Question

COLLAPSE As we see in Chapter 13, Financial Statement Analysis, we are now making the transition from accounting concepts to finance concepts and the tools available to us to compare the results of a company to another that are produced in accounting. What is the purpose of performing a horizontal and vertical analysis? What are the other names for these types of analyses? Lastly, pick one or two ratios that were discussed in the chapter, describe what it intends to measure, is a higher number better or worse as a result, and how is the ratio calculated.

Answer 1

i am refering this material

http://www.swlearning.com/accounting/porteralt3e/instructor/im/pn_chap13.pdf

Vertical analysis of financial statements is a technique in which the relationship between items in the same financial statement is identified by expressing all amounts as a percentage a total amount. This method compares different items to a single item in the same accounting period. The financial statements prepared by using this technique are known as common size financial statements.

This analysis is performed on the income statement as well as the balance sheet.

Balance Sheet:

When applying this method on the balance sheet, all of the three major categories accounts (i.e. assets, liabilities, and equity) are compared to the total assets. All of the balance sheet items are presented as a proportion of the total assets. These percentages are shown along with the absolute currency amounts. For example, suppose a company has three assets; cash worth $4 million, inventory worth $7 million and fixed assets worth $9million. The vertical analysis method will show these as

Cash: 20%
Inventories: 35%
Fixed Assets: 45%

Income Statement:

And when applying this technique to the income statement, each of the expense is compared to the total sales revenue. The expenses are presented as a proportion of total sales revenue along with the absolute amounts. For example, if the sales revenue of a company is $10 million and the cost of sales is $6 million, the cost of sales will be reported as 60% of the sales revenue.

PURPOSE OF VERTICAL ANALYSIS

The main advantage of using vertical analysis of financial statements is that income statements and balance sheets of companies of different sizes can be compared. Comparison of absolute amounts of companies of different sizes does not provide useful conclusions about their financial performance and financial position.

Usually the vertical analysis is performed for a single accounting period to see the relative proportions of different account balances. But it is also useful to perform vertical analysis over a number of periods to identify changes in accounts over time. It can help to identify unusual changes in the behavior of accounts. For example, if the cost of sales has been consistently 45% in the history, then a sudden new percentage of 60% should catch the attention of analysts. Reasons behind this change should be investigated and then measures should be taken to bring this percentage back to its normal level.

From the income statements and balance sheets, a company may portray a pretty good hold on their financial affairs. But as an investor, it’s your responsibility to check each item and understand why there is a difference. Your minute attention to details may help you discover something about the company which the company wanted to hide from all the potential investors.

ANOTHER NAME: COMMON SIZE ANALYSIS

Companies can inflate profit or show an undervalued statement by changing a few things here and there. But if you pay attention to details, you would be able to discover what’s actually going on within the company.

With such analysis, you would be able to understand how this company may do in the upcoming years, what they are trying to accomplish over the years, and what’s their recent purchase, sales, revenue, net income, fixed assets, current assets, capital structure and every minute data mentioned in the balance sheet and income statement.

Unlike other ratios, this technique gives investors an overall picture of where a company stands in terms of financial matters, what they are trying to do with the funds, and how profitable the company can be in the near future.

PURPOSE OF HORIZONTAL ANALYSIS

Horizontal Analysis of Financial Statements is one of the most important techniques to find out how a company is doing financially. It is used for evaluating trends year over year (YoY) or quarter over quarter (QoQ).

If you are an investor and thinking about investing in a company, only a year-end balance sheet or income statement wouldn’t be enough for you to judge how a company is doing. You need to look at a couple of years at least to be sure. Better yet, if you can see many years of balance sheets and income statements and make a comparison among them.

Through horizontal analysis of financial statements, you would be able to see two actual data for consecutive years and would be able to compare each and every item. And on the basis of that, you can forecast the future and understand the trend.

ANOTHER NAME- TREND ANALYSIS

QUICK RATIO

What is Quick Ratio?

The quick ratio is a financial indicator of short-term liquidity or the ability to raise cash to pay bills due in the next 90 days. It is defined as: quick assets divided by current liabilities, and it is also known as the acid-test ratio and the quick liquidity ratio:

Quick Ratio = Quick Assets / Current Liabilities

Terms used are:

Quick assets: The sum of a company’s cash, cash equivalents (i.e., money market accounts, certificates of deposits, savings accounts, Treasury bills that mature within 90 days), marketable securities (publicly traded stocks and bonds, commercial paper), and receivables. It does not include other current assets such as inventory and prepaids (such as prepaid insurance), which can’t be quickly turned into cash.

Current liabilities: These are obligations that must be paid within one year. They include the interest on long-term debt that must be paid in the next year. Common payables include those for wages, taxes, interest, utilities and insurance.

Ratio of 1:1 is held to be the ideal quick ratio indicating that the business has in its possession enough assets which may be immediately liquidated for paying off the current liabilities.

What Is the Current Ratio?

The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.

KEY TAKEAWAYS

The current ratio compares all of a company’s current assets to its current liabilities. These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less.

The current ratio is sometimes referred to as the “working capital” ratio and helps investors understand more about a company’s ability to cover its short-term debt with its current assets.

Weaknesses of the current ratio include the difficulty of comparing the measure across industry groups, overgeneralization of the specific asset and liability balances, and the lack of trending information.

Formula and Calculation for Current Ratio

To calculate the ratio, analysts compare a company's current assets to its current liabilities. Current assets listed on a company's balance sheet include cash, accounts receivable, inventory and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt.

Current Ratio=Current assets/Current liabilities ​​

Interpreting the Current Ratio

A ratio under 1 indicates that the company’s debts due in a year or less are greater than its assets (cash or other short-term assets expected to be converted to cash within a year or less.)

On the other hand, in theory, the higher the current ratio, the more capable a company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities. However, while a high ratio, say over 3, could indicate the company can cover its current liabilities three times, it may indicate that it's not using its current assets efficiently, is not securing financing very well, or is not managing its working capital.