Lecture Slide 10 Ratio Alalysis
Chapter 6: Financial Statement Analysis
Overview of Financial Statement Analysis
Financial statement analysis is essential for making informed business decisions.
Three primary methods of financial analysis are:
Horizontal Analysis
Vertical Analysis
Ratio Analysis
1. Horizontal Analysis
Definition: Involves comparing financial statement items over a period, typically year-over-year.
Example: Henderson Company Comparative Balance Sheets (2013 vs 2014)
Cash decreased by 76%.
Accounts Receivable: Increased by 22%.
Inventory: Increased by 73%.
Accounts Payable: Increased by 70%.
Insights: Significant fluctuation in these items may indicate deteriorating financial health.
2. Vertical Analysis
Definition: A method to compare items on a single financial statement as a percentage of total figures (common-size analysis).
Example: Common-size comparative balance statements for Henderson show:
Cash: 1.9% of total assets in 2014 vs 9.8% in 2013.
Inventory's percentage of total assets rose from 19.9% to 28.1%.
Insights: Changes in these percentages highlight shifts in asset composition, potentially indicating operational challenges.
3. Ratio Analysis
Purpose: A key tool for assessing liquidity, solvency, and profitability.
Categories of Ratios:
Liquidity Ratios: Measure the ability to meet short-term obligations.
Key Ratios: Current Ratio, Acid-Test Ratio, Accounts Receivable Turnover.
Example: Henderson's Current Ratio = Current Assets / Current Liabilities = 1.48:1.
Solvency Ratios: Assess long-term financial health.
Key Ratios: Debt-to-Equity Ratio, Times Interest Earned.
Example: Henderson has $0.89 of debt for every $1 of equity.
Profitability Ratios: Evaluate the company's ability to generate earnings.
Key Ratios: Gross Profit Ratio, Profit Margin, Return on Equity.
Example: Henderson’s profit margin decreased from 11.5% in 2013 to 7.1% in 2014.
Key Insights from Ratio Analysis
Liquidity Analysis: Important for understanding if a company can pay its short-term debts.
Solvency Analysis: Important for assessing long-term viability; worry when ratios suggest dependence on borrowing.
Profitability Analysis: Essential for understanding operational effectiveness in managing resources and controlling costs.
Conclusion
Financial statement analysis is vital for stakeholders (managers, investors, creditors) to make informed decisions. Each type of analysis provides unique insights that, when combined, create a robust picture of a company’s financial performance.