The Portable MBA in Finance and Accounting, 4th Edition

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Analyzing Financial Statements

Les Livingstone

How to Analyze Financial Statements

Imagine that you are a health professional, such as a nurse or a physician, and that you work in the emergency room of a busy hospital. Patients arrive with all kinds of serious injuries or illnesses, some barely alive or perhaps even dead. Others arrive with less urgent problems, or minor complaints, or only vaguely suspected ailments. Your training and experience have taught you to perform a quick triage, in order to identify and prioritize the most endangered patients by means of vital signs, such as respiration, pulse, blood pressure, temperature, and reflexes. Next, there follows a more detailed diagnosis, based on appropriate medical tests.

We check the financial health of a company in much the same fashion, by analyzing the financial statements. The vital signs are tested mostly by various financial ratios, which are calculated from the financial statements. The financial vital signs can be classified into three main categories:

1. Short-term liquidity.

2. Long-term solvency.

3. Profitability.

Next, we explain each of these three categories in turn.

Short-Term Liquidity

In the emergency room, the first question is: Can this patient survive? By the same token, the first issue in analyzing financial statements is: Can this company survive? Business survival means being able to pay the bills, meet the payroll, and come up with the rent. In other words, is there enough liquidity to provide ...