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Financial statement analysis involves the assessment and evaluation of the firm's past performance, its present
condition, and future business potentials. The analysis serves to provide information about the following:
1. Profitability of the business firm;
2. The firm's ability to meet its obligations;
3. Safety of the investment in the business;
4. Effectiveness of management in running the firm; and
5. Over-all company marketability
HORIZONTAL ANALYSIS- involves comparing figures shown in the financial statements of two or more consecutive
periods.
Formula:
Percentage Most recent value - Base period value
Change = -------------------------------------
Base period value
VERTICAL ANALYSIS- the process of comparing figures in the financial statements of a single period. It involves
converting the figures in the statements to a common base i.e. ratios, percentages. Converted financial statements are
called Common Size Financial Statements.
RATIO ANALYSIS- involves the development of mathematical relationships between accounts in the financial
statements.
A. TESTS OF LIQUIDITY (Liquidity refers to the company's ability to pay its short-term current
liabilities as they fall due).
b. Inventory Turnover:
Merchandising Firms
e. Current Assets Turnover = Cost of Sales + Operating Expenses (excluding depreciation and
amortization) / Average Current Assets
o Measures the movement and utilization of current assets to meet operating
requirements.
B. TESTS OF SOLVENCY (solvency refers to the company's ability to pay all its debts, whether such
liabilities are current or non-current)
1. Times Interest Earned =Income before tax + Interest expense / Interest Expense
- Determines the extent to which operations cover interest expense
8. Sales to fixed assets (plant turnover) = Net Sales / Fixed Assets (Net)
- Test roughly the efficiency of management in keeping plant properties employed.
9. Book value per share on common stock = Common stock equity / # of outstanding common
stock
- Measures recoverable amount in the event of liquidation if assets are realized at their book
values.
10. Times Preferred Dividend requirements = Net income After Taxes / Preferred Dividend
Requirements
- Indicates ability to provide dividends to preferred stockholders.
12. Sinking fund payments bef. Tax = Sinking fund payment after taxes / 1 - Tax Rate
C. TESTS OF PROFITABILITY
2. Return of Total Assets (ROA) = Income before Interest & Taxes / Average total assets
- Efficiency with which managers use total assets to operate the business.
3. Return on Owners' equity = Income after tax / Ave. Owners' Equity
- Measures the amount earned on the owners' or stockholders' investment.
D. MARKET TESTS: