Glossary

2.1 Financial statement analysis

7 min read•august 19, 2024

Financial statement analysis is a crucial tool for assessing a company's health and performance in mergers and acquisitions. It involves examining balance sheets, income statements, and cash flow statements to identify trends, strengths, and weaknesses.

Key techniques include horizontal, vertical, and . These methods help evaluate profitability, liquidity, solvency, and efficiency. By understanding these metrics, decision-makers can better assess potential merger targets and acquisition opportunities.

Objectives of financial statement analysis

  • Assess the financial health and performance of a company to inform decision-making in mergers, acquisitions, and complex financial structures
  • Identify trends, strengths, weaknesses, and potential red flags in a company's financial statements to determine its suitability as a merger or acquisition target
  • Provide insights into a company's profitability, liquidity, solvency, and efficiency to support processes and valuation assessments

Key financial statements

Balance sheet

Top images from around the web for Balance sheet

  • Classified Balance Sheet | Financial Accounting View original

    Is this image relevant?

  • The Balance Sheet | Boundless Business View original

    Is this image relevant?

  • Classified Balance Sheet | Financial Accounting View original

    Is this image relevant?

1 of 3

Top images from around the web for Balance sheet

  • Classified Balance Sheet | Financial Accounting View original

    Is this image relevant?

  • The Balance Sheet | Boundless Business View original

    Is this image relevant?

  • Classified Balance Sheet | Financial Accounting View original

    Is this image relevant?

1 of 3
  • Provides a snapshot of a company's financial position at a specific point in time
  • Consists of assets (resources owned by the company), liabilities (obligations owed by the company), and equity (residual interest in the assets after deducting liabilities)
  • Helps assess a company's liquidity, solvency, and financial stability (current assets vs. current liabilities, )

Income statement

  • Reports a company's financial performance over a specific period (quarterly, annually)
  • Includes revenue, expenses, and net income or loss
  • Allows for the analysis of a company's profitability and efficiency (, , )

Cash flow statement

  • Presents the inflows and outflows of cash during a specific period
  • Categorized into operating, investing, and financing activities
  • Helps assess a company's ability to generate cash, meet its obligations, and fund growth opportunities

Techniques for financial statement analysis

Horizontal analysis

  • Compares financial statement items over time (year-over-year, quarter-over-quarter)
  • Identifies trends, growth rates, and changes in a company's performance
  • Helps assess the consistency and sustainability of a company's financial results

Vertical analysis

  • Expresses each financial statement item as a percentage of a base figure (total assets, total revenue)
  • Allows for the comparison of a company's financial composition across different periods or with industry benchmarks
  • Identifies changes in the relative importance of financial statement components

Ratio analysis

  • Calculates ratios using financial statement data to assess various aspects of a company's performance
  • Includes profitability, liquidity, solvency, efficiency, and
  • Enables comparisons with industry benchmarks and peer companies to identify strengths and weaknesses

Profitability ratios

Gross profit margin

  • Measures the percentage of revenue remaining after deducting the cost of goods sold
  • Calculated as: GrossProfitMargin=(Revenue−CostofGoodsSold)/RevenueGross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue
  • Higher gross profit margins indicate better profitability and pricing power (Apple, luxury goods)

Operating profit margin

  • Measures the percentage of revenue remaining after deducting operating expenses
  • Calculated as: OperatingProfitMargin=OperatingIncome/RevenueOperating Profit Margin = Operating Income / Revenue
  • Higher operating profit margins suggest better operational efficiency and cost management (Walmart, Amazon)

Net profit margin

  • Measures the percentage of revenue remaining after deducting all expenses, including taxes and interest
  • Calculated as: NetProfitMargin=NetIncome/RevenueNet Profit Margin = Net Income / Revenue
  • Higher net profit margins indicate better overall profitability and financial performance (Microsoft, Alphabet)

Return on assets (ROA)

  • Measures how efficiently a company generates profits from its assets
  • Calculated as: ROA=NetIncome/AverageTotalAssetsROA = Net Income / Average Total Assets
  • Higher ROA suggests better asset utilization and profitability (Coca-Cola, Johnson & Johnson)

