What are the ways and methods of analysis of financial statements?

Introduction

Financial statement information is used by both external and internal users, including investors, creditors, managers, and executives. These users must analyze the information in order to make business decisions, so understanding financial statements is of great importance. Several methods of performing financial statement analysis exist. This article discusses two of these methods: horizontal analysis and vertical analysis.

Horizontal Analysis

Methods of financial statement analysis generally involve comparing certain information. The horizontal analysis compares specific items over a number of accounting periods. For example, accounts payable may be compared over a period of months within a fiscal year, or revenue may be compared over a period of several years. These comparisons are performed in one of two different ways.

Absolute Dollars

One method of performing a horizontal financial statement analysis compares the absolute dollar amounts of certain items over a period of time. For example, this method would compare the actual dollar amount of operating expenses over a period of several accounting periods. This method is valuable when trying to determine whether a company is conservative or excessive in spending on certain items. This method also aids in determining the effects of outside influences on the company, such as increasing gas prices or a reduction in the cost of materials.

Percentage

The other method of performing horizontal financial statement analysis compares the percentage difference in certain items over a period of time. The dollar amount of the change is converted to a percentage change. For example, a change in operating expenses from $1,000 in period one to $1,050 in period two would be reported as a5% increase. This method is particularly useful when comparing small companies to large companies.

Vertical Analysis

The vertical analysis compares each separate figure to one specific figure in the financial statement. The comparison is reported as a percentage. This method compares several items to one certain item in the same accounting period. Users often expand upon vertical analysis by comparing the analyses of several periods to one another. This can reveal trends that may be helpful in decision making. An explanation of Vertical analysis of the income statement and vertical analysis of the balance sheet follows.

Income Statement

Performing vertical analysis of the income statement involves comparing each income statement item to sales. Each item is then reported as a percentage of sales. For example, if sales equals $10,000 and operating expenses equals $1,000, then operating expenses would be reported as10% of sales.

Balance Sheet

Performing vertical analysis of the balance sheet involves comparing each balance sheet item to total assets. Each item is then reported as a percentage of total assets. For example, if cash equals $5,000 and total assets equals $25,000, then cash would be reported as20% of total assets.

Analyzing a single period financial statement works well with vertical analysis. On the income statement, percentages represent the correlation of each separate account to net sales. Express all accounts other than net sales as a percentage of net sales. Net income represents the percentage of net sales not used on expenses. For example, if expenses total69 percent of net sales, net income represents the remaining31 percent. Vertical analysis performed on balance sheets uses total assets and total liabilities for comparison of individual balance sheet accounts.

Horizontal analysis is the comparison of data sets for two periods. Financial statements users review the change in data much like an indicator. Optimistic analysts look for growth in revenue, net income and assets in addition to reductions in expenses and liabilities. Calculating absolute dollar changes requires the user to subtract the base figure from the current figure. Expressing changes with percentages requires the user to divide the base figure by the current figure, and multiply by100.

Review of three or more financial statement periods typically represents trend analysis, a continuation of horizontal analysis. The base year represents the earliest year in the data set. Although dollars can represent subsequent periods, analysts commonly use percentages for comparability purposes. Users review statements for patterns of incremental change representing changes in the business in questions. Financial statement improvements include increased income and decreased expenses.

Ratios express a relationship between two more financial statement totals, and compare to budgets and industry benchmarks. Five common categories of ratios exist: liquidity, asset turnover, leverage, profitability and solvency. Reviewing ratios for performance compared with prior periods or industry specific benchmarks provides financial statements users with recognition of strengths and weaknesses. Risk Management Association, or RMA, publishes data on industry specific benchmarks for more in-depth analysis.

Analyzing financial statements presents an opportunity for reviewing past data and possibly budgets. However, the data used is historical in nature, indicating it may not be a good representation of the future due to unforeseeable circumstances. Market value of assets and liabilities can be under or overstated significantly leaving statement users unaware of the real value of a balance sheet. Pro forma statements, or forward-looking financial statements, provide estimates at best resulting in speculation.

Evaluating the performance of a business can be challenging, and requires a systematic collection and review of financial information. Financial statements provide this summary of collected data. The three primary statements include income, balance sheet and statement of cash flows. Public companies also have a statement of equity. Reviewing and analyzing financial statements provide the user with trends and indicators to compare operations and management.

Analyzing a single period financial statement works well with vertical analysis. On the income statement, percentages represent the correlation of each separate account to net sales. Express all accounts other than net sales as a percentage of net sales. Net income represents the percentage of net sales not used on expenses. For example, if expenses total69 percent of net sales, net income represents the remaining31 percent. Vertical analysis performed on balance sheets uses total assets and total liabilities for comparison of individual balance sheet accounts.

Horizontal analysis is the comparison of data sets for two periods. Financial statements users review the change in data much like an indicator. Optimistic analysts look for growth in revenue, net income and assets in addition to reductions in expenses and liabilities. Calculating absolute dollar changes requires the user to subtract the base figure from the current figure. Expressing changes with percentages requires the user to divide the base figure by the current figure, and multiply by100.

Financial statement analysis is an exceptionally powerful tool for a variety of users of financial statements, each having different objectives in learning about the financial circumstances of the entity.

 I agree with the answer given by Rehan Qureshi   Chief Financial Officer (CFO)

Horizontal Analysis

Vertical Analysis

Ratio Analysis

Financial analysis focuses on the financial statements, as they are a disclosure of a financial performance of a business entity. “A Financial Statement is an organized collection of data according to logical and consistentaccounting procedures. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show assets position at a moment of time as in the case of balance sheet, or may reveal a series of activities over a given period of times, as in the case of an income statement.”