Financial Statement Analysis Flashcards, test questions and answers

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What is Financial Statement Analysis?

Financial statement analysis is the process of reviewing and analyzing a company’s financial statements to gain insight into the financial health and performance of the business. This type of analysis involves assessing three key areas: liquidity, profitability, and solvency. The purpose is to identify areas where management could improve operations or take advantage of opportunities for growth.Liquidity refers to a company’s ability to pay its bills as they come due. This can be evaluated by looking at the current ratio, which compares current assets (such as cash and accounts receivable) to current liabilities (like accounts payable). A healthy ratio should be greater than 1, indicating that the company has enough resources available to meet its obligations in a timely manner. If this is not the case, it may indicate that management needs to make changes in order to increase its working capital or improve its cash flow situation.Profitability measures how well a company is able generate profits from its operations. This can be assessed by examining gross profit margin, operating profit margin, and net profit margin ratios which compare revenues with expenses from different periods or between competitors within an industry. High margins generally indicate that management has been successful in controlling costs and generating revenue efficiently over time. Low margins may suggest that there are problems with cost containment or pricing strategies that need attention from management in order for profitability targets to be reached going forward. Finally, solvency evaluates whether a company has sufficient long-term resources available in order cover any debt obligations it may have incurred throughout its operation period. Cash flow indicators such as free cash flow (FCF), debt-to-equity ratio (D/E), return on investment (ROI), and interest coverage ratio should all be evaluated when assessing solvency since these metrics measure how much cash is available after accounting for all fixed costs like debt payments and capital expenditures during an accounting period. A healthy D/E ratio will generally fall between 1-2 while ROI should exceed 10%. An interest coverage ratio below 1 indicates potential insolvency risks while FCF signals whether there are enough funds left over after paying all expenses over time so future investments can still be made without taking on additional debts or diluting equity holders’ interests with new shares issued through stock options etc. Clearly understanding these metrics provides important insight into how well positioned companies are for making long-term investments decisions without jeopardizing their financial security along the way.