Financial Statement Analysis
FoundationFinancial statement analysis computes and interprets accounting ratios to evaluate a firm's profitability, liquidity, solvency and management efficiency; ratios only make sense when compared over time and with peers, and their limitations must be understood.
- Ratio analysis turns statement figures into comparable indicators for judging profitability, liquidity, solvency and efficiency
- Gross profit ratio = gross profit ÷ net sales × 100%; current ratio = current assets ÷ current liabilities; the quick ratio deducts inventory first
- Benchmarks of about 2 (current) and 1 (quick) are rules of thumb — comment always in industry and trend context
文體小知識：商業知識說明文——講解會計比率的分類與計算，示範如何評論企業的盈利能力、變現能力與管理效能。
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1A single figure in the financial statements says little on its own: a net profit of one million dollars is remarkable for a snack shop but trivial for a major bank. Financial statement analysis links related items in the statements into ratios and compares them with the firm's own past figures and industry peers, so that sound conclusions about profitability and liquidity can be drawn.
2Ratios fall into four broad groups. Profitability ratios measure the ability to earn profit — gross profit ratio, net profit ratio and return on capital employed. Liquidity ratios measure the ability to meet short-term debts — current ratio and quick ratio. Management efficiency ratios include inventory turnover and accounts receivable turnover, while solvency is judged by gearing ratios reflecting long-term financial risk.
3The arithmetic is simple. Take the gross profit ratio: gross profit divided by net sales, times one hundred. For example, a firm with net sales of $600,000 and cost of sales of $420,000 earns gross profit of $180,000, a gross profit ratio of 30%. The current ratio is current assets divided by current liabilities — around 2 is conventionally sound — and the quick ratio, excluding inventory, is ideally around 1.
4Ratios are only the starting point; interpretation earns the marks. Follow three steps — compute, compare, conclude: compare with previous years for trends, with peers for relative standing, then explain causes in the firm's context. For example, a falling gross profit ratio may simply reflect rising purchase costs or price promotions rather than poor management.
5Ratio analysis has limits too. Statements are prepared on historical cost, so figures may not reflect current values; firms can window-dress before the year end to make ratios look healthy; and the analysis covers financial information only, so non-financial factors such as brand value, staff quality and customer satisfaction — which also shape a firm's prospects — should be considered alongside.
1Summary 重點摘要
Financial statement analysis computes and interprets accounting ratios to evaluate a firm's profitability, liquidity, solvency and management efficiency; ratios only make sense when compared over time and with peers, and their limitations must be understood.
2Vocabulary cards Vocabulary
The method of dividing related items in the financial statements to form ratios for evaluating performance.
Gross profit divided by net sales times 100, showing the margin left after deducting cost of sales.
Net profit divided by net sales times 100, showing the final margin after all expenses.
How efficiently capital generates returns; the higher the ratio, the more efficient the use of capital.
Current assets divided by current liabilities, measuring the ability to meet short-term debts; around 2 is conventionally sound.
Also called the acid-test ratio: (current assets less inventory) divided by current liabilities — stricter than the current ratio.
Cost of sales divided by average inventory; faster turnover ties up less capital in stock.
The share of debt in the capital structure; the higher the ratio, the greater the financial risk.
Net profit divided by the number of ordinary shares issued — a key return measure for shareholders.
Arranging transactions just before the year end to flatter the statements and distort ratios.
3Step by step Steps
- Step 1: Why ratio analysis is neededSingle figures in the statements cannot be compared directly: firms of different sizes naturally report very different profits. A ratio divides two related items, removing the size factor so that different years and different firms can be compared. For example, firm A earns $100,000 net profit and firm B $1,000,000 — B looks better; but if A employs only $200,000 of capital while B employs $10,000,000, A wins decisively on return on capital employed. Analysis begins by turning figures into comparable ratios.
- Step 2: Profitability ratiosProfitability answers how much earning power the firm has. Gross profit ratio = gross profit ÷ net sales × 100%, showing the gap between price and cost of sales; net profit ratio = net profit ÷ net sales × 100%, counting every expense; return on capital employed measures how efficiently capital earns returns. For example, a firm with a high gross ratio but low net ratio earns healthy margins that are being eaten by administrative expenses or interest — management should control costs rather than rush to raise prices.
- Step 3: Liquidity ratiosLiquidity measures whether the firm can pay debts due within a year on time. Current ratio = current assets ÷ current liabilities, conventionally sound at about 2; quick ratio = (current assets − inventory) ÷ current liabilities, stricter because inventory is slow to convert and may fall in value, ideally around 1. For example, a current ratio of 2 with a quick ratio of only 0.4 means most current assets are stock — if goods stop selling, the firm could run out of cash. Always read the two ratios together.
