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Financial Statement Analysis: Definition, Purpose, Elements & Examples

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  • 0:01 Financial Statement Analysis
  • 1:13 Liquidity Ratio
  • 2:32 Debt Ratio
  • 3:22 Profitability Ratio
  • 4:30 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define financial statement analysis and discuss the main categories. You'll also learn how to calculate a financial ratio in each category and analyze the results.

Financial Statement Analysis

Nikki is a Manager of Finance at Star & Moon Accounting Firm. Her boss has asked her to give a presentation to newly hired financial analysts on financial statement analysis. The following week, Nikki started her presentation by asking the new hires, 'What are the main financial statements?' One new hire raised her hand and said, 'The income statement, the balance sheet, statement of owner's equity, and the statement of cash flow.'

Nikki said, 'Excellent, you know the basic financial statements. Now what is financial statement analysis?' There was a blank stare on the faces of the new hires. No one raised their hand so she said, 'Financial statement analysis involves using two or more line items from a financial statement, which forms a ratio, to make calculations and interpret results. Financial statement analysis is categorized by liquidity, debt, and profitability. Each of you here will be assigned a category and will be responsible for calculating and analyzing ratios in that prospective area.' For the remainder of this lesson, we'll discuss each financial statement ratio category, show an example of each and look at how to analyze the calculated results.

Liquidity Ratio

Nikki started explaining liquidity by asking the new hires, 'If a business needed to purchase supplies, which asset could they turn into cash the fastest: a savings account or inventory?' We all said in unison, 'A savings account.' She then called on a new hire on the back row and asked why. He answered by explaining that all a business would have to do is go to the bank and withdraw the money, but with inventory, they would have to wait for it to sell to get the cash. Nikki replied excitedly, 'Absolutely! Liquidity is our ability to turn assets into cash.'

Let's look at an example of a liquidity ratio, the current ratio. Current in this instance means short term, less than a year. The current ratio is calculated by taking current assets divided by current liabilities. Assets are items the business owns, such as a truck, and liabilities are obligations the business owes, such as a loan. The current ratio tells us how well we're able to pay our current liabilities by liquidating our current assets. The higher the result, the better we're able to pay our liabilities or obligations. This analysis is important to determine how well we're able to pay our obligations with what we own. Now let's look at a debt ratio.

Debt Ratio

The debt ratio explains what percentage of our assets are financed with loans. Nikki went on to say, 'Remember, assets are items we own, such as a truck, and a truck loan is considered a liability or debt.' To calculate the debt ratio, you take total liabilities divided by total assets. But remember, you don't use just one asset or one liability, but all of them. The higher the percentage, the more of your assets are calculated with debt. In other words, the higher the percentage, the less of the asset you own. This ratio would be important to determine how much debt a company is in and if they're in a solid financial position to take on more debt. Just as important as debt is profitability - a business must make a profit, after all, that's what they're in business to do.

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