This reading describes selected applications of financial statement analysis. In all cases, the analyst needs to have a good understanding of the financial reporting standards under which financial statements are prepared. Because standards evolve over time, analysts must make sure their knowledge is current in order to make good investment decisions.

Evaluating a company's historical performance addresses not only what happened but also the causes behind the company's performance and how the performance reflects the company's strategy. The analyst needs to create common-size financial statements, calculate the financial ratios of the company, its competitors, and the industry, and make necessary adjustments. After processing the data, the analyst should perform:

• time series analysis to compare the company's performance to itself over time to examine the trend of its ratios (e.g., profitability, efficiency, liquidity, and solvency ratios).
• cross-sectional analysis to compare these ratios to those of its competitors or the industry.

When examining the data, the analyst should try to find answers to critical questions, including:

• What are the key performance indicators of the company, in light of its competitive strategy?
• What is driving the company's current performance? Specifically, what factors are causing the changes of a particular ratio over time? Why?
• What aspects of performance are critical for the company to succeed in the market? How did the company do in the past?
• What strategy does the company have and what were its impacts on the company's performance in the past?

Two examples are presented in the textbook to illustrate the application.

Practice Question 1

Sales of differentiated products at premium prices would generally be reflected most directly in ______, if all other factors remain equal.

I. higher gross profit margin
II. higher ROA
III. more expenses
IV. higher ROE

Correct Answer: I and III