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Financial Statement Analysis Review
Introduction to Finance (FIN2303)
Algonquin College
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Financial Statement Analysis
REVIEW QUESTIONS
1. Why is it important to use ratios to analyze financial
statements?
Ratios can help managers and analysts make the connection between different accounts or groups of accounts on statements of income and statements of financial position and can facilitate comparisons with competitors and industry norms. Ratios are excellent tools to analyze financial statements that improve the decision-making process.
2. What does management want to achieve when it tries to
“ensure liquidity” and
“maintain solvency”?
Ensure liquidity means the ability for the business to respect its short- term financial obligations such as paying their working capital loans, employees, and suppliers on time. Maintain solvency means the ability for the business to service its debts (short- term and long-term) in addition to maintaining a good ratio between all debts and all assets. 3. Financial ratios are analyzed by four groups of individuals: managers, short-term lenders, long-term lenders, and equity investors. What is the primary emphasis of each group in evaluating ratios?
Managers will emphasize the ratios that apply to their areas of concern (such as trade receivables and inventories), but all managers seek to maximize return on assets. Short-term lenders will be concerned with measures of liquidity to ensure that funds are available for repaying loans. Long-term lenders may be more interested in measures of solvency to be sure a business is not overextended in debt and can pay its principal and interest obligations over a long period of time. Equity investors will be interested to some extent on return on assets ratios as indicators of the ability to pay dividends, but over the long run, equity investors are interested in long-term prosperity because it increases the value of their investments. 4. What is the purpose of vertical analysis and horizontal analysis?
Vertical analysis divides each component by a total that contains that component. In the case of the statement of income, all accounts shown on the statement are divided by revenue. In the case of the statement of financial position, all account shown in the asset section of the statement are divided by total assets while all accounts shown on the liability and equity side of the statement are divided by total liabilities and equity.
Liquidity ratios measure the ability of a business to have enough cash to pay its day-to-day operating expenses and retire other liabilities on schedule. 8. Differentiate between the current ratio and the quick ratio.
The current ratio is current assets divided by current liabilities, which determines the number of times current assets exceed current liabilities. The quick ratio considers only the more liquid current assets, such as cash, marketable securities, and trade receivables; it excludes the inventory account.
Financial Statement Analysis Review
Course: Introduction to Finance (FIN2303)
University: Algonquin College
