Financial accounting analysis involves the use of a company's financial statements to evaluate its liquidity, solvency and profitability. The practice of financial accounting primarily concerns itself with transforming a company's financial transactions into several financial statements that can be used to evaluate its financial position. The three main statements used to conduct a financial accounting analysis are the balance sheet, the income statement and the statement of cash flows.
The first component of a financial accounting analysis involves evaluating a company's liquidity. Liquidity measures the ability of a company to pay its short-term liabilities. Short-term liabilities are defined as any obligation that is expected to become payable within one year. Several ratios, known as liquidity ratios, are used to measure a company's ability to meet its current obligations.
The most common liquidity ratios include the current ratio, working capital, the inventory turnover ratio and the receivables turnover ratio. The current ratio divides current assets by current liabilities, which can be obtained from the company's balance sheet. In a financial accounting analysis, the current ratio's figure represents the monetary value of current assets that the company has compared to the value of its current liabilities. A healthy current ratio figure would need to be a value greater than 1.0 and can be compared against the company's prior year history and the industry average.
When measuring a company's solvency, financial accounting calculations reveal a company's ability to repay its debt and related interest. In a financial accounting analysis, solvency can be measured by the debt-to-total-assets ratio, the cash debt coverage ratio, the times interest earned ratio and free cash flow. Solvency ratios use information from a company's balance sheet, income statement and the statement of cash flows.
Similar to a consumer's credit rating that takes total debt to income into account, the debt-to-total-assets ratio measures a company's proportion of total liabilities against its total assets. The cash debt coverage ratio illustrates how many times the cash flow from operations could cover the average total liabilities. Cash flow from operations includes cash earned from the sale of goods and services versus financing or investing. The more times cash flow from operations can cover the average total liabilities, the better.
Profitability, in a financial accounting analysis, is a measure of how much income a company is making from its operations, assets and investing activities. Many of the ratios used in profitability analysis utilize information from the income statement and the balance sheet. In addition to measuring earnings per share and the return on common stockholders' equity, profitability examines the gross profit rate, the asset turnover ratio, the payout ratio and the price-to-earnings ratio. The gross profit ratio indicates how much of net sales are contributing to a company's overall profit, and the return on assets ratio indicates how much of net income is coming from the average total assets.