ORIGINAL

Overview of Financial Statement Analysis

Financial statement analysis involves gaining an understanding of an organization's financial

situation by reviewing its financial reports. The results can be used to make investment and
lending decisions. This review involves identifying the following items for a company's
financial statements over a series of reporting periods:

 Trends. Create trend lines for key items in the financial statements over multiple time periods,
to see how the company is performing. Typical trend lines are for revenue, the gross margin, net
profits, cash, accounts receivable, and debt.

 Proportion analysis. An array of ratios are available for discerning the relationship between the
size of various accounts in the financial statements. For example, one can calculate a company's
quick ratio to estimate its ability to pay its immediate liabilities, or its debt to equity ratio to see
if it has taken on too much debt. These analyses are frequently between the revenues and
expenses listed on the income statement and the assets, liabilities, and equity accounts listed on
the balance sheet.

Financial statement analysis is an exceptionally powerful tool for a variety of users of financial
statements, each having different objectives in learning about the financial circumstances of the
entity.

Users of Financial Statement Analysis

There are a number of users of financial statement analysis. They are:

 Creditors. Anyone who has lent funds to a company is interested in its ability to pay back the
debt, and so will focus on various cash flow measures.

 Investors. Both current and prospective investors examine financial statements to learn about a
company's ability to continue issuing dividends, or to generate cash flow, or to continue
growing at its historical rate (depending upon their investment philosophies).
 Management. The company controller prepares an ongoing analysis of the company's financial
results, particularly in relation to a number of operational metrics that are not seen by outside
entities (such as the cost per delivery, cost per distribution channel, profit by product, and so
forth).

 Regulatory authorities. If a company is publicly held, its financial statements are examined by
the Securities and Exchange Commission (if the company files in the United States) to see if its
statements conform to the various accounting standards and the rules of the SEC.

Methods of Financial Statement Analysis

There are two key methods for analyzing financial statements. The first method is the use of
horizontal and vertical analysis. Horizontal analysis is the comparison of financial information
over a series of reporting periods, while vertical analysis is the proportional analysis of a
financial statement, where each line item on a financial statement is listed as a percentage of
another item. Typically, this means that every line item on an income statement is stated as a
percentage of gross sales, while every line item on a balance sheet is stated as a percentage of
total assets. Thus, horizontal analysis is the review of the results of multiple time periods, while
vertical analysis is the review of the proportion of accounts to each other within a single period.

The second method for analyzing financial statements is the use of many kinds of ratios. Ratios
are used to calculate the relative size of one number in relation to another. After a ratio is
calculated, you can then compare it to the same ratio calculated for a prior period, or that is
based on an industry average, to see if the company is performing in accordance with
expectations. In a typical financial statement analysis, most ratios will be within expectations,
while a small number will flag potential problems that will attract the attention of the reviewer.
There are several general categories of ratios, each designed to examine a different aspect of a
company's performance. The general groups of ratios are:

1. Liquidity ratios. This is the most fundamentally important set of ratios, because they measure
the ability of a company to remain in business. Click the following links for a thorough review
of each ratio.

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

o Current ratio. Measures the amount of liquidity available to pay for current liabilities.
o Quick ratio. The same as the current ratio, but does not include inventory.

o Liquidity index. Measures the amount of time required to convert assets into cash.

2. Activity ratios. These ratios are a strong indicator of the quality of management, since they
reveal how well management is utilizing company resources. Click the following links for a
thorough review of each ratio.

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

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

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

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

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

o Working capital turnover ratio. Measures a company's ability to generate sales from a certain
base of working capital.

3. Leverage ratios. These ratios reveal the extent to which a company is relying upon debt to fund
its operations, and its ability to pay back the debt. Click the following links for a thorough
review of each ratio.

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

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

o Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.

4. Profitability ratios. These ratios measure how well a company performs in generating a profit.
Click the following links for a thorough review of each ratio.

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

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

o Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of sales.
o Margin of safety. Calculates the amount by which sales must drop before a company reaches its
break even point.

o Net profit ratio. Calculates the amount of profit after taxes and all expenses have been deducted
from net sales.

o Return on equity. Shows company profit as a percentage of equity.

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

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

Problems with Financial Statement Analysis

While financial statement analysis is an excellent tool, there are several issues to be aware of
that can interfere with the interpretation of the analysis results. These issues are:

 Comparability between periods. The company preparing the financial statements may have
changed the accounts in which it stores financial information, so that results may differ from
period to period. For example, an expense may appear in the cost of goods sold in one period,
and in administrative expenses in another period.

 Comparability between companies. An analyst frequently compares the financial ratios of

different companies in order to see how they match up against each other. However, each
company may aggregate financial information differently, so that the results of their ratios are
not really comparable. This can lead an analyst to draw incorrect conclusions about the results
of a company in comparison to its competitors.

 Operational information. Financial analysis only reviews a company's financial information, not
its operational information, so you cannot see a variety of key indicators of future performance,
such as the size of the order backlog, or changes in warranty claims. Thus, financial analysis
only presents part of the total picture.
PARAPHRASE

Overview of Financial Statement Analysis

Reviewing the financial reports for the purpose of having an understanding about the situation as
to the financial position of the organization is called financial statements analysis and the result can be
used as a help in making decisions regarding lending and investments. Trends and Proportion Analysis
are involved by identifying these two in reviewing the financial statements of the company over a course
of reporting periods.

To be able to see how well the performance of the company, trend lines must be created for the
key items in the financial statements over many periods. These trend lines are commonly for revenue, the
gross margin, net profits, cash, accounts receivable, and debt.

