Financial statement analysis is the ability to evaluate a business for financial and management purposes. Inferring conclusions from financial analysis is valid only if the analysis is objective and it includes several sources of information, for example:
1. Review of the accounting policies of an organization
2. Analysis of recently audited financial statements including footnotes or other supplemental information, and
3. Analysis of relationships among components of the financial statements, such as ratio analysis.
One of the areas where forensic accountants must be strong is financial analysis. Knowing the meaning of financial indicators is helpful in reaching conclusions about specific scenarios y how they fit within the expectations or perhaps, how far an entity is from similar organizations within a given industry.
For example, if an accountant wants to analyze an industry’s financial behavior during a period of five years based on financial ratios of solvency, it would give him or her a picture where the company analyzed stands. It also helps identify unreasonable indicators that could be a red flag of wrongdoing. It points out strengths and weaknesses and in order to be effective, financial ratios should be used along with other evaluation techniques.
Solvency ratios are related to debt management and are also known as the gearing ratios. Solvency ratios can point out weaknesses in a corporation that could lead that business into a bankruptcy proceeding. Liquidity and profitability decline are red flags of potential business failure. Short-term solvency is the ability of a business to meet its current liabilities as they become due. Long-term solvency refers to the ability of a business to stay as a going concern for many years.
The Investopedia @ investopedia.com states that one of many ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size of a company's after-tax income excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations.
The measure is usually calculated by dividing the de result of adding the after tax net profit plus depreciation and dividing by the sum of long term liabilities plus short term liabilities. According to the Investopedia, companies with a solvency ratio greater than 20% are considered financially healthy. By the same token, the lower a company’s solvency ratio, the greater the probability that the company will default on its debt.
The table below shows a list of solvency ratios during a five-year time frame. To be able to draw conclusions from this table, the accountant must know what each financial ratio measures and how they are interpreted. Financial ratios measure elements of operating performance and financial position at an internal level and industry-wide as well.
| Financial Ratios: Solvency | |||||
|---|---|---|---|---|---|
| Ratio Description | 2005 | 2006 | 2007 | 2008 | 2009 |
| Accounts Payable : Business Revenue: % | 0.03 | 0.03 | 0.07 | 0.03 | 0.04 |
| Current Liabilities : Inventory % | 4.22 | 5.19 | 6.14 | 7.43 | 6.20 |
| Current Liabilities : Net Worth % | 1.20 | 1.45 | 2.08 | 1.16 | 1.27 |
| Current Ratio % | 1.47 | 2.05 | 1.73 | 1.39 | 2.08 |
| Days Payable % | 35.19 | 23.47 | 20.19 | 51.11 | 28.56 |
| Quick Ratio % | 1.11 | 1.16 | 0.98 | 1.37 | 1.41 |
| Current Liabilities : Net Worth % | 1.20 | 1.45 | 2.08 | 1.16 | 1.27 |
| Total Liabilities : Net Worth % | 2.20 | 2.54 | 3.08 | 3.16 | 2.27 |
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