Healthcare Economics and Finance

HMP 703

Financial Statement Analysis

(Chapter 4 Zelman et al.)
 Learning Objectives
• In this chapter, you will be able to:
➢ Analyze the financial statements of healthcare organizations using the
horizontal analysis, vertical analysis and ratio analysis.

➢ Calculate and interpret liquidity, profit and activity ratios.

2
 Overview
• Financial statement analysis is the process of analyzing a company's financial
statements for decision-making purposes.
• External stakeholders use it to understand the overall health of an organization
as well as to evaluate financial performance and business value.
• Internal constituents use it as a monitoring tool for managing the finances.
• Financial statement analysis is used by internal and external stakeholders to
evaluate business performance and value.
• Financial accounting calls for all companies to create a balance sheet, income
statement, and cash flow statement which form the basis for financial statement
analysis.
• Horizontal, vertical, and ratio analysis are three techniques analysts use when
analyzing financial statements.
 What Is Financial Statement Analysis?
• Financial Statement Analysis (FSA) is the diagnostic and investigative
study of Financial Statements in order to take logical business decisions.
• Financial Statement Analysis takes the raw financial information from the
financial statements and turns it into usable information the can be used to
make decisions.
• To understand Financial Statement Analysis or FSA, you must first study the
previous chapter (Ch 3) about the Financial Statements.

4
Common Types Of Financial Statements
1. Balance Sheets. (Assets = Liabilities + Shareholders’ Equity)
2. Statement of cash flows.
3. Statement of operations.

5
 What Is Financial Statement Analysis?
• Financial statement analysis involves gaining an understanding of an
organization's financial situation by reviewing its financial reports. The results can
be used to make investment and lending decisions.
• Financial statement analysis is the process of evaluating a company’s
performance or value through a company’s balance sheet, income statement, or
statement of cash flows. By using a number of techniques such as horizontal,
vertical, or ratio analysis, investors may develop a more nuanced picture of a
company’s financial profile.
• Financial Statement Analysis is considered as one of the best ways to analyze
the fundamental aspects of a business.
• It helps in understanding the financial performance of the company derived from its
financial statements. This is an important metric to analyze the company’s
operating profitability, liquidity, leverage, etc.

6
Financial statement analysis, seeking to
describe and explain:
• Financial Statement Analysis is a technique of answering various
questions regarding the performance of a firm in the past, present, and
future.

7
 What Are the Different Types of
Financial Statement Analysis?
• Most often, analysts will use three main techniques for analyzing a
company's financial statements.
• First, horizontal analysis involves comparing historical data. Usually, the
purpose of horizontal analysis is to detect growth trends across different
time periods.
• Second, vertical analysis compares items on a financial statement in
relation to each other. For instance, an expense item could be expressed as
a percentage of company sales.
• Finally, ratio analysis, a central part of fundamental equity analysis,
compares line-item data. P/E ratios, earnings per share, or dividend yield
are examples of ratio analysis.
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 Types Of Financial Statement Analysis
• Most often, analysts will use three main techniques for analyzing a
company's financial statements.
1. Vertical analysis
2. Horizontal analysis (also known as trend analysis)
3. Ratio analysis

• Vertical and horizontal analysis are two related, but different, techniques
used to analyze financial statements. They each refer to the way in which a
financial statement is read, and the comparisons that an analyst can draw
from that reading.

9
 Vertical analysis
• Vertical analysis is very simple than horizontal analysis because it allows
businesses to reveal the outcomes after studying the income statement
and balance sheet.
• It plays a significant role in financial statement preparation to achieve
optimal results. An income statement allows a business to have a look at
the margins, expenses and cost of goods sold.
• The details provided by the balance sheet let businesses to notify the
changes after evaluating three important categories such as assets,
equities, and liabilities.

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 Vertical Analysis
• Vertical analysis is the process
of reading down a single
column in a financial
statement.
• Vertical analysis is used to
determine how individual line
items in a statement relate to
another item in the report.
• For example, in an income
statement, each line item might
be listed as a percentage of
gross profit.

