Warning signs in financial statements

Published on August 29, 2019   11 min
Hi, I'm Michael McDonald. I'm a Professor of Finance at Fairfield University in Fairfield Connecticut. I'd like to talk to you about "Warning Signs in Financial Statements".
To begin with, when we're trying to evaluate financial statements, we're not just talking about a task that's important for business people or business majors or even accountants or finance people. In particular, these issues affect anyone that works at a company. As a result, whether you're a business person or a non-finance person, it's still important to have a good understanding on how the company is performing relative to its expected plan and how the firm is performing relative to where we might hope to see it in the future. To help us with this, we have a tool that we call ratio analysis. Ratio analysis, uses relationships between different pieces of the financial statements, to gauge the financial condition and performance of the firm. Now basically, you can break down ratio analysis into four different areas. Activity ratios, liquidity ratios, debt ratios, and profitability ratios. The activity ratios help us to evaluate whether a firm is doing a good job of maintaining the operations of the business. In other words, is taking the money that's invested into assets and using that effectively. Liquidity ratios, tell us whether or not the firm is facing any kind of short-term liquidity crunch. Meaning, are they facing any pressures based on short term obligations. Repayment of bank loans as an example, maybe meeting debt requirements or perhaps even just paying off employees or suppliers. The debt ratios as the name imply, talk about whether or not a firm is able to meet its longer-term debt obligations. How much debt does the firm have on hand, versus how much is it able to pay off. Then finally, profitability ratios. Again as the name implies, analyze whether or not the firm is able to effectively profit from the sales it's making. We can look at all four of these kinds of ratios in order to analyze, whether or not the firm is doing well or whether there are any warning signs or red flags we should look out for.