Analysing financial statements involves evaluating three characteristics of a company: its liquidity , its profitability, and its solvency .
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A short-term creditor , such as s bank, is primarily interested in the ability of the borrower to pay obligations when they come due.
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A long-term creditor , such as a bondholder looks to measures of profitability and solvency that indicate the firm’s ability to survive over a long period of time.
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Shareholders are interested in the profitability and solvency of the enterprise. They assess the likelihood of dividends and the growth potential of the shares.
Comparison of financial information can be made on a number of different bases.
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Intracompany basis compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years.
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Intercompany basis compares an item or financial relationship of one company with the same item or relationship in one or more competing companies.
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Industry averages basis compares an item or financial relationship of a company with industry averages published by Dun & Bradstreet, Statistics Canada, etc.
There are three basic tools of analysis:
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Horizontal (trend) analysis
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Vertical (common size) analysis
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Ratio analysis
Horizontal analysis (trend analysis ) is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.
Although a horizontal analysis is relatively straightforward, complications can occur. If an item has no value in the base year or preceding year and a value in the next year, no percentage change can be calculated. If a negative amount appears in the base or preceding year and a positive amount exists the following year, or vice versa, no percentage change can be calculated.

Horizontal analysis compares changes in a single item between any two years.
SEE PAGE 892 formula: current year - base year base year
It is often useful to study percentages over a number of years to determine the direction, or trend a business is taking. This is done by comparing each year's amounts to the base year. formula: current year
base year
Vertical analysis (common size analysis ) is a technique that expresses each item within a financial statement as a percentage of a base amount. The base amount for asset items is total assets. The base amount for liability and shareholders’ equity items is total liabilities and shareholders’ equity . The base amount for income statement items is net sales . Vertical analysis is seldom performed on the statement of retained earnings or the cash flow statement.
Vertical analysis shows the relative size of each item on the balance sheet and income statement. It can also show the change in the percentage for individual items from one period to the next. Another benefit of vertical analysis is that it enables one to compare companies of different sizes.
Vertical analysis highlights the relationship of each item to a total figure.
SEE PAGE 895
formulas: income statement item net sales balance sheet item
total assets
(pp. 898 —915: pay particular attention to “Accounting in Action”)
Ratio analysis expresses the relationships between selected items of financial statement data. The relationship is expressed in terms of a percentage, a rate, or a simple proportion.
Although ratios provide valuable information in themselves, they are typically used to compare competing company results.

Ratios can be classified as follows:
A. Liquidity ratios measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.
B. Profitability ratios measure the income or operating success of an enterprise for a given period of time.
C. Solvency ratios measure the ability of the enterprise to survive over a long period of time.
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A. Liquidity Ratios
The current ratio is a widely used measure of a company’s liquidity and short-term debt paying ability. It shows the ability to pay total current liabilities using total current assets
In other words, how much is there in current assets for each dollar in current liabilities?
Anything under 1 means that there is less in current assets than in current liabilities.
The higher the ratio, the stronger the financial position
The acid test ratio is a more precise measure of a company’s immediate short-term liquidity.
It shows the ability to pay total current liabilities if they all became due immediately. Only the most liquid of current assets are included, as inventory and pre-paid expenses may not be quickly converted to cash.
The cash current debt coverage ratio uses net cash provided by operating activities to determine if the company is generating sufficient cash to meet its current obligations.
The receivables turnover ratio is used to assess the liquidity of receivables. It shows the number of times AR were turned into cash in a year. This shows the efficiency in collecting
AR. The higher the better; the usual range is between 7.0 and 10.0
The inventory turnover ratio measures the number of times, on average, the inventory is turned (sold) during the period. A high turnover may indicate insufficient inventory being kept on hand. A low turnover may indicate excess inventory being kept on hand. This figure should be compared to those of similar businesses.
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B. Profitability Ratios
The gross profit margin ratio is a measure of the percentage of each dollar of sales that results in gross profit. High-volume enterprises such as grocery stores generally have low profit margins. Low-volume enterprises such as jewellery stores generally have high profit margins.

The profit margin ratio measures the percentage of each dollar in sales that results in net income.
The cash return on sales ratio is similar to the profit margin. It measures the percentage of each dollar of sales that results in cash. Results differ among different types of businesses.
The ability to command a premium price or to keep costs under strict control increases the rate of return.
The asset turnover ratio measures how efficiently a company uses its assets to generate sales. The resulting number shows the dollars of sales produced by each dollar of assets.
Asset turnover ratios vary considerably among industries.
An overall measure of profitability is the return on assets ratio. It shows the amount of income earned from each dollar's worth of assets. This should be compared to how well similar businesses use their assets to earn a profit.
The return on common shareholders’ equity shows how many dollars of net income were earned for each dollar invested by the owners. The usual range is .10 to .15
—this means 10 -
15 cents earned on each dollar invested.
Earnings per share is a measure of the net income earned on each common share. This is most useful when several years' data are compared. The usual goal is a 10 to 15 percent increase each year.
The price-earnings (PE) ratio measures the ratio of the market price of each common share to the earnings per share. It shows the market price an investor would have to pay for a share to earn one dollar. Results differ among different types of businesses (check out communications firms!).
Book value per share measures the equity a common shareholder has in the net assets of a corporation for each share owned.
The payout ratio measures the percentage of earnings distributed as cash dividends.
Companies that have high growth rates usually have low payout ratios, because they reinvest most of their net income in the business.
The dividend yield reports the rate of return a shareholder earned from dividends during the year. It shows the market price of common stock for each dollar received in dividends. In other words, how much you would have to invest in common stock, at the going rate, to earn
$1 in dividends. The usual ranges for established firms are 5 to 8 cents on the dollar; 0 to 3 cents for growing firms.
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C. Solvency Ratios
The debt to total assets, or debt , ratio measures the percentage of the total assets provided by creditors. For example, .90 means that 90% of assets were financed; .10 means that 10% of assets were financed (the lower, the better). The usual range is between .57 and .67.
It also provides some indication of the company’s ability to absorb losses without hurting the interests of creditors.
The interest coverage ratio provides an indication of the company’s ability to meet interest payments as they come due.It shows how many times over the operating income can cover the interest expense. The usual range is between 2.0 and 3.0. This should be analyzed along with the debt ratio to determine a firm's ability to pay debts.
The cash interest coverage ratio is the cash-based counterpart to interest coverage.
The cash total debt coverage ratio is a cash-based measure of solvency is ratio indicates a company’s ability to repay its liabilities from cash generated from operating activities without having to liquidate assets.
FOR CALCULATIONS:
Averages are calculated using beginning-of-year and end-of-year figures .
Two decimal places should be used for % and $ results.
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Estimates : Financial statements contain numerous estimates. To the extent that estimates are inaccurate, the financial ratios and percentages are inaccurate.
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Cost : Traditional financial statements are based on cost and are not adjusted for price level changes. Comparisons of financial data from different periods may be rendered invalid by significant inflation or deflation.
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Alternative accounting methods : Variations among companies in the application of generally accepted accounting principles may hamper comparability.
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Atypical data : Fiscal year end data may not be typical of the financial condition during the year. Firms frequently establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels.
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Diversification of firms : Many firms are so diversified that they cannot be classified by industry. Others appear to be comparable but are not. The requirement to report segment information helps to reduce this limitation.