11
 Vertical (Common-Size) Analysis
• Vertical analysis is useful for analyzing the balance sheet.
• It aims to answer the general question, What percentage of one line item
with another line item?
• It called ‘common size’ because it converts every line item to a
percentage, thus allowing comparisons between the financial accounts of
the organizations of different sizes.
𝑳𝒊𝒏𝒆 𝒊𝒕𝒆𝒎 𝒐𝒇 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
• Vertical analysis = 𝐗𝟏𝟎𝟎
𝑩𝒂𝒔𝒆 𝒍𝒊𝒏𝒆 𝒊𝒕𝒆𝒎

12
 Vertical analysis
Comparative (Partial) Balance Sheet
December 31, 2011
Common-Size
Percent
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000 ($12,000 ÷
Prepaid expenses 3,000 1,200 $315,000) × 100
Total current assets $ 155,000 $ 164,700 = 3.8%
Property and equipment:
Land 40,000 40,000 12.7%
Buildings and equipment, net 120,000 85,000 ($23,500 ÷
Total property and equipment $ 160,000 $ 125,000 $289,700) × 100 =
$ 315,000 $ 289,700 8.1%
Total assets

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 Vertical analysis
Comparative (Partial) Balance Sheet
December 31, 2011
Common-Size
Percent
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
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 Horizontal Analysis
• A horizontal analysis involves comparing the current year performance of
a business with the performance of previous years.
• It is usually done with the income statements and balance sheets that can
help come to a conclusion.
• In addition, it allows businesses to get more ideas about the changes in
detail for making a decision accordingly.
• Horizontal financial statement analysis is used to identify trends such as
whether revenue is increasing or decreasing each year.

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 Horizontal Analysis
• Horizontal analysis refers to
the process of reading current
financial data in comparison to
previous reporting periods.
• Also called “trend analysis,”
reading a financial statement
in this way allows an individual
to see how different financial
metrics have changed over
time:
• For example, whether
liabilities have increased or
decreased from Q1 to Q2. 16
 Horizontal Analysis
• Looks at the percentage change in a line item from one year to the next.

• Goal – What is the percentage change in a line item from one year to the
next year?

𝒔𝒖𝒃𝒔𝒆𝒒𝒖𝒆𝒏𝒕 𝒚𝒆𝒂𝒓−𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒚𝒆𝒂𝒓

• Horizontal Analysis = 𝑿 𝟏𝟎𝟎
𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒚𝒆𝒂𝒓

17 17
 Horizontal Analysis
Calculate Change in Dollar Amount
Dollar Analysis period Base period
change = amount
–
amount

E.g., since we are measuring the amount of

the change between 2016 and 2015, the
dollar amounts for 2015 become the “base”
period amounts.

Calculate Change as a Percent

Percent Dollar change
change
=
Base period amount × 100
 Horizontal Analysis
Comparative (partial) Balance Sheet
December 31, 2011
Dollar Percent
2011 2010 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200 1,800
Total current assets $ 155,000 $ 164,700
$12,000 –
Property and equipment: $23,500 =
Land 40,000 40,000 -
$(11,500) 0.0
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000 ($11,500 ÷ $23,500) ×
Total assets $ 315,000 $ 289,700 100 = 48.9%
* Percent rounded to first decimal point.
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 Horizontal Analysis
Comparative (partial) Balance Sheet
December 31, 2011
Dollar Percent
2011 2010 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets $ 155,000 $ 164,700 $ (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment $ 160,000 $ 125,000 $ 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
* Percent rounded to first decimal point.
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 Trend Analysis
• It compares changes over a longer period of time by
comparing each year with a base year.
• It is used to reveal patterns in data covering
successive periods.
• We can use to see the trend over time.

Trend Any subsequent year – base year × 100

percent = Base year

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 Trend Analysis

Berry Products
Income Information
For the Years Ended December 31,
Item 2007 2008 2009 2010 2011
Operating Income 1,054,186 330,909 500,098 1,232,565 1,453,567

Percentage
change from 2007

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 Trend Analysis
Berry Products
Income Information
For the Years Ended December 31,
Item 2007 2008 2009 2010 2011
Operating Income 1,054,186 330,909 500,098 1,232,565 1,453,567

-68.6% -52.6% 16.9% 37.9%

Percentage
change from 2007

2007 is the base period

Trend Any subsequent year – base year × 100

percent = Base year
Trend 330,909 – 1,054,186 × 100 = -68.6%
percent = 1,054,186 23
 Ratio Analysis
• Ratio Analysis is a quantitative analysis technique that establishes the
relationship between two or a combination of more than two items of
financial statements.
• It is usually used to evaluate various aspects of a company’s operating and
financial performance. That financial performance, like its efficiency,
liquidity, profitability, and solvency, is helpful for the management in
making certain decisions.

