Financial Statement Analysis: Explained

by | Dec 8, 2017 | Bookkeeping

Financial statements are an essential tool that helps businesses determine the true state of their finances and make informed decisions. Financial statement analysis literally involves an examination of a business’ financial statements, and will typically cover the following areas:

 

  1. Solvency – is the business/company able to fulfill its financial obligations in a healthy manner, both in the present and in the future?
  2. Profitability – one obstacle that cripples a lot of businesses, particularly small ones, is the failure to distinguish between making a profit and actually enjoying high profitability. Profitability analysis will show how much profit the business is making in comparison to the resources that are being funneled into it.
  3. Stability – Is the business strong enough to continue to exist profitably in the long run? The leverage structure of a business will be particularly important when considering its long-term stability.

 

 

Methods of financial statement analysis

There are three main techniques used in financial statement analysis: horizontal analysis, vertical analysis, and the use of financial ratios. These are not three completely separate methods, but are complementary and should be used in combination with one another.

 

Horizontal analysis compares the financial information of a business from one period to another (or more), whereas vertical analysis involves the comparison between individual line items within the respective financial statements. In both cases, ratios and percentages are used as critical indicators for analysis. Here are the major groups of ratios used in financial statement analysis and what they mean:

 

 

#1. Liquidity Ratios

This class of financial ratios measures and provides information on the ability of a business to meet its debts and other financial obligations. A poor liquidity status means that a business may soon run out of money or even into bankruptcy. Liquidity ratios that can be used for financial statement analysis include:

  • Cash coverage ratio – shows the amount of cash readily available to cover interest payments on any loans.
  • Current ratio – reflects the business’ ability to meet its full financial obligations, and includes items such as inventory.
  • Quick ratio – as the name implies, this ratio is meant to show how much money or near-money assets a business has at hand, and differs from the current ratio in that this excludes inventory.
  • Liquidity Index – a measure of the speed with which assets may be turned into cash.

 

#2. Activity ratios

This class of financial ratios can be used to determine the efficacy of business in regards to management. Some of the major activity ratios are:
Accounts payable turnover ratio – shows how quickly a company can pay its suppliers.

  • Accounts receivable turnover ratio – provides a measure of the business’s ability and effectiveness at recovering accounts receivable.
  • Fixed asset turnover ratio – measures sales in comparison to available fixed assets.
  • Inventory turnover ratio – shows how much inventory is needed to generate any given sales volume.
  • Sales to working capital ratio – shows the working capital requirement to match a given sales volume
  • Working capital turnover ratio – measures the sales generation ability against an available working capital

 

#3. Leverage ratios

Leverage ratios are a class of ratios that outline the financing structure of a business, i.e. is the business more heavily financed by internally generated funds or by debt? There are three major leverage ratios:

  • Debt to equity ratio – measures the amount of debt a business has versus its shareholders’ equity.
  • Debt service coverage ratio – this is a measure of a business’s capacity to fulfill its debt repayments.
  • Fixed charge coverage – demonstrates the capability of a business to cover its fixed costs.

 

#4. Profitability ratios

This class of ratios shows how efficient a business is at making profits. Here are some of the major profitability ratios:

  • Breakeven point – shows the volume of sales required for the business to break even.
  • Contribution margin ratio – measures profit after variable costs have been deducted from total sales.
  • Gross profit ratio – shows how much profit a business makes from sales, without factoring in its expenses.
  • Return on assets – the return on assets (ROA) and the return on equity are two of the most important profitability ratios. The ROA shows the amount of net profit a business is making, in comparison to its expenditure on Assets.
  • Return on operating assets – this ratio is a narrower version of the ROA: it measures net profit as a percentage of the actual assets utilized in production/operations.
  • Return on equity ratio – The return on equity ratio (ROE), provides a measure of how much net profit a business is making in comparison to its equity base.

 

 

How to read ratios for financial statement analysis?

Using financial ratios is relatively easy. They are either expressed as regular ratios (i.e. x:y), as fractions (i.e. x/y), or as percentages (x/y * 100). Whichever way they are expressed, what you need to know is that a higher figure is positive when you measure variables such as profits, but negative when you measure variables such as debt.

 

As a business owner, understanding these fundamentals for financial statement analysis is key to identifying financial trends, areas of concern and opportunities your business can build on.