Analysis of Financial Statements

Tools of Financial Statement Analysis

Horizontal Analysis – is a technique for evaluating a series of financial statement data over
a period of time.
Vertical Analysis – is a technique for evaluating financial statement data that expresses
each item
in a financial statement in terms of percent of a base amount.
Ratio Analysis – expresses relationship among selected items of financial statement data.

Financial Ratios:
Tests of Liquidity – refers to company’s ability to pay its current liabilities as they fall due
Tests of Solvency – ability of the company to pay its debts
Tests of Profitability – measurements of degree of success (or failure) of profit-directed
activities of a firm or division thereof.

Tests of Liquidity:
• Current ratio (banker’s ratio, Working capital ratio)
It is a measure of adequacy of working capital. It is the primary test of solvency to meet
current obligations from current assets.
= Current assets / Current liabilities

• Quick ratio (Acid Test Ratio)

It measures the number of times that the current liabilities could be paid with the available
cash and near cash items. Quick assets refer to all current assets except inventories and
prepaid expenses.
= Quick assets / Current Liabilities

• Receivables turnover
It is the time required to complete one collection cycle from the time receivables are
recorded, then collected, to the time new receivables are recorded again.
= Net (credit) sales / Average receivables

• Average age of receivables (average collection period or days ‘sales in receivables)

It indicates the average number of days during which the company must wait before
receivables are collected.
= 360 days / Receivables turnover
 • Inventory turnover
It measures the number of times that the inventory is replaced during the period.
= Cost of goods sold / Average merchandise inventory

• Average age of inventory (Inventory Conversion Period or Days’ sales in inventory)

It indicates the average number of days during which the company must wait before the
inventories are sold
= 360 days / Inventory turnover

• Normal Operating Cycle

= Average age of Receivables + Average age of Inventory

• Trade Payables Turnover

= Net credit purchases/Average Trade Payables

• Average age of Trade Payables

It indicates the length of time during which payables remain unpaid.
= 360days/ Payables turnover

• Current Assets Turnover

It measures the movement and utilization of current assets to meet operating
requirements.
= Cost of sales + Operating Expenses **/Average current assets
** Exclude depreciation, amortization and other expenses related to long term
assets.

Tests of Solvency:
• Times Interest Earned - It determines the extent to which operations cover interest
expense
=EBIT/Interest Expense

• Debt-Equity Ratio - Proportion of assets provided by creditors compared to that

provided by owners
=Total Liabilities/Total SHE

• Debt Ratio - Proportion of total assets provided by creditors

=Total Liabilities/Total Assets

• Equity Ratio - Proportion of total assets provided by owners

=Total SHE/Total Assets