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 Ratio Analysis
• Ratio analysis is the process of analyzing the information in a financial
report as it relates to another piece of information in the same report.
• There are many different kinds of ratios which can help you gain insight into
the health of a company. These are generally broken into the following broad
categories:
1. Liquidity Ratios: Liquidity ratios offer insight into how liquid a company is,
which is important in measuring a company’s ability to stay in business.
2. Profitability Ratios: These ratios offer insight into how profitable a company is.
3. Activity Ratios: Activity ratios offer insight into how well a company is utilizing
resources.

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 Ratio Analysis
• Preferred approach for gaining an in-depth understanding of financial
statements.
• Ratio expresses the relationship between 2 numbers as a single
number.
 Categories of Ratios Analysis
1. Liquidity ratios. This is the most fundamentally important set of ratios, because they measure
the ability of a company to remain in business. How well is the organization positioned to meet
its short-term obligations?
1. Current ratio.
2. Quick ratio.

2. Profitability ratios. These ratios measure how well a company performs in generating a
profit.
1. Operating margin ratio.
2. Return on net assets.

3. Activity ratios. These ratios are a strong indicator of the quality of management, since
they reveal how well management is utilizing company resources. How efficiently is the
organization using its assets to produce revenues?
1. Fixed asset turnover ratio.
2. Total asset turnover ratio.
Liquidity Ratios
 Liquidity Ratios
• Liquidity ratios. This is the most fundamentally important set of ratios,
because they measure the ability of a company to remain in business.
1. Current ratio. Measures the amount of liquidity available to pay for
current liabilities.
2. Quick ratio. The same as the current ratio, but does not include
inventory.

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 Liquidity Ratios/ Current Ratio
• The current ratio is an important measure of liquidity because short-term
liabilities are due within the next year.
➢ This means that a company has a limited amount of time in order to raise the
funds to pay for these liabilities.
• Current assets like cash, cash equivalents, and marketable securities can easily
be converted into cash in the short term.
➢ This means that companies with larger amounts of current assets will more
easily be able to pay off current liabilities when they become due without
having to sell off long-term, revenue generating assets.

The current ratio measures a firm’s ability to pay off its

short-term liabilities with its current assets.
 Liquidity Ratios/ Current Ratio
• Formula.

• Analysis
➢ The current ratio helps investors and creditors understand the liquidity of a
company and how easily that company will be able to pay off its current
liabilities.

➢ This ratio expresses a firm’s current debt in terms of current assets. So a

current ratio of 4 would mean that the company has 4 times more current
assets than current liabilities.

➢ A higher current ratio is always more favorable than a lower current ratio
because it shows the company can more easily make current debt payments.
 Liquidity Ratios/ Current Ratio
• Example. According to Hospital X’s balance sheet it reported $100,000 of current
liabilities and only $25,000 of current assets.
• Hospital X’s current ratio would be calculated like this:

• As you can see, Hospital X only has enough current assets to pay off 25 percent of
his current liabilities.
• This shows that Hospital X is highly leveraged and highly risky.
• Banks would prefer a current ratio of at least 1 or 2, so that all the current liabilities
would be covered by the current assets. Since Hospital X’s ratio is so low, it is
unlikely that he will get approved for the loan.
 Liquidity Ratios/ Current Ratio
• Calculate the current ratio?
Hospital Current assets Current liabilities Interpreting the current ratio
✓ Hospital A has more than
enough to cover its current
Hospital A $ 2,514,335 $ 1,395,190
liabilities if they come due.
✓ For every $1 of current debt, the
Hospital B $ 1,954,134 $ 3,394,418 hospital has 58 cents available
to pay for the debt in hospital B.
• Solution:
Hospital Current assets Current liabilities Current ratio

