Question

How do we use financial ratios to analyze the performance of a company? What do we mean when we refer to horizontal and vertical analysis?

***paragraph form (minimum of 200 words)

Answer 1

Financial ratios to analyze the performance of a company:

Ratio means the mathematical relationship between two variables. Financial ratio means the relationship between various items of financial statements of a company. Financial ratio is a tool for evaluation of performance of a company.

The ultimate objective of the whole financial accounting is to prepare and present useful information for the intended users of financial information. Here information users means Investors, Managers, Creditors, Lenders, and Government. The financial statement consists of various terminologies and calculations and also it quite lengthy and tough to understand for a person who do not have that much knowledge of finance. Financial ratios helps the information users in this regard. Financial ratios expresses the relationships between various variables or items of the financial statement in more easy way from which any person who does not have that much knowledge of finance can easily understand and predict about the performance of the organisation.

Investors can get the proper idea about the performance and profitability of the company just looking into the ratios and they need not to go deeper into the financial statements. Here main performance measuring financial ratios are, Profitability ratio – Gross profit ratio, Net profit ratio, Operating ratio etc, Liquidity ratio – Current ratio, Quick ratio, Working capital ratio etc. Solvency Ratio – Debt assets ratio, Debt equity ratio, Interest coverage ratio etc. Efficiency ratio – Inventory turnover ratio, Debtors turnover ratio etc.

So, ratios helps a person to understand and analyze the performance of a company easily as it is easy to understand the relationships and effects of those parameters of the financial statements which affects the performance of the company.

Horizontal analysis:

Horizontal analysis means comparing the performance of the company with its previous years’ performance. In horizontal analysis items of financial statement of more than one year of the same company are compared side by side and if there is any increase or decrease, it is recorded accordingly. It is a tool of internal analysis i.e. the performance of the same company for more than one year is being compared.

Vertical Analysis:

Vertical analysis means comparing the various items of the financial of a company for the same year with a base selected from the same financial statement. In this case one base is selected and a 100% weight is assigned to it, then other items of the same financial statement is expressed as a percentage based on that selected Base Item.

For example, for profit & loss statement, Sale/Turnover is selected as the base item then, Cost of goods sold, gross profit, Net profit etc are expressed as percentage based on sales. This is also a internal analysis technique.

** If you have any more question about the subject matter feel free to comment below. Please press the thumbs up button if it was helpful for you.

Thank You ..!