: What is financial statement analysis?
The process of applying analytical tools to a company’s financial statements to understand its financial health. Requires:
Financial information
Standards of comparison
Analysis tools
What are the three main standards of comparison in financial analysis?
- Intra-company comparison – compares to prior years of the same company (e.g., horizontal analysis)
- Inter-company comparison – compares to competitors (vertical analysis is useful)
- Industry or market standards – obtained from websites or industry reports
: Name the three common analytical tools used in financial statement analysis.
- Horizontal analysis – compares financial results across time
- Vertical analysis – compares balances to a base account in the same statement
- Ratio analysis – compares different balances to assess profitability, liquidity, and solvency
What is horizontal analysis?
Calculates the change in an account from one period to the next in dollar and percentage terms:
What is vertical analysis?
Expresses each account as a percentage of a base amount on the same statement to allow comparison across companies or time.
What is ratio analysis?
Expresses relationships between financial statement figures, allowing intra-company and inter-company comparisons. Key categories:
Profitability
Liquidity
Solvency
Who is interested in profitability ratios?
Creditors (ability to pay debts)
Shareholders (dividends and share price growth)
Managers (performance evaluation and incentives)
Common profitability ratios
Profit Margin
Return on Equity (ROE)
Return on Assets (ROA)
Earnings per Share (EPS)
Price-to-Earnings (P/E)
Profit margin formula and interpretation
net profit/sales
Measures ability to generate profit from sales. Higher = better.
Return on Equity (ROE)
net profit/average shareholders equity
Shows effectiveness of using shareholders’ funds to generate profit.
Return on Assets (ROA) formula and interpretation
net profit/average total assets
Shows ability to generate profits from all resources, not just equity.
Earnings per Share (EPS) formula
Net profit/average number of ordinary shares
Indicates return for each share held by investors.
Price-to-Earnings (P/E) ratio formula
market price per share/Earnings per share
Shows investors’ willingness to pay for each $1 of earnings.
Liquidity ratios measure what?
A company’s ability to meet short-term obligations.
Current Ratio formula
current assets/current liabilities
Higher = greater liquidity.
Quick ratio
(cash + accounts receivable + short term investments)/current liabilities
Measures ability to pay liabilities immediately.
Receivables Turnover formula
sales revenue/average accounts receivable Higher = faster collection of receivables.
Inventory Turnover
cost of goods sold/average inventory
Higher = faster inventory movement; usually desirable.
Solvency ratios measure what?
A company’s ability to meet long-term obligations and remain financially healthy over time.
Debt-to-Assets ratio formula
total liabilities/total assets
Lower = less risky capital structure.
Debt-to-Equity ratio formula
total liabilities/shareholders equity
Higher = riskier capital structure.
Times Interest Earned formula
net profit + interest + tax / interest expense
Higher = easier to cover interest payments; less risk of insolvency.
Why compare ratios to industry benchmarks?
To see how a business is performing relative to competitors or industry standards.
Trend analysis in financial statements
Graphical representation of financial data or ratios over time to identify patterns, compare to industry trends, and predict future performance.
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