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
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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.
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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.
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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 days payable outstanding 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.
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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.
