Hi, I am Amy Ford and in this video we are
going to cover financial statement analysis as well as earnings per share (EPS). How do accountants and financial professionals
analyze financial statements? This analysis involves the comparison of one company against
another. Or it could be comparing this year and last year for the same company. The most
common method used to do this financial statement analysis is through ratio analysis. We will
be learning how to calculate ratios in each of these areas which are commonly tested on
both the CPA and CMA exams. Liquidity measures a firm’s ability to pay
its current obligations as they come due and remain in business in the short run. Activity
is a measure of how quickly major noncash assets are converted to cash. Solvency is
a firm’s ability to pay its noncurrent obligations as they come due and remain in business in
the long run. And lastly, we will cover profitability ratios, which measure how effectively the
firm is using its resource base to generate a return.
We are going to begin with liquidity. Liquidity measures a firm’s ability to pay
its current obligations as they come due and remain in business in the short run. This
means that we will utilize those “current” items on the balance sheet to calculate these
items in our liquidity ratio analysis. Just remembering to use “current” items for these
liquidity measures could help you get the correct answer on a multiple choice question. One basic liquidity ratio is the current ratio.
To calculate, you divide the current assets by the current liabilities. The result is
a ratio that measures the relationship between current assets and current liabilities. A
firm must have enough current assets to meet upcoming obligations. A low current ratio
indicates a short term liquidity issue, where the firm may not be able to pay the bills,
so to speak, in the short term. On the other hand, if the current ratio is excessively
high, that could indicate that management is not investing idle assets productively. Net working capital is the difference between
current assets and current liabilities. This figure reports the resources the company would
have to continue operating in the short run if it had to pay off all of its current liabilities
at once. The quick ratio, which is also commonly called
the acid test ratio, is similar to the current ratio. The quick ratio though only includes
the quick assets in the numerator: cash, marketable securities and net receivables. Other items
that would be current assets, like inventory and prepaid expenses, are excluded from the
calculation of the quick ratio. This quick ratio is a more conservative measure than
the basic current ratio. Here is an example of a calculation question
for the current ratio. The key is that the problem gives you lots
of data and you need to be able to pick out the important pieces to answer the question.
The only data you need to calculate the current ratio for year 2 is the current assets and
current liabilities. Now once you realize you can ignore all those other numbers, this
isn’t so hard anymore, is it? The current ratio formula is to divide the
current assets of 4,200,000 by the current liabilities of 1,800,000. The answer is 2.33. We would say the current ratio is 2.33 to 1 Isn’t financial statement analysis an interesting
topic? Have you learned from what we have covered so far? I hope so and if you want
to learn more, such as the calculations for solvency and profitability analysis as well
as the always difficult earnings per share calculation, then click the link below or
go to gleim.com and look for our Free Basic Accounting course in the CPA Free Resources
section. In the course, you will find great information
on other topics such as all the details on how to prepare financial statements and record