| The financial statement analysis process provides | | | | tools for comparing items that appear on financial |
| a systematic approach for extracting and | | | | statements such as the income statement or the |
| evaluating the accounting information needed for a | | | | balance sheet, whether for one year or over |
| specific business purpose. Although every analysis | | | | several years. However, for a more in-depth |
| is different, the process used is likely to be | | | | analysis of the relationships between these items, |
| similar. | | | | an analyst needs to examine certain commonly |
| The financial statement analysis process includes | | | | used financial ratios. |
| establishing the goal or goals that the analysis is | | | | Ratios examine relationships rather than amounts. |
| supposed to achieve which helps draw the | | | | Therefore, a company of one size can be directly |
| analyst’s attention to the most relevant | | | | compared with a second company, or companies, |
| information. Typical general goals include screening, | | | | that are of a different size or that operate in a |
| diagnosis, forecasting, and reconstruction. A full | | | | different business. If analysts compare published |
| review of the financial statements and the notes | | | | ratios rather than self-calculated ratios, it is |
| produces a rounded view of the company and | | | | important for them to be aware of how published |
| may call attention to specific areas that should be | | | | ratios have been calculated because not all |
| analyzed in detail. The selection of techniques to | | | | analysts calculate ratios in exactly the same way. |
| generate the information required depends on the | | | | In addition, analysts should look into not only ratios |
| goal of the analysis .As well as ratios, common | | | | that are below expectations, but also ratios that |
| techniques include common-size statements, | | | | are significantly better than expected. Exceptional |
| vertical analysis, and horizontal analysis. The | | | | ratios may be a result of decisions that sacrifice |
| application of appropriate techniques is often a | | | | long-term profitability and growth for short-term |
| mechanical process, although care should be taken | | | | profitability. Ratios are grouped into the following |
| that differences in ratio calculation, accounting | | | | broad categories for analyzing financial |
| policies, asset valuation, and so on are understood | | | | statements: profitability, efficiency, liquidity and |
| so that a valid comparison between companies | | | | leverage. |
| can be made. Finally, interpretation of the results | | | | A company’s ability to operate profitably is |
| requires putting the results in context- for | | | | crucial to its survival as a going concern. |
| example, by comparing results with industry | | | | Commonly used GAAP-based profitability ratios |
| benchmarks. | | | | are net profit margin, return on assets, return on |
| One technique used for analyzing financial | | | | equity, and the DuPont identity. |
| statements is vertical analysis. It can be difficult to | | | | Efficiency ratios concentrate on how well the |
| see even basic financial relationships when looking | | | | company manages and uses its assets. The |
| at the numerical values in a company’s | | | | DuPont identity shows that one efficiency |
| financial statements. Therefore, it is helpful to | | | | ratio-asset turnover- is a component of both |
| construct common-size statements and perform | | | | ROA and ROE. Two additional turnover ratios, the |
| a vertical analysis in order to look for any unusual | | | | accounts receivable ratio and the inventory |
| percentages in the common-size statements that | | | | turnover ratio, are typically used in the |
| identify items that have an excessively large or | | | | GAAP-based efficiency analysis. |
| small value when considered relative to other | | | | Liquidity refers to a company’s ability to |
| values reported in the same accounting period. | | | | convert assets into cash in order to satisfy its |
| Both single period and multiple period vertical | | | | obligations. The ability to meet current obligations |
| analyses can be used. | | | | on time is important to all companies. It can be |
| Another technique used for analyzing financial | | | | measured using working capital, the current ratio |
| statements is horizontal analysis. It involves | | | | and the acid test ratio. |
| making comparisons across two or more years | | | | One of the most commonly used measures of |
| of financial statements data. Although horizontal | | | | financial leverage in financial statement analyses is |
| analysis techniques can be applied to the balance | | | | the debt-to-equity ratio. Another view of how a |
| sheet to quantify the changes in current or total | | | | company has financed its assets is provided by |
| assets over time, this type of analysis is usually | | | | the company’s debt-to-assets ratio. |
| focused on quantifying the changes in a | | | | The financial statements provide the information |
| company’s profitability over time. | | | | necessary for the company to manage its |
| Both vertical and horizontal analyses are excellent | | | | working capital. |