Business leaders, investors and even lenders frequently rely on financial statement analysis to gain valuable insights into a company’s profitability and solvency. If you are thinking about going into accounting, finance or a related field, being able to perform financial statement analysis is an important skill with many potential applications.
So, what exactly does financial statement analysis entail, why does it matter and what kinds of insights can you gain from this practice?
Why Financial Statements Matter
Financial statements are among the most valuable and insightful business documents, providing critical insights to inform business decisions at all levels. In many ways, it can be helpful to look at a financial statement as a snapshot of a company’s profitability and operational success at any given time.
The Value of Mastering Ratio Analysis
One common method used in financial statement analysis is known as ratio analysis. Specifically, ratio analysis is a strategy that involves calculating ratios using formulas to assess different aspects of a company’s overall performance, such as profitability and solvency. Some examples of ratios used in ratio analysis include:
- Profitability ratios, which assess a company’s overall earning power and profits.
- Activity ratios, which look at how efficiently a company can manage its assets.
- Solvency ratios, which assess a company’s ability to pay off debts.
- Liquidity ratios, which look specifically at a company’s ability to pay its bills and meet other short-term financial obligations (like paying employees).
In accountancy and finance, performing different types of ratio analysis is an important skill, and one that will likely be used often.
Building Confidence in Financial Decisions
Ultimately, the purpose of any financial statement analysis is to get a better idea of where a company stands when it comes to specific areas of its finances. The insights gained from this type of analysis can help business leaders make more confident and informed decisions for the future success of the company.
Understanding Financial Ratios
Financial ratios are a common tool used to look more closely at specific areas of a company’s finances. However, there are many potential applications of these ratios and different categories that may be used for a variety of purposes.
Definition and Importance of Ratios
In simplest terms, financial ratios refer to numerical comparisons within a company’s financial statements. These ratios are important for business professionals, including business leaders, because they can provide important insights that may affect decision-making. Many investors and stakeholders also rely on financial ratios to determine whether to invest in a company and to make stock decisions, so they are a critical aspect of business finance.
Categories of Financial Ratios
We have already covered some common types of financial ratios above, but there are many categories of financial ratios that business leaders and other professionals may use to get a better feel for a company’s financial health. Some additional categories include:
- Leverage ratios, or how much a company relies on loans/borrowing to meet financial needs.
- Efficiency ratios, or how efficiently a company uses assets and liabilities to operate.
- Coverage ratios, or how effectively a business manages financial obligations to lenders, creditors and suppliers.
Liquidity Ratios: Assessing Short-Term Financial Health
Liquidity ratios are used to assess a company’s short-term financial viability based on its ability to meet short-term financial obligations, such as paying employees.
Current Ratios and Quick Ratios Explained
There are two important types of liquidity ratios commonly used: current ratios and quick ratios. The major difference between the two is that quick ratios are cash and cash equivalents, and accounts receivable (not inventory), whereas current ratios take every asset into account and are expected to be consumed in one year.
Applications of Liquidity Ratios
In addition to being used to assess a company’s overall financial health, creditors may also use liquidity ratios to determine a company’s creditworthiness for loans. Meanwhile, investors may use this information when deciding whether or not to invest in a business.
Profitability Ratios: Measuring Business Success
Being able to measure profitability ratios is also important as an accountant or finance professional. Specifically, profitability ratios look at a company’s ability to generate profits in relation to its revenue.
Gross Margin and Net Profit Margin
Two potential measurements of profitability are gross and net profit margins, and it is important to understand the differences between the two (and when to use them). A gross profit margin looks at the percentage of revenue that remains after subtracting production costs, whereas net profit margin accounts for all business expenses.
Return on Assets (ROA)
Return on assets, on the other hand, is a measurement of a company’s profitability in relation to its total assets. This ratio is calculated by dividing the company’s net income by the value of its assets for any given period and can be used to make informed and strategic business decisions.