Hospital A $ 2,514,335 $ 1,395,190 1.80

Hospital B $ 1,954,134 $ 3,394,418 0.58

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 Liquidity Ratios/ Quick Ratio
• The quick ratio or acid test ratio is a liquidity ratio that measures the ability
of a company to pay its current liabilities when they come due with only
quick assets.
• Quick assets are current assets that can be converted to cash within 90
days or in the short-term.
• Cash, cash equivalents, short-term investments or marketable securities,
and current accounts receivable are considered quick assets.
• The acid test of finance shows how well a company can quickly convert its
assets into cash in order to pay off its current liabilities. It also shows the
level of quick assets to current liabilities.
• It is an indicator of a company’s short-term liquidity
• It measures a company’s ability to meet its short-term obligations
with its most liquid assets.
 Liquidity Ratios/ Quick Ratio
• Formula:

• Analysis
➢ The acid test ratio measures the liquidity of a company by showing its ability to pay off its
current liabilities with quick assets.
➢ If a firm has enough quick assets to cover its total current liabilities, the firm will be
able to pay off its obligations without having to sell off any long-term or capital assets.
➢ Higher quick ratios are more favorable for companies because it shows there are more
quick assets than current liabilities.
 Liquidity Ratios/ Quick Ratio
• Example. Let’s assume Pharmacy X Store is applying for a loan to remodel the
storefront. The bank asks Pharmacy X for a detailed balance sheet, so it can
compute the quick ratio. Pharmacy X’s balance sheet included the following
accounts:
➢ Cash: $10,000
➢ Accounts Receivable: $5,000
➢ Inventory: $5,000
➢ Stock Investments: $1,000
➢ Prepaid taxes: $500
➢ Current Liabilities: $15,000
• The bank can compute Pharmacy X’s quick ratio like this.
• As you can see Pharmacy X’s quick ratio is
1.07.
• This means that Pharmacy X can pay off all of
her current liabilities with quick assets and still
have some quick assets left over.
 Liquidity Ratios/ Quick Ratio
• Now let’s assume the same scenario except Pharmacy X did not provide the bank
with a detailed balance sheet. Instead, Pharmacy X’s balance sheet only included
these accounts:
➢ Inventory: $5,000
➢ Prepaid taxes: $500
➢ Total Current Assets: $21,500
➢ Current Liabilities: $15,000
• Since Pharmacy X’s balance sheet doesn’t include the breakdown of quick assets,
the bank can compute their quick ratio like this:
 Liquidity Ratios/ Quick Ratio
• Calculate the quick ratio?
Company Cash & marketable Net accounts Current
securities receivables liabilities
Company A 363,181 1,541,244 1,395,190
Company B 158,458 1,400,013 3,394,418

• Solution:
Company Cash & marketable Net accounts Current Quick
securities receivables liabilities ratio
Company A 363,181 1,541,244 1,395,190 1.36
Company B 158,458 1,400,013 3,394,418 0.46
Interpreting the Quick Ratio: ✓ Company A has $1.36 of liquid assets available to cover each dollar of short-term
debt, thus, the company is in a good liquidity position.
✓ However, company B may not be able to pay off their current debts using only quick
assets since it has a quick ratio below 1.
 Liquidity Ratios/ Quick Ratio
Calculate the quick ratio?

Company A Company B Company C

40
 Liquidity Ratios/ Quick Ratio

Solution:
Company A Company B Company C

Interpreting the Quick Ratio

• A quick ratio <1 does not necessarily mean the company is facing bankruptcy
✓ it could mean that the company is relying heavily on inventory
✓ It indicates that the company may be having problems collecting on its account receivables
• The higher the quick ratio, the better the company's liquidity position.
• Too high a quick ratio may indicate that the company has too much cash sitting in its reserves.
Profitability Ratios
 Profitability Ratios
• Profitability ratios. These ratios measure how well a company
performs in generating a profit.
1. Operating margin ratio. also known as the operating profit margin,
is a profitability ratio that measures what percentage of total
revenues is made up by operating income.
2. Return on net assets. Shows company profits as a percentage of
fixed assets and working capital.

