Benefits and Limitations of Ratio and Financial Statement Analysis

July 25, 2013
MGMT640

Executive Summary
In corporate finance, both ratio and financial statement analysis are important tools that can be used in order to assess a company’s strength financially. They can be used in order to forecast a business’ prospective cash flow and ability to grow in the future, as well as a company’s strengths and weaknesses. Income statements, balance sheets, the statement of retained earnings, and the statement of cash flows are the four primary types of financial statements used in corporate finance. All of these financial statements serve to analyze a firm’s …show more content…

If the numbers show that the firm is not operating at an optimal level or there is a sudden decline in profit, managers can delve further into the firm’s operations using ratio analysis to look for problem areas and address them accordingly. For instance, ratio analysis can allow analysts to view the rate turnover of a specific product line and examine whether something is lacking in that product line that is hindering the firm’s ability to get rid of that inventory to consumers. Such ratio analysis will be elaborated upon later in this paper.
There are four types of financial statements; income statements, balance sheets, the statement of retained earnings, and the statement of cash flows, which are all vital and interrelated. The income statement calculates the firm’s net income or its earnings after expenses have been deducted and is used to calculate retained earnings at the end of the year (Parrino, 2011). Net income is calculated as followed: Net Income = Revenues - Expenses
The balance sheet summarizes what assets the firm has at a specific point in time, as well as how the firm has financed such assets (Parrino, 2011). Total assets is calculated as followed: Total Assets = Total Liabilities + Total Stockholders’ Equity
The value of assets will change annually since firms often buy and sell assets, thus altering the firm’s value and financing. Such changes are indicated in the statement of cash flows, which gives a summary of changes in the firm’s