Financial Statement Analysis Explained

1. Ratio Analysis

Ratio Analysis is a method used to evaluate the financial health and performance of a company by comparing different financial statement items. It helps in understanding the relationship between various financial metrics and provides insights into the company's efficiency, liquidity, profitability, and solvency.

a. Liquidity Ratios

Liquidity Ratios measure a company's ability to meet its short-term obligations. The most common liquidity ratios include:

• Current Ratio: Calculated as Current Assets divided by Current Liabilities. It indicates whether a company has enough current assets to cover its current liabilities.
• Quick Ratio: Similar to the Current Ratio but excludes inventory from current assets. It provides a more conservative measure of liquidity.

Example: If a company has $500,000 in current assets and $200,000 in current liabilities, the current ratio is 2.5, indicating that the company has 2.5 times more current assets than current liabilities.

b. Profitability Ratios

Profitability Ratios assess a company's ability to generate profit relative to its revenue, assets, or equity. Key profitability ratios include:

• Gross Profit Margin: Calculated as Gross Profit divided by Revenue. It shows the percentage of revenue that remains after deducting the cost of goods sold.
• Return on Equity (ROE): Calculated as Net Income divided by Shareholders' Equity. It measures the return generated on shareholders' investment.

Example: If a company has $1,000,000 in revenue and $600,000 in cost of goods sold, the gross profit margin is 40%, indicating that 40% of the revenue is profit before other expenses.

2. Trend Analysis

Trend Analysis involves examining financial data over a series of reporting periods to identify patterns and trends. It helps in understanding the company's historical performance and predicting future financial outcomes. Trend analysis can be applied to various financial metrics such as revenue, expenses, and profitability.

a. Horizontal Analysis

Horizontal Analysis compares financial data from multiple periods to identify changes over time. It is typically expressed as a percentage change from the base year.

Example: If a company's revenue was $1,000,000 in 2021 and $1,200,000 in 2022, the percentage change is 20%, indicating a 20% increase in revenue from 2021 to 2022.

b. Vertical Analysis

Vertical Analysis involves expressing each item on a financial statement as a percentage of a base figure, such as total assets or total revenue. It helps in comparing the relative importance of different items within the financial statement.

Example: If a company's total assets are $5,000,000 and its cash balance is $500,000, the cash balance represents 10% of the total assets. This helps in understanding the proportion of cash relative to the total assets.

c. Common-Size Financial Statements

Common-Size Financial Statements are a type of vertical analysis where each item on the financial statement is expressed as a percentage of a base figure. This format allows for easier comparison between different companies or periods.

Example: A common-size income statement might show revenue as 100%, with all other items expressed as a percentage of revenue. This makes it easier to compare the cost structure and profitability of different companies.