• For most of these ratios, having a higher value from a previous period
indicates that the company is doing well.

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 Profitability Ratios/ Operating Margin Ratio
• The operating margin ratio is a profitability ratio that measures what
percentage of total revenues is made up by operating income.
• In other words, the operating margin ratio demonstrates how much
revenues are left over after all the variable or operating costs have
been paid.

• Formula:
(Total Operating Revenues )

• Operating margin is a measurement of what proportion of a company's

revenue is left over after paying for variable costs of production such as
wages, raw materials, etc.
 Profitability Ratios/ Operating Margin Ratio
• Analysis
• The operating profit margin ratio is a key indicator for investors and
creditors to see how businesses are supporting their operations.
• If companies can make enough money from their operations to support the
business, the company is usually considered more stable.
• On the other hand, if a company requires both operating and non-operating
income to cover the operation expenses, it shows that the business’ operating
activities are not sustainable.
• A higher operating margin is more favorable compared with a lower ratio
because this shows that the company is making enough money from its
ongoing operations to pay for its variable costs as well as its fixed costs.
• For instance, a company with an operating margin ratio of 20 percent means
that for every dollar of income, only 20 cents remains after the operating
expenses have been paid.
 Profitability Ratios/ Operating Margin Ratio
• Calculate the operating margin ratio?
Year Operating income Total operating revenues
20X1 $ 330, 909 $ 11,012,021
20X0 $ 1,054,186 $ 10,819,693
• Solution:
Year Operating income Total operating revenues Operating Margin
20X1 $ 330, 909 $ 11,012,021 0.03
20X0 $ 1,054,186 $ 10,819,693 0.10

• 20X1’s operating margin 0.03. Only 3 cents remains to cover all non-operating expenses or
fixed costs. This means that 97 cents on every dollar of sales is used to pay for variable costs.

• 20X0’s operating margin 0.10. Only 10 cents remains to cover all non-operating expenses or
fixed costs. This means that 90 cents on every dollar of sales is used to pay for variable costs.
 Profitability Ratios/
Return on Net Assets (RONA)
• It is a performance ratio, which compares the income generated by a
business and the fixed assets used to generate the income.
➢ In other words, it is useful to understand how much income
these assets are producing.
• It measures the efficiency of a company in generating returns on the
assets it owns.
• Generally, the higher this ratio is the better it is. Higher RONA may
imply that the company is using its assets efficiently and effectively.
• Also, an increasing RONA may indicate an improving profitability and
financial performance of a company.
- The return on net assets is a measure of financial performance of a company which takes the use of assets into

account. Higher RONA means that the company is using its assets and working capital efficiently and effectively.

- RONA is used by investors to determine how well management is utilizing assets.

 Profitability Ratios/
Return on Net Assets (RONA)
• Formula.

• Where working capital= current assets – current liabilities

 Profitability Ratios/
Return on Net Assets (RONA)
• Example. Using the financial data presented in the table below, calculate the
return on net assets ration for three years for a hypothetical company A.
Solution

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Activity Ratios
 Activity Ratios
• Activity ratios. These ratios are a strong indicator of the quality of
management, since they reveal how well management is utilizing
company resources.
• It is also called Efficiency Ratios.
• It is used to answer the following question: “For each dollar invested in
assets, how many dollars of revenue (return) are being generated”?
• The higher the ratio, the more efficiently the assets are being generated.
• In general: activity ratios= Revenues/Assets
• Some selected activity ratios are:
1. Total asset turnover ratio, measures the efficiency with which a
company uses its assets to produce sales.
2. Fixed asset turnover ratio. Measures a company's ability to
generate sales from a certain base of fixed assets.
 Activity Ratios/
Total Asset Turnover Ratio
• The asset turnover ratio is an efficiency ratio that measures a
company’s ability to generate sales from its assets by comparing net
sales with average total assets.
• In other words, this ratio shows how efficiently a company can use
its assets to generate sales.
• The total asset turnover ratio calculates net sales as a percentage of
assets to show how many sales are generated from each dollar of
company assets.