In proportion analysis, to be able to determine and understand the relationship between two or
more accounts in the financial statements, array of ratios are available. An example is a quick ratio where
it can calculate the company’s ability to pay its short-term obligations through its short-term assets.
Another example is the debt to equity ratio where it can calculate how much debt can be covered by the
company’s equity. These analyses are more commonly used in income statement accounts and balance
sheet accounts.

Financial statement analysis is a strong and great tool that can be used for studying and
understanding the financial statements that is able to cover variety information that can cater different
users depending on how they can use the information about the financial report.

Users of Financial Statement Analysis

There is variety of users of the financial statement analysis. They are creditors, investors,
management and regulatory authorities. Creditors are the ones who lend money to the company
that is used as funds that is why the creditor mainly focuses on the ability of the company to pay
back the money that was lent by them. Investors are the ones who invest to the company and are
interested in the ability of the company to gain profits continuously. Management is the one who
analyzes the overall performance of the company in all aspects like how they should make their
strategy according to the analyzed financial reports and the like. Lastly, the regulatory authorities
are the ones who examine if the company’s financial reports are according to the accounting
standards and rules and regulations under the authority like SEC.

Methods of Financial Statement Analysis

 In analyzing financial statements, the two key methods are using horizontal and vertical
analysis and using many kinds of ratios.

The first method is where horizontal analysis and vertical analysis were being used. In
horizontal analysis, the financial information are being compared according to periods while in
vertical analysis, the financial information are being compared according to the line items
within the financial statements. Horizontal analysis is the review of the results of multiple
periods but vertical analysis is the review of the results that is only for a singl e period.

The second method is where many kinds of ratios are being used in analyzing financial
statements. In order to determine the relation of one item to another, the ratios are being used in
this kind of analysis. The ratios that were calculated can be used to be able to compare it to the
prior period’s ratio or to be able to know if the company is doing great based on their
expectations to be able to reach their goals. There are so many ratios that can be used according
to what aspect of the financial statements you want to examine. The general groups of ratios are
liquidity ratios, activity ratios, leverage ratios and profitability ratios.

Liquidity ratios are set of ratios that focus on measuring the ability of the company to
continue doing business and able to cover the company’s current liabilities. The ratios under
this are cash coverage ratio, current ratio, quick ratio and liquidity index. Cash coverage ratio
shows how much interest can be paid using the available cash of the company. Current r atio
shows how much current liabilities can be covered by the current assets of the company. Quick
ratio shows how much current liabilities can be covered by the quick assets of the company.
Liquidity index shows how much time is needed to be able to convert its assets into cash.

Activity ratios are set of ratios that focus on how well the company utilizes its assets and
other resources. The ratios under this are accounts payable turnover ratio, accounts receivable
turnover ratio, fixed asset turnover ratio, inventory turnover ratio and working capital turnover
ratio. Accounts payable turnover ratio shows how fast the company is able to pay its suppliers.
Accounts receivable turnover ratio shows how fast the company is able to collect its receivable
from its customers. Fixed asset turnover ratio shows how well the company is able to covert its
fixed assets into sales. Inventory turnover ratio shows how the company is able to retain certain
amount of inventory that is needed to support the generation of sales. Working capital turnover
ratio shows how well the company is able to use its working capital to generate sales.
 Leverage ratios are set of ratios that focus on measuring the company’s ability to clear
its obligations and how much debt that is used in the funding operations if the company. The
ratios under this are debt to equity ratio, debt service coverage ratio and fixed charge coverage.
Debt to equity ratio shows how much debt is used in order to fund the company’s operations
against its equity. Debt service coverage ratio shows how well the company is able to pay its
overall obligations. Fixed charge coverage shows how well the company is able to pay its fixed
costs.

Profitability ratios are set of ratios that focus on measuring the company’s ability to
perform its operations to be able to generate profits. The ratios under this are breakeven point,
contribution margin ratio, gross profit ratio, margin of safety, net profit ratio, return on equity,
return on net assets and return on operating assets. Breakeven point shows how much sales or
how many units where the company is at level of its breakeven where the company has no loss
and no profit. Contribution margin ratio shows the ratio of the contribution margin over sales
where contribution margin is the difference between sales and variable costs. Gross profit ratio
shows the ratio of the gross profit over sales where gross profit is the difference between sales
and cost of sales. Margin of safety shows how much sales or how many units can the company
fail to be able to reach its breakeven point. Net profit ratio is the ratio of the net profit over
sales where the net profit is the difference between net sales and profit after taxes and all
expenses. Return on equity shows the ratio of profit over equity where it shows how much
percent in the equity the company is able to gain a return from its profit. Return on net assets
shows the ratio of profit over net assets where it shows how much percent in the fixed assets
and working capital the company is able to gain a return from its profit. Return on operating
assets shows the ratio of profit over operating assets where it shows how much percent in the
assets the company is able to gain a return from its profit.

Problems with Financial Statement Analysis

Although financial analysis is a great tool, there are some issues that may interfere in
analyzing the financial statements and may affect the interpretation of the results. The following
issues that should be aware of are comparability between periods, comparability between
companies and operational information.
 First, the issue that may encounter in comparing financial statements between periods is
that the company may have changed the records of the accounts in the financial statements that
may change the interpretation of the results of the analysis like an expense recorded as an
administrative expense in this period but different in the next period. Then, the issue that may
encounter in comparing financial statements between companies is that each company has its
own way of summarizing their own reports and the company that compares its financial
statements to the other may also have different way that makes their information unable to
compare with each other. It may lead to a different conclusion that may lead the analyst to a
different direction that may affect the company negatively. Last issue is that a financial analyst
deriving information from operational information. A financial analyst cannot derive any key
indicators from operational information but only in the company’s financial information.