Review of

Financial
Statement
Preparation,
Analysis, and
Interpretation
Financial Statement Analysis

Financial statement analysis involves gaining an

understanding of an organization's financial situation
by reviewing its financial statements.

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
revenues, 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.
Proportion analysis.
 Ratio Analysis:These ratios  Percentage Analysis: This
involve comparing different involves expressing different
financial numbers to gain financial values as
insights into a company's percentages of a relevant
performance and financial total. For example:
health.  Expense as a Percentage of
Revenue: Analyzing how
 Profitability Ratios: Measure much of the revenue is
a company's ability to consumed by expenses.
generate profits (e.g., profit  Net Income Margin: Expressing
margin). net income as a percentage
 Liquidity Ratios: Assess a of revenue.
company's ability to meet  Trend Analysis: Monitoring
short-term obligations (e.g., trends helps identify
current ratio). improvements or potential
issues in a company's
 Debt Ratios: Evaluate the financial performance.
level of debt relative to
equity and assets (e.g.,  Benchmarking: Comparing a
debt-to-equity ratio). company's ratios and
percentages with industry
benchmarks or competitors.
• Measuring the profitability
The main objective of a business is to earn a satisfactory
return on the funds invested in it. Financial analysis helps in
ascertaining whether adequate profits are being earned
on the capital invested in the business or not. It also helps
in knowing the capacity to pay the interest and dividend

• Indicating the trend of Achievements

Financial statements of the previous years can be
compared and the trend regarding various expenses,
purchases, sales, gross profits and net profit etc. can be
ascertained. Value of assets and liabilities can be
compared and the future prospects of the business can
be envisaged.
• Assessing the growth potential of the business
The trend and other analysis of the business
provides sufficient information indicating the
growth potential of the business.

• Comparative position in relation to other firms

The purpose of financial statements analysis is to
help the management to make a comparative
study of the profitability of various firms engaged
in similar businesses. Such comparison also helps
the management to study the position of their
firm in respect of sales, expenses, profitability
and utilising capital, etc.
• Assess overall financial strength
The purpose of financial analysis is to assess the
financial strength of the business. Analysis also
helps in taking decisions, whether funds required
for the purchase of new machines and
equipment's are provided from internal sources of
the business or not if yes, how much? And also to
assess how much funds have been received from
external sources.

• Assess solvency of the firm

The different tools of an analysis tell us whether
the firm has sufficient funds to meet its short term
and long term liabilities or not.
Users of Financial Statement Analysis
• 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.
 Horizontal analysis is the comparison of
historical financial information over a series of
reporting periods, or of the ratios derived from this
financial information

A common problem with horizontal analysis is

that the aggregation of information in the financial
statements may have changed over time, due to
ongoing changes in the chart of accounts, so that
revenues, expenses, assets, or liabilities may shift
between different accounts and therefore appear to
cause variances when comparing account balances
from one period to the next.
Horizontal Analysis of Income Statement is usually in a two-year format,
such as the one shown below, with a variance also shown that states
the difference between the two years for each line item.
Horizontal analysis is also known as trend analysis.

2021 2022 Variance

Sales $1,000,000 $1,500,000 $500,000

Cost of goods sold 400,000 600,000 (200,000)
Gross margin 600,000 900,000 300,000
Salaries and wages 250,000 375,000 (125,000)
Office rent 50,000 80,000 (30,000)
Supplies 10,000 20,000 (10,000)
Utilities 20,000 30,000 (10,000)
Other expenses 90,000 110,000 (20,000)
Total expenses 420,000 615,000 (195,000)
Net profit $180,000 $285,000 $105,000
 Horizontal Analysis of Balance Sheet is also usually in a two-
year format, such as the one shown below, with a variance
showing the difference between the two years for each line
item. 20X1 20X2 Variance

Cash $100,000 80,000 $(20,000)

Accounts receivable 350,000 525,000 175,000
Inventory 150,000 275,000 125,000
Total current assets 600,000 880,000 280,000
Fixed assets 400,000 800,000 400,000
Total assets $1,000,000 $1,680,000 $680,000
Accounts payable $180,000 $300,000 $120,000
Accrued liabilities 70,000 120,000 50,000
Total current liabilities 250,000 420,000 170,000
Notes payable 300,000 525,000 225,000
Total liabilities 550,000 945,000 395,000
Capital stock 200,000 200,000 0
Retained earnings 250,000 535,000 285,000
Total equity 450,000 735,000 285,000
Total liabilities and equity $1,000,000 $1,680,000 $680,000
Vertical Analysis of the Income Statement
The most common use of vertical analysis in an income statement is to
show the various expense line items as a percentage of sales, though it
can also be used to show the percentage of different revenue line items
that make up total sales.
$ Totals Percent
Sales $1,000,000 100%
Cost of goods sold 400,000 40%
Gross margin 600,000 60%

Salaries and wages 250,000 25%

Office rent 50,000 5%
Supplies 10,000 1%
Utilities 20,000 2%
Other expenses 90,000 9%
Total expenses 420,000 42%
Net profit 180,000 18%
Vertical Analysis of the Balance Sheet
The central issue when creating a vertical analysis of a balance sheet is
what to use as the denominator in the percentage calculation.