Return on equity (ROE)

  • Measures how efficiently a company generates profits from the money invested by shareholders
  • Calculated as: ROE=NetIncome/AverageShareholder′sEquityROE = Net Income / Average Shareholder's Equity
  • Higher ROE indicates better returns for shareholders and profitability (Procter & Gamble, Nike)

Liquidity ratios

Current ratio

  • Measures a company's ability to pay short-term obligations using its current assets
  • Calculated as: [CurrentRatio](https://www.fiveableKeyTerm:CurrentRatio)=CurrentAssets/CurrentLiabilities[Current Ratio](https://www.fiveableKeyTerm:Current_Ratio) = Current Assets / Current Liabilities
  • A current ratio above 1 indicates that a company has sufficient current assets to cover its current liabilities (General Electric, PepsiCo)

Quick ratio

  • Measures a company's ability to pay short-term obligations using its most liquid assets (excludes inventory)
  • Calculated as: [QuickRatio](https://www.fiveableKeyTerm:quickratio)=(Cash+MarketableSecurities+AccountsReceivable)/CurrentLiabilities[Quick Ratio](https://www.fiveableKeyTerm:quick_ratio) = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
  • A quick ratio above 1 suggests that a company can meet its short-term obligations without relying on inventory sales (Intel, Cisco Systems)

Cash ratio

  • Measures a company's ability to pay short-term obligations using only cash and cash equivalents
  • Calculated as: [CashRatio](https://www.fiveableKeyTerm:cashratio)=(Cash+CashEquivalents)/CurrentLiabilities[Cash Ratio](https://www.fiveableKeyTerm:cash_ratio) = (Cash + Cash Equivalents) / Current Liabilities
  • A higher cash ratio indicates a stronger liquidity position and ability to meet short-term obligations (Berkshire Hathaway, Apple)

Solvency ratios

Debt-to-equity ratio

  • Measures the proportion of a company's financing that comes from debt compared to equity
  • Calculated as: Debt−to−EquityRatio=TotalLiabilities/TotalShareholder′sEquityDebt-to-Equity Ratio = Total Liabilities / Total Shareholder's Equity
  • A lower debt-to-equity ratio suggests a more financially stable company with less reliance on debt financing (Costco, Visa)

Debt-to-assets ratio

  • Measures the proportion of a company's assets that are financed by debt
  • Calculated as: [Debt−to−AssetsRatio](https://www.fiveableKeyTerm:debt−to−assetsratio)=TotalLiabilities/TotalAssets[Debt-to-Assets Ratio](https://www.fiveableKeyTerm:debt-to-assets_ratio) = Total Liabilities / Total Assets
  • A lower debt-to-assets ratio indicates a company has a stronger financial position and is less leveraged (Home Depot, McDonald's)

Interest coverage ratio

  • Measures a company's ability to make interest payments on its debt using its operating income
  • Calculated as: [InterestCoverageRatio](https://www.fiveableKeyTerm:InterestCoverageRatio)=OperatingIncome/InterestExpense[Interest Coverage Ratio](https://www.fiveableKeyTerm:Interest_Coverage_Ratio) = Operating Income / Interest Expense
  • A higher interest coverage ratio suggests a company can comfortably meet its debt obligations (ExxonMobil, Chevron)

Efficiency ratios

Inventory turnover

  • Measures how efficiently a company manages its inventory by calculating how many times inventory is sold and replaced during a period
  • Calculated as: [InventoryTurnover](https://www.fiveableKeyTerm:InventoryTurnover)=CostofGoodsSold/AverageInventory[Inventory Turnover](https://www.fiveableKeyTerm:Inventory_Turnover) = Cost of Goods Sold / Average Inventory
  • A higher inventory turnover ratio indicates better inventory management and sales performance (Toyota, Honda)

