Explain the purpose of analysis. The purpose of financial statement analysis is to help users make better business decisions. Internal users want information to improve company efficiency and effectiveness in providing products and services. External users want information to make better and more informed decisions in pursuing their goals. The common goals of all users are to evaluate a company's (1) past and current performance, (2) current financial position, and (3) future performance and risk.

Identify the building blocks of analysis. Financial statement analysis focuses on four "building blocks" of analysis: (1) liquidity and efficiency—ability to meet short-term obligations and efficiently generate revenues; (2) solvency—ability to generate future revenues and meet long-term obligations; (3) profitability— ability to provide financial rewards sufficient to attract and retain financing; and (4) market prospects—ability to generate positive market expectations.

Describe standards for comparisons in analysis. Standards for comparisons include (1) intracompany—prior performance and relations between financial items for the company under analysis; (2) competitor—one or more direct competitors of the company; (3) industry—industry statistics; and (4) guidelines (rules of thumb)—general standards developed from past experiences and personal judgments.

Identify the tools of analysis. The three most common tools of financial statement analysis are (1) horizontal analysis— comparing a company's financial condition and performance across time; (2) vertical analysis—comparing a company's financial condition and performance to a base amount such as revenues or total assets; and (3) ratio analysis—using and quantifying key relations among financial statement items.

Summarize and report results of analysis. A financial statement analysis report is often organized around the building blocks of analysis. A good report separates interpretations and conclusions of analysis from the information underlying them. An analysis report often consists of six sections: (1) executive summary, (2) analysis overview, (3) evidential matter, (4) assumptions, (5) key factors, and (6) inferences.

Explain the form and assess the content of a complete income statement. An income statement has four potential sections: (1) continuing operations, (2) discontinued segments, (3) extraordinary items, and (4) earnings per share.

Explain and apply methods of horizontal analysis. Horizontal analysis is a tool to evaluate changes in data across time. Two important tools of horizontal analysis are comparative statements and trend analysis. Comparative statements show amounts for two or more successive periods, often with changes disclosed in both absolute and percent terms. Trend analysis is used to reveal important changes occurring from one period to the next.

Describe and apply methods of vertical analysis. Vertical analysis is a tool to evaluate each financial statement item or group of items in terms of a base amount. Two tools of vertical analysis are common-size statements and graphical analyses. Each item in common-size statements is expressed as a percent of a base amount. For the balance sheet, the base amount is usually total assets, and for the income statement, it is usually sales.

Define and apply ratio analysis. Ratio analysis provides clues to and symptoms of underlying conditions. Ratios, properly interpreted, identify areas requiring further investigation. A ratio expresses a mathematical relation between two quantities such as a percent, rate, or proportion. Ratios can be organized into the building blocks of analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects.