From the course: Corporate Financial Statement Analysis

Use key tools to analyze financial statements

From the course: Corporate Financial Statement Analysis

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Use key tools to analyze financial statements

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Now, when it comes to corporate financial statement analysis there are several common methods of analysis. One method relates to what is called common size financial statements. We prepare common size financial statements by dividing financial statement numbers by either total sales or total assets. A common size income statement, for example, is prepared by dividing all the numbers on the income statement by sales. A lot of information can be gleaned from this simple set of calculations. With common size statements, you can compare financial statements of different sizes across time for the same company and across companies at the same point in time. For example, I'm sure you've heard the term profit margin. What does that term mean and where does it come from? Well profit margin means the amount of profit generated in cents for every dollar of sales. It is easily computed by dividing the bottom number from the income statement, net income or net profit, by the top number on the income statement, sales or revenues. When someone is talking about a firm's profitability, this is usually the ratio they are referring to. Common size statements can also tell us about a company's gross profit, which is different from profit margin. Oh, by the way, don't worry about these terms right now. More explanation will come. The point is this, we can get a lot of powerful information with a few simple calculations. Now another common method for analyzing financial statement is called financial ratio analysis, which involves examining the relationships between specific financial statement numbers. We will introduce you to one of my favorite things in all of accounting, the DuPont framework, which tells us about the profitability, the efficiency, and the leverage of a company. With this analysis, we will be able to tell how a company is doing on those three dimensions. When it comes to financial ratio analysis, there's a four-step process. First, we'll use the DuPont framework to break down return on equity into its component parts. Return on equity is a general, overall measure of how well a firm is doing. Once we've done the DuPont framework, we'll then prepare common-size financial statements. This is step two. Step three will involve using additional ratios to assess a firm's profitability, efficiency, and leverage. Based on these first three steps, we should be able to identify individuals that we need to speak to about the financial results. This is the fourth and the most important step. We'll see these four steps throughout this course as we do our financial statement analysis. It is important to point this out over and over and over again. The numbers are the start of the analysis process. The numbers are not the end of the process. An analysis of the numbers will eventually lead us to individuals who are responsible for those numbers. If we want the numbers to be different, we need to find the individuals who influence those numbers and motivate them to change. Always remember, people make the numbers. Numbers don't make the people.

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