Financial statement analysts use a variety of techniques to evaluate a company's short- and long-term profitability, business trends and performance indicators. Horizontal and vertical analyses show financial statement items in percentage and dollar forms. Liquidity ratios reflect cash availability. Profitability ratios analyze sales and expense trends. Solvency ratios indicate a firm's long-term ability to repay debt.
A financial statement analyst uses horizontal analysis to compare two years' financial data and shows changes in percentage or in dollars. This specialist also could compare several years in order to detect trends or operating indicators. For example, a finance specialist might review a company's statement of profit and loss and compute dollar and percentage variations in sales over a ten-year period to assess business performance.
Vertical analysis helps a firm understand business performance and segment productivity by evaluating common size statements. Such statements indicate operating items in percentage and dollar forms. Vertical analysis specialists compute each item as a percentage of a base amount. For example, ABC Finance's common size balance sheet--showing assets, liabilities and owners' equity--could show asset items as percentages of total assets. If ABC Finance's total assets amount to $100 million, and cash available is $12 million, a common size balance sheet will show total assets at 100% and cash available at 12%.
Profitability ratios reflect a business entity's success in increasing net income by raising sales. Such ratios could be net profit, gross profit, operating or expense ratios. For example, a financial analyst might evaluate XYZ Company's net profit ratio--also called profit margin--to evaluate the company profitability during a quarter. Profit margin equals net income over sales.
Liquidity ratios evaluate a company's ability to pay current liabilities with current assets. Current financial items are also referred to as short-term items. Assets are what a business owns, and liabilities, what it owes. Current assets include cash, inventories and accounts receivable. Current liabilities--or debt--could include bank loans, salaries and accounts payable. For example, a specialist might calculate a firm's current ratio--current assets over current liabilities--to evaluate whether the firm has sufficient funds to pay short-term obligations.
Activity ratios indicate how quickly a company transforms its resources into sales. For instance, a firm's inventory turnover--sales divided by inventories--reflects how long it takes the firm to sell goods received and replenish stocks.
Long term solvency or leverage ratios indicate a company's ability to pay long-term obligations on time. Long-term obligations--or liabilities--could include items payable within five or ten years. Leverage ratios also analyze whether a firm will have sufficient funds to pay interests. Long-term liabilities could include 10-year bonds payable or bank loans. For example, an analyst might compute Company ABC's debt-to-equity ratio to ensure that the company has enough equity or capital to pay debts.