Interpretation of Financial Statements
When reviewing the financial statements of a business, what interpretation can be extracted from these statements? This article covers several types of financial statement analysis, mostly related to the ratio comparison of different line items in the statements. By comparing these results, and especially over multiple reporting periods, you can arrive at a reasonable estimation of the financial results and condition of a business.
There are two key techniques for analyzing financial statements. The first 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 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. Later sections describe horizontal and vertical analysis more fully.
Another heavily-used technique is ratio analysis. Ratios are used to calculate the relative size of one number in relation to another. After you calculate a ratio, 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 target company is performing in accordance with expectations. In a typical financial statement analysis, most ratios will be within expectations, leaving a small number of outlier ratios that require additional detailed analysis.
There are several general categories of ratios, each designed to examine a different aspect of a company’s performance. These categories are:
Liquidity ratios. This is the most fundamentally important set of ratios, because they measure the ability of a company to remain in business. Samples of ratios in this category are:
- Cash coverage ratio. Shows the amount of cash available to pay interest.
- Current ratio. Measures the amount of liquidity available to pay for current liabilities.
- Quick ratio. The same as the current ratio, but does not include inventory.
- Liquidity index. Measures the amount of time required to convert assets into cash.
Activity ratios. These ratios are a strong indicator of the quality of management, since they reveal how well management is utilizing company resources. Samples of ratios in this category are:
- Accounts payable turnover ratio. Measures the speed with which a company pays its suppliers.
- Accounts receivable turnover ratio. Measures a company’s ability to collect accounts receivable.
- Inventory turnover ratio. Measures the amount of inventory needed to support a given level of sales.
- Fixed asset turnover ratio. Measures a company’s ability to generate sales from a certain base of fixed assets.
- Sales to working capital ratio. Shows the amount of working capital required to support a given amount of sales.
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. Samples of ratios in the category are:
- Debt to equity ratio. Shows the extent to which management is willing to fund operations with debt, rather than equity.
- Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.
Profitability ratios. These ratios measure how well a company performs in generating a profit. Samples of ratios in this category are:
- Breakeven point. Reveals the sales level at which a company breaks even.
- Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of sales.
- Net profit ratio. Calculates the amount of profit after taxes and all expenses have been deducted from net sales.
- Return on net assets. Shows company profits as a percentage of fixed assets and working capital.
by Sue Anderson - Based on 30 years of experience in continuing education for accountants. Currently program director for online CPE provider, CPE Link. Formerly with the California CPA Education Foundation managing key operational areas including marketing, program development, and distance learning.