Why do financial statement analysis

This statement separates the cash flow from operations, investing, and financing activities in a consolidated statement. Financial statements are the best means to determine what has happened in the past and gauge current trends.

No one statement provides sufficient information for company financial analysis. But by putting together the three financial statements, the analyst has the information needed to understand the financial position, profitability, and operating, investing, and financing activities of a company. All three company financial statements are connected. The profit or loss from the income statement will be reflected in the assets and liabilities of the balance sheet. 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? 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. This ratio is the 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:. A 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. 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:.

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.

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? 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 to improve their long-term business viability.

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 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. 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. 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 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.

The outcome of 0. Over time, Banyan Goods would like to see this turnover ratio increase. Inventory turnover measures how many times during the year a company has sold and replaced inventory. But in order to conduct accurate financial statement analysis, developing skills and intuition is as important as following best accounting practices. Financial statement analysis can benefit organizations in numerous ways. It provides internal and external stakeholders with the opportunity to make informed decisions regarding investing.

And as top executives and others in management rely on accounting to provide an accurate depiction of the effects of their decisions, financial statement analysis helps with matters of corporate governance as well. Business growth depends on the accurate and timely analysis of financial statements. While the rapid pace of business today is placing more importance on insights gathered by accountants, developing knowledge is still an essential aspect of growing a business. Founded in , Ohio University is the ninth oldest public university in the United States.

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Skip to main content. What Is Financial Statement Analysis? Methods of Financial Statement Analysis Financial statement analysis can be conducted using either horizontal and vertical analysis, or analysis that uses ratios.

Examples of liquidity ratios include the cash coverage ratio, current ratio, quick ratio and liquidity index.

Examples of activity ratios include the accounts payable turnover ratio, accounts receivable turnover ratio, fixed asset turnover ratio, inventory turnover ratio, sales-to-working capital ratio and working capital turnover ratio. Examples of leverage ratios include the debt service coverage ratio, debt-to-equity ratio and fixed charge coverage.