Receivables turnover

  • Measures how efficiently a company collects its accounts receivable by calculating how many times receivables are collected during a period
  • Calculated as: [ReceivablesTurnover](https://www.fiveableKeyTerm:ReceivablesTurnover)=NetCreditSales/AverageAccountsReceivable[Receivables Turnover](https://www.fiveableKeyTerm:Receivables_Turnover) = Net Credit Sales / Average Accounts Receivable
  • A higher receivables turnover ratio suggests better credit and collection policies (Mastercard, American Express)

Payables turnover

  • Measures how efficiently a company pays its accounts payable by calculating how many times payables are paid during a period
  • Calculated as: [PayablesTurnover](https://www.fiveableKeyTerm:PayablesTurnover)=CostofGoodsSold/AverageAccountsPayable[Payables Turnover](https://www.fiveableKeyTerm:Payables_Turnover) = Cost of Goods Sold / Average Accounts Payable
  • A lower payables turnover ratio indicates a company is taking longer to pay its suppliers, which may suggest cash flow issues (General Motors, Ford)

Asset turnover

  • Measures how efficiently a company uses its assets to generate revenue
  • Calculated as: [AssetTurnover](https://www.fiveableKeyTerm:AssetTurnover)=Revenue/AverageTotalAssets[Asset Turnover](https://www.fiveableKeyTerm:Asset_Turnover) = Revenue / Average Total Assets
  • A higher asset turnover ratio indicates better asset utilization and efficiency (Walmart, Kroger)

Market value ratios

Earnings per share (EPS)

  • Measures the portion of a company's profit allocated to each outstanding share of common stock
  • Calculated as: EPS=(NetIncome−PreferredDividends)/WeightedAverageNumberofSharesOutstandingEPS = (Net Income - Preferred Dividends) / Weighted Average Number of Shares Outstanding
  • Higher EPS suggests better profitability and potential for stock price appreciation (Apple, Microsoft)

Price-to-earnings (P/E) ratio

  • Measures the relationship between a company's stock price and its earnings per share
  • Calculated as: P/ERatio=MarketPriceperShare/EarningsperShareP/E Ratio = Market Price per Share / Earnings per Share
  • A higher P/E ratio may indicate that investors expect higher growth and profitability in the future (Amazon, Netflix)

Dividend yield

  • Measures the annual dividend income per share relative to the stock price
  • Calculated as: [DividendYield](https://www.fiveableKeyTerm:dividendyield)=AnnualDividendsperShare/MarketPriceperShare[Dividend Yield](https://www.fiveableKeyTerm:dividend_yield) = Annual Dividends per Share / Market Price per Share
  • A higher dividend yield may attract income-oriented investors (AT&T, Verizon)

Dividend payout ratio

  • Measures the proportion of a company's earnings paid out as dividends
  • Calculated as: [DividendPayoutRatio](https://www.fiveableKeyTerm:dividendpayoutratio)=DividendsperShare/EarningsperShare[Dividend Payout Ratio](https://www.fiveableKeyTerm:dividend_payout_ratio) = Dividends per Share / Earnings per Share
  • A lower dividend payout ratio suggests a company is retaining more earnings for growth and reinvestment (Alphabet, Facebook)

Limitations of financial statement analysis

  • Historical data may not accurately predict future performance, especially in rapidly changing industries or economic conditions
  • Differences in accounting methods and estimates across companies can limit comparability
  • Non-financial factors (management quality, industry trends, competitive landscape) are not captured in financial statements but can significantly impact a company's performance and value

Using financial statement analysis for decision-making

Evaluating financial health

  • Assess a company's overall financial position, profitability, liquidity, and solvency to determine its attractiveness as a merger or acquisition target
  • Identify potential red flags or areas of concern that may impact the success of a merger or acquisition (high debt levels, declining profitability)

Comparing companies

  • Use financial ratios and benchmarks to compare the performance of potential merger or acquisition targets within the same industry
  • Identify companies that outperform their peers in key areas (profitability, efficiency, growth) and may offer or strategic advantages
  • Analyze changes in a company's financial performance over time to identify positive or negative trends that may impact its future prospects
  • Assess the sustainability and consistency of a company's financial results to determine its suitability for a merger or acquisition

