Defined as a method used to review and analyze the financial statements of a business entity, financial statement analysis provides insight into an entity's future performance by reviewing its past performance. This insight can also enhance the decision-making process by identifying problem areas. Financial statement analysis can be achieved through the use of horizontal analysis, vertical analysis, and ratio analysis. Vertical analysis compares line items as a percentage of another, while horizontal analysis compares line items from the current period with those of a previous period. Ratio analysis compares line items across financial statements in various categories, including liquidity, solvency, and profitability.
At A Glance
Financial statement analysis uses analytical methods and ratios to evaluate the performance of a business, including the business’s liquidity, solvency, and profitability. Horizontal, vertical, and ratio analysis are common methods used to analyze financial statement information.
Horizontal and vertical analysis are two tools commonly used to assess organizational performance. Horizontal analysis helps identify trends over time. Vertical analysis is useful in comparing performance between entities.
Liquidity analysis is designed to assess the ability of the business entity to convert assets to cash. Ratios are used to measure and analyze liquidity in these areas: current position, accounts receivable, inventory, and accounts payable.
- Several ratios, including working capital, current ratio, and quick ratio, are used to assess the current financial position of a business.
- To assess and measure a company’s ability to manage and collect receivables, two ratios are important: accounts receivable turnover and average collection period.
- The ratios known as inventory turnover and number of days sales in inventory are used to analyze and assess how well a business manages its inventory.
- To analyze how often businesses pay their suppliers, the accounts payable turnover ratio and the days payable outstanding ratio are used.
Solvency analysis measures the ability of a business to pay its debt as it matures. The most common solvency ratios are debt-to-equity and times interest earned.
- The purpose of a profitability analysis is to evaluate overall business efficiency and performance. Dupont analysis and several common measures of profitability are frequently used to evaluate overall business efficiency and performance.
- Three sections of the corporate annual reports include management discussion and analysis (MD&A), report on internal control, and report on fairness of the financial statements’ presentation.