- Step 4: Efficiency and solvency ratiosEfficiency ratios ask whether resources are used productively: inventory turnover = cost of sales ÷ average inventory — the faster, the better the goods sell; accounts receivable turnover shows how quickly cash is collected; slow collection may signal customers in arrears and rising bad debts. Solvency is judged by gearing — the share of debt in the capital structure; the heavier the debt, the heavier the fixed interest burden and financial risk. For example, of two supermarkets with similar gross ratios, the one turning stock over faster recycles cash sooner and is clearly more efficient.
- Step 5: Ratios from the investor's angleShareholders and prospective investors watch return-oriented ratios. Earnings per share = profit attributable to ordinary shareholders ÷ number of ordinary shares issued — the higher, the more earned per share; price-earnings ratio = market price per share ÷ earnings per share, showing how many dollars the market pays per dollar of earnings; dividend ratios relate payouts to profits. For example, a high P/E may signal market optimism about growth, or an overvalued share — discuss both sides rather than jumping to one conclusion.
- Step 6: The three-step approach to commentingA computed ratio is raw material; interpretation earns the marks. Follow three steps: first compute the ratio and state the formula; second, compare — with previous years for trends and with peers for relative standing; third, conclude and explain plausible causes. For example, a gross ratio falling for two years could reflect an industry price war, rising purchase costs or weak inventory management; likewise a current ratio of 1.5 is normal for a supermarket yet thin for a manufacturer — commentary detached from industry context is empty talk.
- Step 7: Uses and limitations of ratio analysisRatio analysis is easy to compute and convenient to compare — a sound starting point for evaluating performance. But it rests on historical-cost statements that may not reflect current values; different firms may adopt different accounting policies and depreciation methods, so figures are not always comparable; and firms can window-dress before the year end. For example, collecting a large receivable just before year end instantly beautifies the receivables turnover without any real improvement in operations. Pointing out these limitations unprompted is a mark of high-level answers.
5Worked example Example
Hang Tat Trading Company Limited reports for the year ended 31 December 2024: net sales $600,000, cost of sales $420,000, current assets $160,000 (including inventory of $70,000) and current liabilities $80,000. Compute the gross profit ratio, the current ratio and the quick ratio, and comment on the company's liquidity.
- Gross profit ratio first: gross profit = net sales − cost of sales = $600,000 − $420,000 = $180,000; gross profit ratio = $180,000 ÷ $600,000 × 100% = 30%.
- Current ratio next: $160,000 ÷ $80,000 = 2 — at the conventional benchmark of about 2.
- Quick ratio next: ($160,000 − $70,000) ÷ $80,000 = $90,000 ÷ $80,000 = 1.125 — above the benchmark of about 1.
- Comment: both a current ratio of 2 and a quick ratio of 1.125 are sound, showing ample current assets to meet short-term debts without relying on selling inventory; whether a gross ratio of 30% is good requires comparison with previous years and peers.
- Answer: Gross profit ratio = ($600,000 − $420,000) ÷ $600,000 × 100% = 30%; current ratio = $160,000 ÷ $80,000 = 2; quick ratio = ($160,000 − $70,000) ÷ $80,000 = 1.125. Commentary: with a current ratio of 2, every $1 of current liabilities is covered by about $2 of current assets, and after excluding inventory the quick ratio of 1.125 still exceeds short-term debts — liquidity is sound and inventory is not an excessive share of current assets. As for the 30% gross profit ratio, the figure is neither good nor bad in itself: it must be compared with the company's own past performance and the industry average, watching also the control of operating expenses, before profitability can be judged fully.
6Common mistakes Mistakes
7Quick check Quick check
Q1What is the formula for the gross profit ratio?
Q2A firm has current assets of $200,000 (including inventory of $80,000) and current liabilities of $100,000. What is the quick ratio?
Q3What does a current ratio of about 2 generally indicate?
Q4Why must ratio analysis be compared with past years and peers?
Q5Give two limitations of ratio analysis.
8Recap Recap
- Ratio analysis turns statement figures into comparable indicators for judging profitability, liquidity, solvency and efficiency
- Gross profit ratio = gross profit ÷ net sales × 100%; current ratio = current assets ÷ current liabilities; the quick ratio deducts inventory first
- Benchmarks of about 2 (current) and 1 (quick) are rules of thumb — comment always in industry and trend context
- Three-step commentary: compute, compare (past years and peers), conclude with explanations
- Limits include historical cost, window dressing and neglected non-financial factors — state them proactively for high-level answers