Forecasting future performance

  • Use historical financial data and trends to develop projections and models of a company's future performance
  • Incorporate assumptions about the impact of a merger or acquisition on the combined entity's financial statements to assess the potential benefits and risks of the transaction

Key Terms to Review (33)

Accretion/dilution analysis: Accretion/dilution analysis is a financial assessment used to evaluate the impact of an acquisition on a company's earnings per share (EPS). It determines whether the acquiring company's EPS will increase (accretion) or decrease (dilution) as a result of the transaction, helping stakeholders understand the financial implications of mergers and acquisitions. This analysis is crucial for assessing the attractiveness of potential deals and influences decision-making in corporate finance.
Asset Turnover: Asset turnover is a financial ratio that measures the efficiency of a company in using its assets to generate sales revenue. It indicates how well a company is utilizing its assets to produce income, with higher ratios suggesting better performance. This metric is essential for assessing operational efficiency and can provide insights into the company's overall asset management strategy.
Balance Sheet: A balance sheet is a financial statement that presents a company's financial position at a specific point in time, showing the assets, liabilities, and equity. It is essential for understanding a company's financial health, as it helps stakeholders evaluate what the company owns and owes. The balance sheet follows the accounting equation, where assets equal liabilities plus equity, providing a clear snapshot of the company's resources and obligations.
Cash Flow Statement: A cash flow statement is a financial report that provides a detailed summary of the cash inflows and outflows of a business over a specific period. It highlights how cash is generated and spent, allowing stakeholders to understand the liquidity position of the company. This statement is essential for analyzing the operational efficiency, investment activities, and financing strategies of a business, linking directly to overall financial performance and decision-making.
Cash ratio: The cash ratio is a liquidity measure that evaluates a company's ability to cover its short-term liabilities using only its most liquid assets, specifically cash and cash equivalents. This ratio is a conservative indicator of financial health, as it focuses solely on the immediate availability of cash without considering other current assets. Understanding the cash ratio helps stakeholders assess how well a company can meet its obligations in the short term, which is critical for financial stability and operational efficiency.
Current Ratio: The current ratio is a financial metric that measures a company's ability to pay its short-term liabilities with its short-term assets. This ratio is crucial for assessing liquidity and financial health, as it provides insight into whether a company can cover its debts that are due within one year. A higher current ratio indicates a stronger ability to meet obligations, while a lower ratio could suggest potential liquidity issues, making it an important consideration in evaluating overall financial stability and operational efficiency.
Debt-to-assets ratio: The debt-to-assets ratio is a financial metric that measures the proportion of a company's total assets that are financed by debt. This ratio helps assess a company’s financial leverage and risk, indicating how much of the company's assets are funded through borrowing. A higher ratio suggests more leverage, which can imply greater financial risk, while a lower ratio indicates a more conservative approach to financing.
Debt-to-equity ratio: The debt-to-equity ratio is a financial metric that compares a company's total debt to its shareholders' equity, indicating the proportion of company financing that comes from creditors versus shareholders. This ratio helps assess a firm's financial leverage and risk, showing how much debt is used to fuel growth compared to equity investments. A high ratio may suggest higher financial risk, while a low ratio can indicate a more stable financial position.
Dividend payout ratio: The dividend payout ratio is a financial metric that indicates the proportion of earnings a company distributes to its shareholders in the form of dividends. It is calculated by dividing the total dividends paid by the net income of the company. This ratio helps investors understand how much profit is being returned to shareholders compared to what is being retained for reinvestment in the business.
Dividend yield: Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price. It is expressed as a percentage and helps investors understand the return on investment they can expect from dividends alone. A higher dividend yield can indicate a potentially attractive investment, but it should be considered alongside other factors such as the company’s overall financial health and growth prospects.
Due Diligence: Due diligence refers to the comprehensive appraisal of a business or investment opportunity, typically conducted before a merger or acquisition. This process involves reviewing financial records, legal obligations, operational performance, and potential risks to ensure that all material facts are known and assessed before finalizing a transaction. It serves as a critical step to validate the information provided by the target company and to identify any issues that could impact the value of the deal.
