The purpose of financial statement analysis is not only to understand the historical results of financial statements but also to use that information to forecast the future.
Accountants and analysts should consider the major characteristics of a company when analyzing its financial statements that are evaluated through Liquidity ratios, Profitability ratios and Solvency ratios.
Liquidity ratios. It measures of the short-term debt-paying ability of a Company.
- Current Ratio = Current Assets/Current Liabilities (Measures the short-term debt-paying ability)
- Acid Test or Quick Ratio = Cash + Marketable Securities + Accounts Receivable / Current Liability (Measures the immediate short-term liquidity)
Activity ratios – measure the efficiency of the conduct of business activity.
1. Accounts receivable turnover = Net Sales/Ave. Net Accounts receivable: (Measures the number of times in a year that receivables were collected)
2. Average collection period = 365 days/Accounts receivable turnover or Accounts receivable net/Net Credit Sales/365 days (Measures the average number of days that receivables were collected)
3. Inventory Turnover = Cost of Goods Sol/ Average Inventory: (Measures the number of times in a year that inventories were sold).
4. Average Sales Period = 365 days/Inventory turnover or Accounts payable/ CGS/365 days: (Measures the average number of days that inventories were sold).
Profitability ratios – measures of the income or operating success of an enterprise for a given period of time.
1. Profit margin = Net Income/Sales (Measures the net income generated by each peso sale)
2. Asset turnover = Net Sales/Average Total Assets (Measures how assets are efficiently used to generate sales)
3. Return on Assets = Net Income/Total Assets (Measures overall profitability of assets)
4. Return on Equity = Net Income/Average Common Stockholders’ Equity ( Measures profitability of owner’s investment)
5. Earnings per share = Net Income or (Earnings after tax–Preferred Dividends)/ Average number of common shares outstanding or Earnings available to common stockholder/Average number of common shares outstanding (Measures net income per common share outstanding)
6. Price Earnings Ratio = Market Value of common stock/Earnings Per Share ( Measures the value investors are willing to give up for every peso earnings they earn)
7. Payout Ratio = Common Cash Dividend/Earnings Available to Common Stockholders (Measures the percentage of earnings distributed as cash dividends)
8. Dividend Yield = Common Cash Dividends/Market Value Common Stock (- Measures the percentage of cash dividends received over the cash investment per share of common stockholders)
9. Book value per share = Common stockholders’ equity/Number of common shares outstanding (Book value per common share)
0. Book value to Market = Book value per share/Market Value of Common stock (Measures the book value per share against perceived market value of common stock)
Solvency Ratios – measures of the ability of the enterprise to survive a long period of time.
1. Time interest earned ratio = Operating income/Interest expense ( Measures the ability to meets interest payments as they become due)
2. Debt-to-equity ratio = Liabilities/Stockholders’ Equity (Measures size of total debt to total capital)
3. Debt ratio = Liabilities/Total Assets (Measures percentage of total assets provided by creditors)
4. Equity ratio = Total Equity/Total Assets (Measures the percentage of total assets provided by owners)
The Liquidity ratios, Profitability ratios and Solvency ratios are indeed useful for accountants and analysts in financial statement analysis for the valuation of the liquidity, profitability and solvency of a Company’s business operations.