• It measures the overall efficiency of the organization’s assets in

producing revenue.
 Activity Ratios/
Total Asset Turnover Ratio
• Formula:
Total Asset Turnover ratio = Total Operating Revenues
Total Assets
• Analysis
➢ This ratio measures how efficiently a firm uses its assets to generate sales,
so a higher ratio is always more favorable.
➢ Higher turnover ratios mean the company is using its assets more
efficiently.
➢ Lower ratios mean that the company isn’t using its assets efficiently and
most likely have management or production problems.
➢ For instance, a ratio of .5 means that each dollar of assets generates 50
cents of sales.
➢ For instance, a ratio of 1 means that the net sales of a company equals the
average total assets for the year. In other words, the company is generating
1 dollar of sales for every dollar invested in assets.
 Activity Ratios/
Total Asset Turnover Ratio
• Calculate the total asset turnover ratio?

Year Total Operating Revenues Total Assets

20X1 11,012,021 10,876,736
20X0 10,819,693 11,315.585

• Solution:
Year Total Operating Revenues Total Assets Total asset turnover
20X1 11,012,021 10,876,736 1.01
20X0 10,819,693 11,315.585 0.96

• As you can see, pharmacy A, 20X0’s ratio is only .96. This means that for every
dollar in assets, pharmacy A 20X0 only generates 96 cents.
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 Activity Ratios/
Fixed Asset Turnover Ratio
• The fixed asset turnover ratio is an efficiency ratio that measures a
companies return on their investment in property, plant, and equipment
by comparing net sales with fixed assets.
• In other words, it calculates how efficiently a company is a producing
sales with its machines and equipment.
• Investors and creditors use this formula to understand how well the
company is utilizing their equipment to generate sales.

• It measures a companies return on their investment in property, plant,

and equipment by comparing net sales with fixed assets.

• It aids in the evaluation of the most productive assets, plant and

equipment.
 Activity Ratios/
Fixed Asset Turnover Ratio
• Formula:
Fixed Asset Turnover ratio = Total Operating Revenues
Net Fixed Assets
Net Fixed Assets = Fixed assets - Accumulated Depreciation

Fixed Asset Turnover ratio = Total Operating Revenues_______

Fixed assets - Accumulated Depreciation
• A high turn over indicates that assets are being utilized efficiently and large
amount of sales are generated using a small amount of assets.
• A low turn over, on the other hand, indicates that the company isn’t using its
assets to their fullest extent. This could be due to a variety of factors.
➢ For example, they might be producing products that no one wants to buy.
➢ Also, they might have overestimated the demand for their product and
overinvested in machines to produce the products.
 Activity Ratios/
Fixed Asset Turnover Ratio
• Example. The total revenue for Al- Amal hospital in 2016 was $250,000
using equipment they paid $100,000 for. The accumulated deprecation
on the equipment is $50,000.
• How is the Fixed Assets Turnover Ratio Calculated?

• Fixed Assets = 250,000

= 5
Turnover Ratio 100,000-50,000

• As you can see, Al- Amal hospital generates five times more sales than
the net book value of their assets.
 Summary
• Three ways have been presented to analyze financial statements.
• Horizontal analysis which examines year to year changes in line items
of financial statements.
• Vertical analysis which compares one line item with another line item
for the same time period.
• Ratio analysis provides an indication of the organization’s ability to
cover current obligations with current assets.
• There are different categories of ratios, including: liquidity, profitability,
and activity ratios.
 Summary
1. Liquidity ratios. This is the most fundamentally important set of ratios, because they
measure the ability of a company to remain in business.
➢ Current ratio. Measures the amount of liquidity available to pay for current liabilities.
➢ Quick ratio. The same as the current ratio, but does not include inventory.

2. Profitability ratios. These ratios measure how well a company performs in generating a
profit.
➢ Return on net assets. Shows company profits as a percentage of fixed assets and working capital.
➢ Operating margin ratio. also known as the operating profit margin, is a profitability ratio that
measures what percentage of total revenues is made up by operating income.

3. Activity ratios. These ratios are a strong indicator of the quality of management, since
they reveal how well management is utilizing company resources.
➢ Total asset turnover ratio, measures the efficiency with which a company uses its assets to
produce sales.
➢ Fixed asset turnover ratio. Measures a company's ability to generate sales from a certain base of
fixed assets.
Thank You