cover interest expenses, indicating a better financial position.
  • - **Profitability:** The company's profitability has decreased, as evidenced by lower net profit margins, return on assets, and return on equity.
  • - **Market Value:** The earnings per share and earnings price ratio indicate a decrease in market value compared to the previous year.
  • Factors Influencing Changes:
  • - The increase in leverage may be a strategic decision to fund expansion or acquisitions, potentially impacting profitability ratios.   - Improved interest coverage suggests the company is effectively managing its debt obligations.
  • - Decrease in profitability could be influenced by various factors such as changes in market conditions or management decisions.
  • - Market value indicators are also influenced by external factors like market sentiment and overall economic conditions.
  • It is important to note that a comprehensive analysis would require more detailed financial information, industry benchmarks, and qualitative factors to provide a more accurate assessment of Fairfax Financial Holdings Limited's financial health and performance.
  • Fairfax Financial Holdings Limited: A Comprehensive Analysis of Financial Ratios and Performance
  • Fairfax Financial Holdings Limited, a global holding company engaged in insurance, reinsurance, and investment management, has released its Consolidated Financial Statements for the years ended December 31, 2022, and December 31, 2021. In this analysis, we delve into the financial ratios, examining key aspects such as Liquidity, Efficiency, Leverage, Coverage, Profitability, and Market Value Indicators, aiming to provide a comprehensive understanding of the company's financial health and performance.
  • Liquidity Ratios: 1. Current Ratio and 2. Quick Ratio: Fairfax Financial Holdings has shown a marginal improvement in both current and quick ratios. The current ratio has increased from 10.38 in 2021 to 10.42 in 2022, and the quick ratio has improved from 9.89 to 10.07. This suggests the company is in a better position to cover its short-term obligations. The slight uptick indicates improved liquidity, which can be attributed to efficient management of current assets.
  • Efficiency Ratios: 3. Inventory Turnover, 4. Days Sales Inventory, 5. Account Receivable Turnover, and 6. Days Sales Outstanding: Unfortunately, the lack of specific data on cost of goods sold and accounts receivable prevents a thorough analysis of efficiency ratios. These ratios are crucial for assessing how effectively the company is managing its inventory and collecting receivables, which are essential components of operational efficiency.
  • Leverage Ratios: 7. Total Debt Ratio and 8. Debt to Equity Ratio: Fairfax Financial Holdings has exhibited an increase in leverage. The total debt ratio has risen from 0.75 in 2021 to 0.78 in 2022, indicating that a higher proportion of assets is financed by debt. Similarly, the debt to equity ratio has increased from 3.06 in 2021 to 3.52 in 2022. While increased leverage can magnify returns, it also introduces higher financial risk, making it crucial for the company to carefully manage its debt obligations.
  • Coverage Ratios: 9. Times Interest Earned and 10. Cash Coverage: The coverage ratios present a positive picture. The times interest earned ratio has significantly improved from 3.33 in 2021 to 9.71 in 2022, suggesting the company is better positioned to cover its interest expenses. The cash coverage ratio has also risen substantially from 5.36 to 11.37, indicating an enhanced ability to cover interest expenses with operating cash flow. These improvements signify effective financial management and reduced risk of financial distress.
  • Profitability Ratios: 11. Gross Profit Margin, 12. Net Profit Margin, 13. Return on Assets, and 14. Return on Equity: Fairfax Financial Holdings has experienced a decline in profitability. Net profit margin has decreased from 13.81% in 2021 to 4.58% in 2022, indicating lower profitability as a percentage of sales. Return on assets has dropped from 4.24% to 1.46%, and return on equity has declined from 17.55% to 6.48%. These reductions may be attributed to various factors, including changes in market conditions, management decisions, or economic factors affecting the insurance and investment industry.
  • Market Value Indicators: 15. Earnings Per Share and 16. Earnings Price Ratio: Earnings per share (EPS) has declined from $141.09 in 2021 to $54.40 in 2022, reflecting a decrease in earnings allocated to each outstanding share. Unfortunately, the absence of market price per share data precludes the calculation of the earnings price ratio. Market value indicators suggest a decrease in the market's valuation of the company.
  • Overall Interpretation: The overall analysis indicates a mixed financial performance for Fairfax Financial Holdings Limited. While improvements in liquidity and coverage ratios reflect positive aspects of financial management, the increase in leverage and decline in profitability raise concerns. It's essential to consider external factors, such as changes in market conditions, regulatory environments, or the impact of global events on the insurance and investment sectors.
  • Factors Influencing Changes: Strategic Leverage: The increase in leverage may be a strategic decision to fund expansion, acquisitions, or investment opportunities. While this enhances returns, it also introduces higher financial risk.
  • Interest Coverage: Improved interest coverage suggests that the company is effectively managing its debt obligations, enhancing financial stability.
  • Profitability Challenges: The decrease in profitability may be influenced by factors such as changes in underwriting conditions, investment performance, or strategic decisions made by the company.
  • Market Sentiment: Market value indicators are also influenced by external factors like market sentiment, investor perception, and broader economic conditions.
  • Conclusion: In conclusion, Fairfax Financial Holdings Limited's financial performance reflects a nuanced situation. The company has made strides in improving liquidity and coverage, but the increase in leverage and decline in profitability pose challenges. A more in-depth analysis would necessitate access to additional financial details, industry benchmarks, and qualitative insights. It is recommended for stakeholders to closely monitor these financial indicators while considering the broader market context. Additionally, understanding the company's strategic initiatives and risk management practices will provide a more holistic view of its financial health.

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