Earnings Per Share (EPS): Earnings per share (EPS) is a financial metric that indicates the portion of a company's profit allocated to each outstanding share of common stock. EPS is a crucial measure used by investors to assess a company’s profitability and is often a key factor in determining a company's stock price. By analyzing EPS, stakeholders can gauge financial performance and compare it against competitors or industry benchmarks.
Efficiency Ratios: Efficiency ratios are financial metrics used to evaluate how effectively a company utilizes its assets and liabilities to generate sales and maximize profits. These ratios provide insights into operational performance, helping stakeholders assess the company's ability to manage its resources efficiently. By analyzing these ratios, one can identify strengths and weaknesses in asset management, indicating potential areas for improvement in operational strategies.
Gross Profit Margin: Gross profit margin is a financial metric that indicates the percentage of revenue that exceeds the cost of goods sold (COGS). This measure helps assess a company's efficiency in producing and selling its products, revealing how well it controls production costs relative to sales. A higher gross profit margin signifies better financial health and profitability, making it a crucial indicator in financial statement analysis.
Horizontal Analysis: Horizontal analysis is a financial statement analysis technique that evaluates financial data over a period of time to identify trends and growth patterns. By comparing line items from financial statements across multiple periods, it helps stakeholders assess the performance and changes in financial position. This method is crucial for understanding the direction in which a company's finances are heading and aids in making informed decisions.
Income Statement: An income statement is a financial report that summarizes a company's revenues and expenses over a specific period, usually a quarter or a year. It provides insights into the company's financial performance, showing how much profit or loss was generated during that period. This statement is crucial for evaluating profitability, making investment decisions, and assessing operational efficiency.
Interest Coverage Ratio: The interest coverage ratio is a financial metric that measures a company's ability to pay interest on its outstanding debt. It is calculated by dividing the company's earnings before interest and taxes (EBIT) by its interest expenses. This ratio indicates how easily a company can meet its interest obligations, helping investors and analysts assess the financial health and risk associated with a company's capital structure.
Inventory Turnover: Inventory turnover is a financial metric that measures how many times a company's inventory is sold and replaced over a specific period, usually a year. A high inventory turnover rate indicates efficient management of inventory, suggesting that goods are sold quickly, while a low turnover can point to overstocking or weak sales. This metric is essential for understanding a company's operational efficiency and its ability to convert inventory into sales, which is particularly important in financial statement analysis.
Liquidity Ratios: Liquidity ratios are financial metrics used to evaluate a company's ability to pay off its short-term obligations with its most liquid assets. They are crucial for assessing the financial health of a business, particularly in determining how well it can meet its current liabilities without relying on the sale of long-term assets. This is particularly relevant when analyzing financial statements and understanding the implications of special purpose entities (SPEs) and variable interest entities (VIEs) in complex financial structures.
Market value ratios: Market value ratios are financial metrics used to evaluate a company's current share price in relation to its earnings, dividends, or other financial metrics. These ratios provide insights into how investors perceive the company's future growth potential and profitability, making them essential for assessing the company's market standing and investment appeal. They help stakeholders understand how much investors are willing to pay for a company's equity compared to its fundamental financial performance.
Net profit margin: Net profit margin is a financial metric that indicates the percentage of revenue that remains as profit after all expenses, taxes, and costs have been deducted from total revenue. It is a critical indicator of a company's overall profitability and operational efficiency, reflecting how effectively a company can convert sales into actual profit. A higher net profit margin implies a more financially healthy business, which can be attractive to investors and stakeholders.
Operating Profit Margin: Operating profit margin is a financial metric that reflects the percentage of revenue that remains after covering operating expenses, excluding taxes and interest. This ratio is crucial as it indicates how efficiently a company is managing its core business operations, highlighting the profitability from its ongoing activities before accounting for external factors such as financing and taxation.
