## Financial Statement Analysis

Financial statement 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. They are used by a variety of stakeholders such as shareholders, creditors, regulatory agencies, and the general public.

Financial statement analysis can be performed through:

**Horizontal analysis**: This involves the comparison of financial information over a series of reporting periods.**Vertical analysis**: This shows each item on a financial statement as a percentage of a base item. For example, in a balance sheet, each asset line item can be calculated as a percentage of total assets.**Ratio analysis**: This involves calculating financial ratios, such as profitability ratios, liquidity ratios, and leverage ratios, to understand the financial health of the company.**Trend analysis**: This involves examining a company’s financial data over a period of time to identify any patterns.

Here are some objectives of financial statement analysis:

**Profitability**: Investors and managers use profitability ratios to gauge how profitable a company is. These ratios include gross margin ratio, net profit margin, return on assets, and return on equity.**Solvency**: Solvency ratios measure a company’s ability to satisfy its long-term obligations. They include debt to equity ratio, equity ratio, and debt ratio.**Liquidity**: Liquidity ratios measure a company’s ability to pay off its short-term debts as they come due. They include current ratio, quick ratio, and cash ratio.**Efficiency**: Efficiency ratios measure how effectively a company uses its assets and liabilities internally. They include asset turnover ratio, inventory turnover ratio, and accounts receivable turnover ratio.

Financial statement analysis helps investors to decide whether to invest in a company, creditors to decide how much credit to grant to a company, and managers to understand how to better control the company’s financial health.

## Example of Financial Statement Analysis

Let’s assume that we are analyzing the financial statements of a fictitious company, “ToyJoy”, which is a manufacturer and retailer of children’s toys.

**Profitability**: The net profit margin is a measure of the profitability of the company. Let’s say ToyJoy had net income of $500,000 on revenues of $2,000,000. The net profit margin would be $500,000 / $2,000,000 = 0.25, or 25%. This means ToyJoy made a profit of 25 cents for each dollar of revenue.**Solvency**: The debt-to-equity ratio is a measure of the financial leverage of the company. Assume ToyJoy has total liabilities of $1,000,000 and shareholder’s equity of $1,500,000. The debt-to-equity ratio would be $1,000,000 / $1,500,000 = 0.67. This suggests that for every dollar of equity, ToyJoy has 67 cents in debt.**Liquidity**: The current ratio is a measure of a company’s ability to pay short-term obligations. Assume ToyJoy has current assets of $600,000 and current liabilities of $300,000. The current ratio would be $600,000 / $300,000 = 2. This implies ToyJoy has twice the amount of current assets as its current liabilities, suggesting it’s in a good position to cover its short-term debts.**Efficiency**: The inventory turnover ratio measures how efficiently a company manages its inventory. If ToyJoy’s cost of goods sold is $1,200,000, and its average inventory during the period is $200,000, then the inventory turnover ratio would be $1,200,000 / $200,000 = 6. This means ToyJoy sold its inventory six times over the course of the year.

By using these types of analysis, investors, creditors, and managers can gain insights into the financial health of ToyJoy, and use this information to make informed decisions.