$ Totals Percent
Cash $100,000 10%
Accounts receivable 350,000 35%
Inventory 150,000 15%
Total current assets 600,000 60%
Fixed assets 400,000 40%
Total assets $1,000,000 100%
Accounts payable $180,000 18%
Accrued liabilities 70,000 7%
Total current liabilities 250,000 25%
Notes payable 300,000 30%
Total liabilities 550,000 55%
Capital stock 200,000 20%
Retained earnings 250,000 25%
Total equity 450,000 45%
Total liabilities and equity $1,000,000 100%
Profitability ratios measure how effectively the firm uses its
resources to generate income. The first three of the ratios
reported here are probably the best known and most widely used
of all financial ratios. Investors are happier the greater the
profitability ratios grow.

• Breakeven point. Reveals the sales level at which

a company breaks even.
(BP = Fixed Cost/ Profit Margin Percentage)
• Contribution margin ratio. Shows the profits left
after variable costs are subtracted from sales.
(CMR = Contribution Margin/ Sales X 100)

• Gross profit ratio. Shows revenues minus the cost

of goods sold, as a proportion of sales.
(GPR= (Gross Profit/ Sales) X10
• Margin of safety. Calculates the amount by
which sales must drop before a company
reaches its break even point.
• MoS = (Actual Sales – Breakeven Sales/
Actual Sales) X100

• Net profit ratio. Calculates the amount of

profit after taxes and all expenses have
been deducted from net sales.
NPR = (Net Profit / Sales) X 100
• Return on equity. Shows company profit as
a percentage of equity.
ROE = (Net income / Avrg. Shareholder
Equity) X100
• Return on net assets. Shows company
profits as a percentage of fixed assets and
working capital.
RONA = (Net income/ Net Assets)x100
• Return on operating assets. Shows
company profit as percentage of assets
utilized.
ROOA = (Operating income/ Avrg. Oprtng
Assets)X100
Liquidity Ratios
A liquid firm is a firm that can meet its various short-
term debt and credit obligations. Those who extend
credit to a firm are particularly concerned with the
firm’s liquidity. The following liquidity ratios point out
problems of this nature.

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 measure the efficiency with which
assets are converted to sales or cash.

• 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.

• Fixed asset turnover ratio. Measures a

company's ability to
generate sales from a certain base of fixed
assets.
• Inventory turnover ratio. Measures the amount of inventory
needed to support a given level of sales.

• Sales to working capital ratio. Shows the amount of working

capital required to support a given amount of sales.

• Working capital turnover ratio. Measures a company's ability to

generate sales from a certain base of working capital.
Financing Ratios measure how leveraged a firm is. For this
reason, we alternatively call them financial leverage ratios or
simply leverage ratios. We learn that firm risk is closely tied to
the firm’s leverage.

• Debt to equity ratio. Shows the extent to which

management is willing to fund operations with debt, rather
than equity.

• Debt service coverage ratio. Reveals the ability of a

company to pay its debt obligations.

• Fixed charge coverage. Shows the ability of a company to

pay for its fixed costs.
Market ratios are distinct from the other ratios in that they are
based, at least in part, on information not contained in the fi
rm’s fi nancial statements.
TECHNIQUES AND TOOLS OF FINANCIAL
STATEMENT ANALYSIS

Financial statements give complete

information about assets, liabilities, equity,
reserves, expenses and profit and loss of an
enterprise

Techniques of analysis of financial

statements are mainly classified into three
categories :
• Cross-sectional analysis

It is also known as inter firm comparison. This analysis

helps in analysing financial characteristics of an
enterprise with financial characteristics of another
similar enterprise in that accounting period.

For example, if company A has earned 15% profit on

capital invested. This does not say whether it is
adequate or not. If we analyse further and find that a
similar company has earned 16% during the same
period, then only we can make a conclusion that
company B is better. Thus, it turns into a meaningful
analysis.
• Time series analysis

It is also called as intra-firm comparison. According

to this method, the relationship between different
items of financial statement is established,
comparisons are made and results obtained. The
basis of comparison may be :

Comparison of the financial statements of different

years of the same business unit. – Comparison of
financial statement of a particular year of different
business units.
• Cross-sectional cum time series
analysis

This analysis is intended to compare the

financial characteristics of two or more
enterprises for a defined accounting
period. It is possible to extend such a
comparison over the year. This
approach is most effective in analysing
of financial statements.