Return on Equity (ROE)
Return on equity is another commonly used profitability ratio that looks at a company’s financial performance by dividing net income by the amount of shareholder equity for any given period. This measurement can be helpful in assessing how well a company is generating income from equity financing.
Return on Investment (ROI)
Finally, return on investment (ROI) is a profitability ratio that divides the net profit of an investment by the initial cost. A higher profitability ratio may indicate better use of investment funds and may further inform decision-making.
Solvency Ratios: Evaluating Long-Term Stability
Solvency ratio is another important metric that looks specifically at a company’s ability to handle long-term liabilities and other debts. Oftentimes, this is done by looking at a debt-to-equity ratio.
Debt-to-Equity Ratio Explained
Figuring out a company’s debt-to-equity (D/E) ratio involves dividing a company’s total debts/liabilities by the amount of shareholder equity, which can be an important indicator of how much a company is relying on debt to operate. A higher debt-to-equity ratio may indicate that a company is too dependent on debt to keep things running, which could create unwanted risks.
Assessing Financial Leverage
Accountants may also look at financial leverage when assessing a company’s statements, which involves using borrowed money to gain additional returns. Financial leverage can be a good indicator of a company’s overall financial well-being, but too much of it could increase risk and affect stability.
Efficiency Ratios: Analyzing Operational Effectiveness
Finally, efficiency ratios look at how well a company is allocating and using its resources to generate profits.
Inventory Turnover and Receivables Turnover
A higher inventory turnover ratio means that a company is moving its goods and products quickly, whereas a lower ratio may indicate a lack of demand or inefficient use of resources. Receivables turnover, on the other hand, looks at how quickly and effectively businesses collect on amounts owed.
Importance of Asset Utilization
Asset utilization is another important measurement of efficiency, looking specifically at how well a company uses assets to generate additional revenue or achieve other organizational goals. This measurement is important because higher asset utilization can reduce operational downtime and optimize profitability.
Trend Analysis and Ratio Interpretation
Both trend analysis and ratio interpretation are important aspects of financial statement analysis, but there are some important pitfalls that accountants and finance professionals should be aware of.
Identifying Patterns in Financial Data
Trend analysis is a strategy used to identify patterns in financial data. Typically, this analysis is performed on data over a set period of time, such as using monthly or quarterly financial statements. From there, it is possible to see trends in how financial data has changed over time, which can assist in future financial forecasting and decision-making.
Common Pitfalls in Ratio Analysis
Although ratio analysis can be an extremely useful tool, there are some potential limitations and pitfalls that accounting and finance professionals need to be aware of. For example, ratio analysis relies solely on past data to predict future trends, which is not always accurate. Likewise, ratio analysis does not take other factors into account, such as market trends or even changes in the economy.
Using Ratios for Strategic Decision-Making
From liquidity and profitability ratios to solvency and efficiency ratios, there are many potential uses for these insights, no matter the size or scope of the business.
Ratios in Investment Analysis
Many investors, for example, use different types of ratio analysis to weight investment options and make informed decisions. For example, a company with a high return on assets (ROA) may be a more lucrative and safe investment opportunity compared to a company with a lower return.
Ratios for Operational Planning
Business leaders rely on ratio analysis insights to improve operational planning and optimize efficiency. For example, business leaders may look at inventory turnover to pinpoint issues with inventory management practices. From there, they can propose changes to streamline operations and cut costs.
Learn More in a Degree Program
As you can see, performing a detailed analysis of financial statements can be a great way for business leaders, investors and other stakeholders to better understand a company’s financial position at any given time. From there, it is possible to make informed decisions regarding future borrowing, liquidity, cash flow and the like.
Whether you plan to become an accountant or are simply interested in business financial and financial technology, having a solid understanding of financial statement analysis strategies can pay off many times over.
Ready to learn more? Keiser University is proud to offer a number of programs that cover critical topics such as financial statement analysis, financial forecasting, ratio analysis and more. Check out our Master of Business Administration in Accounting, our Master of Accountancy or even our Master of Science in Financial Technology to learn more. Then, get in touch with any questions or get started with your online application for admission.
