Evaluating Financial Information
Businesses record and evaluate financial information to gauge their performance. Creditors examine a company's finances to assist in lending decisions. Investors analyze this data to make choices between investing in one business or another. Several methods exist for evaluating financial information.
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Liquidity Ratio Analysis
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Liquidity ratio analysis determines how easily a company can pay its bills. Managers, creditors and investors want to see that the company can pay its bills without struggling to meet those payments. A company that struggles to make monthly payments will have a difficult time making additional creditor payments or paying a return to investors. Common liquidity analysis measures include working capital and the current ratio. Working capital measures the value of current assets available after all of the company's current liabilities are paid. The current ratio divides the current assets by the current liabilities.
Solvency Ratio Analysis
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Solvency ratio analysis determines how likely the business is to continue operating in its current state. Managers, creditors and investors want to see a company that will continue existing for years to come, not one that may file bankruptcy in the near future. Common solvency ratios include the debt to asset ratio and the debt to equity ratio. The debt to asset ratio divides total assets by total liabilities to determine how much the company is able to reduce assets without impacting creditor liabilities. The debt to equity ratio divides total company equity by its total debt to determine whether the company will meet its creditor obligations if it becomes insolvent.
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Profitability Ratio Analysis
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Profitability ratio analysis demonstrates how much money the company earns after paying its expenses. Managers, creditors and investors like to see profitable companies. Common profitability ratios include the gross profit margin and earnings per share. Gross profit margin shows the percentage of revenue available after deducting the cost of the product sold and is calculated by dividing net sales by the difference between net sales and cost of goods sold. Earnings per share shows the amount of money earned per share of common stock. Earnings per share is calculated by dividing net income by the number of shares.
Horizontal Analysis
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Horizontal analysis allows you to determine the percentage of change for each item on the financial statements from year to year. Compare the amounts from two years, determine the difference and divide the difference by the total from the earliest year.
Vertical Analysis
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Vertical analysis allows you to determine what percentage of the total is made up of each individual item. One item on the financial statement equals 100 percent, while everything else is divided by that number to determine the percentage. On the income statement, sales equal 100 percent. On the balance sheet, total assets equal 100 percent.
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