Understanding and Analyzing Financial Statements
Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes. As a business owner, knowing how to analyze financial statements will allow you to assess your company’s strengths and weaknesses, and determine the overall financial position of the company. There are various techniques available to analyze financial statements. Ratio analysis is the most widely utilized technique.
Ratio analysis measures the proportional relationship between two or more financial statement items. As a result, all the information needed to calculate financial ratios can be found on a company’s financial statements. Generally, ratios can be grouped into the following four broad categories:
Liquidity ratios
Activity ratios
Leverage ratios
Profitability ratios
Liquidity Ratios
Liquidity is the ability to convert assets into cash quickly and efficiently. Liquidity ratios measure a company’s ability to pay bills, keep up with payroll, pay vendors and meet other short-term obligations using cash and other current assets. The higher the ratio, the better the company's liquidity position. The most common liquidity ratios include the current ratio, quick ratio, and cash ratio.
Current ratio – The current ratio measures a company's ability to pay off its current liabilities with its total current assets. The current ratio is calculated by dividing total current assets, including cash, accounts receivable, and inventories, by current liabilities.
Quick ratio (or acid-test ratio) – The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes slower-moving items, such as inventory and prepaid expenses, from the calculation. It is also known as the acid-test ratio.
Cash ratio – The cash ratio is the most conservative measure, as it includes only actual cash and marketable securities to measure cash resources to cover current liabilities.
Activity Ratios
Activity ratios measure how effectively a company is using its assets. The higher the activity ratio, the more efficiently the company is operating, as fewer assets are required to maintain a given level of operations. Activity ratios include accounts receivable turnover ratio, inventory turnover ratio, and asset turnover ratio.
Accounts receivable turnover ratio – The accounts receivable turnover ratio measures a company’s ability to collect money from its customers. This ratio can aid in determining whether receivables are excessive when compared to existing levels of credit sales. It is also useful in spotting changes in customer payment habits. The ratio is calculated by dividing net credit sales by average gross accounts receivable.
Inventory turnover ratio – The inventory turnover ratio indicates how efficiently inventories are being managed by measuring, on average, the number of times the inventory was sold during the period. The ratio is calculated by dividing cost of goods sold by average inventory.
Asset turnover ratio – The asset turnover ratio reflects how efficiently a company is using its assets to generate sales. It measures the amount of revenue a company generates per dollar of assets. The ratio is calculated by dividing total sales by total assets.
Leverage Ratios
Leverage ratios measure a company’s capital structure in terms of the mix of its financing sources (debt and equity) and the company’s ability to satisfy its long-term debt and investment obligations. The most widely used leverage ratio is the debt-to-equity ratio. The debt-to-equity ratio measures the balance between resources provided by creditors and resources provided by owners. A low ratio suggests that a company is not fully utilizing the cheaper source of finance (i.e. debt) while a high ratio indicates a higher financial risk as the company has been very aggressive in financing its growth with debt. Debt-to-equity ratios vary from industry to industry. A ratio of 1:1 is normally considered satisfactory for most of the companies. The ratio is calculated by dividing total liabilities by total shareholders’ equity.
Profitability Ratios
Profitability ratios measure a company’s ability to generate earnings from its operations. Three profitability ratios include rate of return on assets, profit margin on sales, and earnings per share.
Rate of return on assets – Return on assets measures the rate of return on all available resources, and measures earnings on all investments provided by owners and creditors. The ratio provides a good measure of profitability because it combines the effects of profit margin and asset turnover. The ratio is calculated by dividing net income by total assets.
Profit margin on sales –Profit margin on sales measures net profitability of each dollar of sales revenue. The ratio provides an approximate measure of management's efficiency. When a company’s profit margin on sales is too low, the company should try to increase sales, reduce expenses, or both. The ratio is calculated by dividing net income by sales.
Earnings per share – Earnings per share measures a company’s profitability. A company with a high earnings per share is perceived to be more profitable. The ratio is calculated by dividing net income by outstanding shares.
Generally, ratios are typically not used in isolation but rather in combination with other ratios. Moreover, a single ratio by itself is likely meaningless. For a ratio to provide meaningful and useful information, you must have a benchmark or standard with which to compare the ratio. Examples of possible benchmarks are industry averages, prior year amounts, a peer company or competitor, or a planned level.
Knowing how to how to analyze your financial statements would allow you to react faster to the ever-changing business landscape, make better decisions, mitigate risk, and optimize your company’s performance. At CPA By Choice we can help you with your financial statements, feel free to call us or message us.