9.4 Analyzing Financial Statements
Now that you know a bit about financial statements, let’s see how they’re used to help owners, managers, investors, and creditors assess a firm’s performance and financial strength. You can glean a wealth of information from financial statements, but first, you need to learn a few basic principles for “unlocking” it.
Trend Analysis from the Income Statement
Peruse an abbreviated financial statement for Apple for 2017 taken directly from their website. You will note that instead of showing only the current year’s results, the company has shown data for the prior year as well.
From this relatively simple exhibit, considerable information about Apple’s performance can be obtained.
For example:
- Apple sales grew at 12.7% from 2016 to 2017, not bad for a company with such a large base of sales already, but certainly not the rapid-growth company it once was. When making yearly comparisons, this is commonly referred to as performing a horizontal analysis.
- Net income as a percent of sales (a ratio also known as return on sales) was 22.7% in 2017 – or in other words, for every $5 in sales, Apple turned more than $1 of it into profit. That is substantial! When calculating ratios as a percent of a larger figure (i.e., Net income as a percent of sales, or cash as a percent of Total Assets) this is commonly referred to as performing a vertical analysis.
Many other calculations are possible from Apple’s data, and we will look at a few more as we explore ratio analysis.
Ratio Analysis
How do you compare Apple’s financial results with those of other companies in your industry or with the other companies whose stock is available to investors? And what about your balance sheet? Are there relationships on this statement that also warrant investigation? These issues can be explored by using ratio analysis, a technique for evaluating a company’s financial performance.
Remember that a ratio is just one number divided by another, with the result expressing the relationship between the two numbers. It’s hard to learn much from just one ratio, or even a number of ratios covering the same period. Rather, the deeper value in ratio analysis lies in looking at the trend of ratios over time and in comparing the ratios for several time periods with those of other companies. There are a number of different ways to categorize financial ratios.
Here are a few sets of categories:
- Profitability ratios: These tell you how much profit is made relative to the amount invested (return on investment) or the amount sold (return on sales).
- Liquidity ratios: These tell you how well-positioned a company is to pay its bills in the near future. Liquidity refers to how quickly an asset can be turned into cash. For example, share of stock is substantially more liquid than a building or a machine.
- Debt ratios: These look at how much borrowing a company has done in order to finance the operations of the business. The more borrowing, the more risk/debt a