Payables Turnover: Payables turnover is a financial metric that measures how quickly a company pays off its suppliers. This ratio indicates the efficiency of a business in managing its accounts payable, reflecting the speed at which it settles its obligations. A higher payables turnover suggests that a company is paying its suppliers more frequently, which can imply strong cash flow management, while a lower ratio might indicate potential liquidity issues or inefficient payment practices.
Price-to-earnings (p/e) ratio: The price-to-earnings (p/e) ratio is a financial metric used to assess the relative value of a company's shares by comparing its current share price to its earnings per share (EPS). This ratio helps investors gauge whether a stock is overvalued or undervalued, providing insight into a company's profitability and market expectations. It is widely used in financial statement analysis as an indicator of how much investors are willing to pay for each dollar of earnings, making it an essential tool for evaluating investment opportunities.
Profitability ratios: Profitability ratios are financial metrics used to assess a company's ability to generate profit relative to its revenue, operating costs, balance sheet assets, or equity. These ratios are crucial for investors and analysts as they provide insight into a company's financial health and operational efficiency. By evaluating profitability ratios, stakeholders can better understand how well a company is performing compared to its competitors and industry benchmarks.
Quick ratio: The quick ratio, also known as the acid-test ratio, is a financial metric that measures a company's ability to meet its short-term obligations using its most liquid assets. It focuses on the company's cash, cash equivalents, and accounts receivable, excluding inventory from current assets, to provide a more stringent assessment of liquidity. This ratio is particularly important in financial statement analysis as it gives insight into a company's operational efficiency and financial health.
Ratio Analysis: Ratio analysis is a quantitative method used to evaluate the financial performance of a company by analyzing relationships between various financial statement figures. It helps investors, creditors, and management assess a company's profitability, liquidity, efficiency, and solvency. By calculating and interpreting these ratios, stakeholders can gain insights into operational performance and make informed decisions regarding investments or management strategies.
Receivables Turnover: Receivables turnover is a financial ratio that measures how efficiently a company collects its accounts receivable over a specific period, typically a year. It indicates how many times the company collects its average accounts receivable during that time frame, which is essential for evaluating a company's liquidity and credit management practices. A higher receivables turnover ratio suggests better performance in managing credit extended to customers and collecting payments.
Return on Assets (ROA): Return on Assets (ROA) is a financial metric that indicates how efficiently a company uses its assets to generate profit. It measures the percentage of profit a company earns for every dollar of assets it owns, providing insight into the operational effectiveness and asset management of a business. ROA is crucial for comparing the performance of companies within the same industry and can help investors understand how well a firm utilizes its assets in generating earnings.
Return on Equity (ROE): Return on Equity (ROE) is a financial metric that measures the ability of a company to generate profits from its shareholders' equity. It is calculated by dividing net income by shareholders' equity, providing insight into how effectively management is using equity financing to grow the business. This ratio is crucial in evaluating a company's financial performance, and it has implications for investment decisions and comparisons across similar firms.
Solvency ratios: Solvency ratios are financial metrics used to measure a company's ability to meet its long-term debts and financial obligations. These ratios provide insights into the financial health and stability of a business, indicating whether it has enough assets to cover its liabilities. Understanding solvency ratios helps assess the risk level for creditors and investors, showing how effectively a company can sustain operations in the long run.
Synergies: Synergies refer to the potential financial benefits that can be achieved when two companies merge or collaborate, leading to greater efficiencies, cost savings, and enhanced revenue generation. These benefits often arise from the combination of resources, capabilities, and market access, which can create a situation where the combined value of the entities exceeds the sum of their individual values. Understanding synergies is crucial for evaluating financial statements, comparing companies, and assessing stock acquisitions.
Vertical analysis: Vertical analysis is a financial analysis method that expresses each item in a financial statement as a percentage of a base figure within the same statement. This technique allows for easy comparison of line items over time or between companies by normalizing figures to a common denominator, enhancing the understanding of financial performance and structure.
© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.
Back
Practice QuizGlossary
Practice QuizGlossary
Next guide