Financial statement analysis (or financial analysis) is the process of reviewing and analyzing a company’s financial statements to make better economic decisions. These statements include the income statement, balance sheet, statement of cash flows, and a statement of retained earnings.
Horizontal analysis (also known as trend analysis) is a financial statement analysis technique that shows changes in the amounts of corresponding financial statement items over a period of time. It is a useful tool to evaluate the trend situations.
The statements for two or more periods are used in horizontal analysis. The earliest period is usually used as the base period and the items on the statements for all later periods are compared with items on the statements of the base period. The changes are generally shown both in dollars and percentage.
Vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets.
The most common use of vertical analysis is within a financial statement for a single time period, so that you can see the relative proportions of account balances. Vertical analysis is also useful for timeline analysis, where you can see relative changes in accounts over time, such as on a comparative basis over a five-year period. For example, if the cost of goods sold has a history of being 40% of sales in each of the past four years, then a new percentage of 48% would be a cause for alarm.
Solvency Ratio is a key metric used to measure an enterprise’s ability to meet its debt and other obligations. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a company’s solvency ratio, the greater the probability that it will default on its debt obligations.
Solvency and liquidity are both terms that refer to an enterprise’s state of financial health, but with some notable differences. Solvency refers to an enterprise’s capacity to meet its long-term financial commitments. Liquidity refers to an enterprise’s ability to pay short-term obligations; the term also refers to its capability to sell assets quickly to raise cash. A solvent company is one that owns more than it owes; in other words, it has a positive net worth and a manageable debt load. On the other hand, a company with adequate liquidity may have enough cash available to pay its bills, but it may be heading for financial disaster down the road.
Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate liquidity. A number of financial ratios are used to measure a company’s liquidity and solvency, the most common of which are discussed below.
Current ratio = Current assets / Current liabilities
The current ratio measures a company’s ability to pay off its current liabilities (payable within one year) with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the company’s liquidity position.
Quick ratio = (Current assets – Inventories) / Current liabilities
= (Cash and equivalents + Marketable securities + Accounts receivable) / Current liabilities
The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets, and therefore excludes inventories from its current assets. It is also known as the “acid-test ratio.”
Days sales outstanding = (Accounts receivable / Total credit sales) x
Number of days in sales
DSO refers to the average number of days it takes a company to collect payment after it makes a sale. A higher DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated quarterly or annually.
Debt to equity = Total debt / Total equity
This ratio indicates the degree of financial leverage being used by the business and includes both short-term and long-term debt. A rising debt-to-equity ratio implies higher interest expenses, and beyond a certain point it may affect a company’s credit rating, making it more expensive to raise more debt.
Debt to assets = Total debt / Total assets
Another leverage measure, this ratio measures the percentage of a company’s assets that have been financed with debt (short-term and long-term). A higher ratio indicates a greater degree of leverage, and consequently, financial risk.
Interest coverage ratio = Operating income (or EBIT) / Interest expense
This ratio measures the company’s ability to meet the interest expense on its debt with its operating income, which is equivalent to its earnings before interest and taxes (EBIT). The higher the ratio, the better the company’s ability to cover its interest expense.