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Unit 3: Analysis of Financial Statements

3.2 Tools for Analysis and Interpretation of Financial Statement Notes

In assessing the significance of various financial data, experts engage in ratio analyses, the process
of determining and evaluating financial ratios. A financial ratio is a relationship that indicates
something about a company’s activities, such as the ratio between the company’s current assets,
current liabilities or between its accounts receivable and its annual sales. The basic sources for
these ratios are the company’s financial statements that contain figures on assets, liabilities,
profits, or losses. Financial ratios are only meaningful when compared with other information.
Since they are most often compared with industry data, ratios help an individual understand a
company’s performance relative to that of competitors; they are often used to trace performance
over time.
Ratio analysis can reveal much about a company and its operations. However, there are several
points to keep in mind about ratios. First, financial statement ratios are “flags” indicating areas of
strength or weakness. One or even several ratios might be misleading, but when combined with
other knowledge of a company’s management and economic circumstances, ratio analysis can
tell much about a corporation. Second, there is no single correct value for a ratio. The observation
that the value of a particular ratio is too high, too low, or just right depends on the perspective of
the analyst and on the company’s competitive strategy. Third, a ratio is meaningful only when
it is compared with some standard, such as an industry trend, ratio trend, a ratio trend for the
specific company being analyzed, or a stated management objective.
In trend analysis, financial ratios are compared over time, typically years. Year-to-year
comparisons can highlight trends, pointing to the need for action. Trend analysis works best
with five years of data.
The second type of ratio analysis, cross-sectional analysis, compares the ratios of two or more
companies in similar lines of business. One of the most popular forms of cross-sectional analysis
compares a company’s financial ratios to industry ratio averages.
Your report containing the analysis of the financial statements is broken down into the various
ratio categories:
1. Predictor Ratios indicate the potential for growth or failure.
2. Profitability Ratios which use margin analysis and show the return on sales and capital
employed.
3. Asset Management Ratios which use turnover measures to show how efficient a company
is in its operations and use of assets.
4. Liquidity Ratios which give a picture of a company’s short-term financial situation or
solvency.
5. Debt Management Ratios which show the extent that debt is used in a company’s capital
structure.

Notes
1. Tools employed in the horizontal analysis are Comparative statements and Trend
percentages.

2. Tools employed in the vertical analysis are Common-size financial statements and
financial ratios.

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