Question

List three basic financial statement analysis procedures , describe how to calculate each procedure, and why to use each procedure

Answer 1

The three important methods of financial statement analysis are:

1. Horizontal Analysis

2. Vertical Analysis

3. Ratio Analysis

1. Horizontal Analysis:

Horizontal analysis spotlights trends and establishes relationships between items that appear on the same row of a comparative statement. This analysis discloses changes on items in financial statements over time. Each item (such as sales) on a row for one fiscal period is compared with the same item in a different period. This analysis can be carried out in terms of changes in dollar amounts, in percentages of change, or in a ratio format. This analysis may be conducted for balance sheet, income statement, schedules of current and fixed assets and statement of retained earnings.

Dollar and Percentage Changes are computed by using the following formulas:

i. Dollar Change = Amount of the item in comparison year – Amount of the item in base year

ii. Percentage Change = (Dollar Change/Amount of the item in the base year) *100

2. Vertical Analysis:

Vertical analysis involves the conversion of items appearing in financial statement columns into terms of percentages of a base figure to show the relative significance of the items and to facilitate comparison. On the balance sheet, individual assets can be expressed in terms of their relationship to total assets. Liabilities and shareholders’ equity accounts can be expressed in terms of their relationship to the total of liabilities and shareholders’ equity. On the income statement, each item is stated as a percentage of sales.

In this analysis the percentage is computed by using the following formula:

Percentage of base = (Amount of individual item/Amount of base) * 100

3. Ratio Analysis:

A ratio is an expression of a mathematical relationship between one quantity and another. If a ratio is to have any utility, the element which constitutes the ratio must express a meaningful relationship. Ratio analysis can disclose relationships which reveal conditions and trends that often cannot be noted by inspection of the individual components of the ratio. Typical ratios are fractions usually expressed in percent or times.

Few example of the ratios of the financial statement analysis are as follows:

i. Current ratio = Current assets/Current liabilities

ii. Quick ratio = (Current assets - prepaid expense - Inventory)/Current liabilities

iii. Cash ratio = (Cash + Cash equivalents)/Current liabilities

iv. Receivable turnover ratio = Net credit sales/Average receivables

v. Inventory turnover ratio = Cost of goods sold/Average Inventory