Financial statement analysis compares ratios and trends calculated from data found on financial statements. Financial ratios allow you to compare your business' performance to industry averages or to specific competitors. These comparisons help identify financial strengths and weaknesses.
- Financial ratios fall into four categories of financial measurements: "profitability, asset utilization, liquidity, and debt utilization," says Stanley Block and Geoffrey Hirt in "Foundations of Financial Management."
- Profitability ratios measure profit realized from different financial sources.They are the profit margin, return on assets and return on equity. To calculate any of these ratios, divide net income by either sales, total assets or stockholders' equity, respectively.
- Asset utilization ratios determine how efficiently a company's assets are managed. These ratios are receivables turnover, average collection period, inventory turnover, fixed asset turnover and total asset turnover. Except for the average collection period, all of the above ratios are calculated by dividing sales by the asset category named in the ratio title.
- Liquidity ratios measure what amount of assets can be immediately converted to cash. These ratios are often used along with cash flow statements to determine a company's ability to pay its creditors. Liquidity ratios are the current and the quick ratio--current assets and quick assets divided by current liabilities.
- Like asset utilization ratios, debt-utilization ratios measure how efficiently a company uses its debt. These ratios are debt to total assets, times interest earned and fixed charge coverage. Debt to total assets is calculated as it is stated, while the others are a little different--income before interest and taxes divided by interest and income before fixed charges and taxes divided by fixed charges.
- Trend analysis lets you compare companies' performances over specific periods of time. For example, over five years, managers can compare how their profit margin has improved or worsened. Complete analysis must also include industry standards.
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