10.6: Financial Statement Analysis

Now that you know a bit about financial statements, let’s see how they’re used to help owners, managers, investors, and creditors assess a firm’s performance and financial strength. You can glean a wealth of information from financial statements, but first, you need to learn a few basic principles for “unlocking” it.

Trend Analysis from the Income Statement

A trend analysis is done by collecting data at selected times and then plotting any observed changes over longer periods. A trend analysis examines the factors that drive business success. The analysis is used to make projections for the future, identify areas that need attention from managers, and benchmark the business against others in the industry.   Some of the most common operating factors tracked in trend analysis include gross margin, sales (in units/dollars), earnings before interest and taxes (EBIT), earnings per common share (EPS), stock price, etc.  The most common line items on the balance sheet included in a trend analysis are total assets, total liabilities, total shareholder equity, debt-to-equity ratio, current ratio, and acid test ratio.^[1]

Refer to Figure 10.8, which is an abbreviated financial statement for a highly successful,  long-established fictitious multinational technology company called InnoTech Inc. for the year 2025. You will note that instead of showing only the current year’s results, the company has shown data for the prior year as well. From this relatively simple exhibit, considerable information about InnoTech’s performance can be obtained.

For example:

• InnoTech sales grew at 12.7% from 2024 to 2025, which is not bad for a company with such a large base of sales already, but certainly not the rapid-growth company it once was. Making yearly comparisons is commonly referred to as performing a horizontal analysis.
• Net income as a percent of sales (a ratio also known as return on sales) was 22.7% in 2025, or in other words, for every $5 in sales, InnoTech turned more than $1 of it into profit. That is substantial! When calculating ratios as a percent of a larger figure (i.e., net income as a percent of sales, or cash as a percent of total assets). This is commonly referred to as performing a vertical analysis.

Many other calculations are possible from InnoTech Inc.’s data, and we will look at a few more as we explore ratio analysis.

Ratio Analysis

How do you compare InnoTech’s financial results, shown in Figure 10.9, with those of other companies in your industry or with the other companies whose stock is available to investors? And what about your balance sheet? Are there relationships in this statement that also warrant investigation? These issues can be explored by using ratio analysis, a technique for evaluating a company’s financial performance.

Remember that a ratio is just one number divided by another, with the result expressing the relationship between the two numbers. It’s hard to learn much from just one ratio, or even a number of ratios covering the same period. Rather, the deeper value in ratio analysis lies in looking at the trend of ratios over time and in comparing the ratios for several time periods with those of other companies. There are a number of different ways to categorize financial ratios.

Here’s one set of categories:

• Profitability ratios tell you how much profit is made relative to the amount invested (return on investment) or the amount sold (return on sales).
• Liquidity ratios tell you how well positioned a company is to pay its bills in the near term. Liquidity refers to how quickly an asset can be turned into cash. For example, shares of stock are substantially more liquid than a building or a machine.
• Debt ratios look at how much borrowing a company has done in order to finance the operations of the business. The more borrowing, the more risk a company has taken on, and so the less likely it is that new lenders will approve loan applications.
• Efficiency ratios tell you how well your assets are being managed.

We could employ many different ratios, but we’ll focus on a few key examples.

Profitability Ratios

Profitability ratios include gross profit margin, net profit margin, and return on equity. Earnings per share (EPS) is a measure of a company’s profitability that indicates how much profit each outstanding share of common stock has earned. It’s calculated by dividing the company’s net income by the total number of outstanding shares. The higher a company’s EPS, the more profitable it is considered to be. Earlier, we looked at the return on sales for InnoTech Inc., and now we will look at its EPS. According to the earlier Figures 10.8 and 10.9, InnoTech Inc. saw its EPS increase from $3.38 in 2024 to $3.92 in 2025, which indicates a profit of about 15%, an excellent return for a company that is considered to be already among the world’s largest. Well-paid analysts will spend hours to understand how these results were achieved every time InnoTech issues new financial statements.

Liquidity Ratios

A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities. Liquidity ratios are one element of measuring the financial strength of a company.  A key liquidity ratio is called the current ratio. It simply examines the relationship between a company’s current assets and its current liabilities. On December 30, 2025 (remember that balance sheets reflect a point in time), InnoTech Inc. had $68.5 billion in current assets and $63.5 billion in current liabilities. Simply put, this means that InnoTech Inc. has more money on hand than they need to pay their bills. When a company has a current ratio greater than 1, they are in good shape to pay its bills; companies selling to InnoTech Inc. on credit would not need to worry that it is likely to run out of money.

InnoTech Inc.’s current ratio = $68.5 Billion / $63.5 Billion = 1.08 (greater than >) 1

Now, let’s look quickly at something that is not part of the ratio; look down one line on the balance sheet to long-term marketable securities and see that InnoTech Inc. owns $207.9 billion. While they are long-term and so not part of the current ratio, these securities are still easily convertible to cash. So, InnoTech Inc. has far more cushion than the current ratio reflects, even though it already reflects a healthy financial position.

Debt Ratios

A key debt ratio, which tells us how the company is financed, is the debt-to-equity ratio, which calculates the relationship between funds acquired from creditors (debt) and funds invested by owners (equity). For this ratio calculation, we use InnoTech Inc.’s total liabilities, not just the line on the balance sheet that says long-term debt, because in effect, InnoTech Inc. is borrowing from those it owes but has not yet paid. InnoTech Inc.’s total liabilities at the end of 2025 were $266.6 billion versus owner’s equity of $140.2 billion, a ratio of 1.9, which means InnoTech Inc. has borrowed more than it has invested in the business.

InnoTech Inc.’s debt-to-equity ratio: $266.6 / $140.2 billion = 1.9

To some investors, that high level of debt might seem alarming. But remember that InnoTech Inc. has invested $207.9 billion in marketable securities. If it wished to do so, InnoTech Inc. could sell some of those securities and pay down its debts, thus improving its ratio. It’s likely that anyone thinking about lending money to InnoTech Inc. and seeing these figures would be confident that InnoTech Inc. has the ability to pay back what they borrow.

Efficiency and Effectiveness Ratios

Efficiency ratios include the inventory turnover ratio, asset turnover ratio, and receivables turnover ratio. These ratios measure how efficiently a company uses its assets to generate revenues and its ability to manage those assets.

There are many more ratios that we could apply to InnoTech Inc. to understand its performance more completely. Yet going deeper into ratios would be beyond the scope of an introductory business course. If you continue your study of business, you will get ample exposure to these ratios in your accounting and finance courses. So, we’ll leave the rest for another day.

Media Attributions

“Figure 10.8: InnoTech Inc. Consolidated Statements of Operations (Income Statement)” is adapted from Chapter 10: Financial Management and Accounting in Business Fundamentals, 1st Edition, © Kerri Sheilds, licensed under CC BY-NC-SA.

“Figure 10.9: InnoTech Inc. Consolidated Statements of Operations (Balance Sheet)” is adapted from Chapter 10: Financial Management and Accounting in Business Fundamentals, 1st Edition, © Kerri Sheilds, licensed under CC BY-NC-SA.