Question

.Answer the following questions about financial ratio analysis.

a. To evaluate a firm's performance， investors need to do two types of comparative analysis.Please briefly address and explain the two analyses.(15%) b.These comparisons could be a difficult task.Address and explain some of the reasons why these comparisons can frequently be either difficult to perform or produce misleading results.(10%)

Answer 1

a]

The two analyses are horizontal analysis and vertical analysis.

Vertical analysis :

This is when each line item in the financial statements is compared to a base line item. For example, a balance sheet can be converted into a common-size balance sheet, where each item in the balance sheet is expressed as a percentage of total assets. Similarly, an income statement can be converted into a common-size income statement, where each item in the income statement is expressed as a percentage of total revenue.

This enables the investor to quickly assess the areas of under/over performance and efficiency/inefficiency.

Horizontal analysis :

This is when each item in the financial statements are compared to their corresponding figures in the previous periods. For example, the financial statements could have the current year/quarter figures, and the corresponding figures for the previous 3 years/quarters.

This enables investors to analyze the trends in the financials, and areas of improvement and concern.

b]

Some of the reasons why these comparisons could be difficult or misleading are :

• In case of negative figures for any items, the comparisons could be meaningless
• Unless a peer-firm comparison is done, the analysis by itself may not be sufficient to draw meaningful conclusions
• Data for previous periods may be unavailable