3.4 Analyzing Financial Statements

Why analyze financial statements

Businesses use financial statement analysis to evaluate profitability, liquidity, and solvency over time and against competitors. Owners, investors, lenders, and managers all rely on ratios calculated from the income statement and balance sheet to make decisions about operations, credit, and investment.

Profitability ratios

Profitability ratios measure how well a business generates earnings. Net profit margin = net income ÷ net sales, showing what percent of revenue becomes profit. Gross profit margin = gross profit ÷ net sales. Higher margins generally signal stronger cost control and pricing power relative to competitors.

Liquidity and solvency ratios

Liquidity ratios, like the current ratio (current assets ÷ current liabilities), show whether a business can pay short-term debts. Solvency ratios, like the debt-to-equity ratio (total liabilities ÷ owner's equity), measure long-term ability to meet obligations and reveal how much of the business is financed by debt versus equity.

Key terms

Financial statement analysis

Evaluating a business's profitability, liquidity, and solvency using ratios from the income statement and balance sheet.

Net profit margin

Net income ÷ net sales; shows what percent of revenue becomes profit.

Current ratio

Current assets ÷ current liabilities; measures ability to pay short-term debts.

Debt-to-equity ratio

Total liabilities ÷ owner's equity; measures how much of the business is financed by debt vs. equity.

Liquidity vs. solvency ratios

Liquidity ratios assess short-term debt-paying ability; solvency ratios assess long-term financial obligation coverage.

Try an AP-style question

What is the current ratio?

1. 60,000
2. 1.5
3. 2.0
4. 0.5