Question

Discuss the pros and cons of these methods of financial statement analysis: ratio analysis, vertical analysis, and horizontal analysis. What do they tell us? Why do we need so many different methods?

Answer 1

Ratio analysis, vertical analysis,horizontal analysis are the methods of financial statement analysis. pros and cones of these are

RATIO ANALYSIS -PROS

1-Ratio analysis helps the management in formulating the policies,forecasting,decision making etc

2-helps the shareholders to value the business. Before investing money in any company the shareholders will assess profitability, security,safety etc of the business. These can be analysed using ratio analysis

3-helps the creditors to know the liquidity of the business.

CONES

1-Non monitory factors are ignored in ratio analysis.They dealt with only monitory items

2-window dressing is possible through ratio analysis,this is done by manipulating accounts with a better picture of financial and profitability of firm .

3-qualitative factors are not considered in ratio analysis.Only quantitative factors are taken into consideration

VERTICAL ANALYSIS-PROS

1-Common size statement helps to analyse the changes in various items in relation to total asset total liability, net sales etc

2-it helps to make a relationship between various items of the financial statements

3-it gives a common base for comparison

CONS

1-It is not suitable for horizontal analysis

2-it does not disclose the reason to change

3-interpretation of data is difficult in this method

HORIZONTAL ANALYSIS-PROS

1-Here figures of two or more periods are placed side by side.so comparison is easy

2-it gives necessary information about financial and operational results of business over a period of time

3-it discloses the trend in sales,costs and profits

CONS

1-price level changes reduces the reliability of financial statements

2-if there is a violation in various accounting principles, then the scope of this analysis will lost

3-internal factors like production,manufacturing operation etc may be different from those of the prior period

Not only these 3 methods ,there are trend analysis,cash flow analysis, fund flow analysis are there. These are used to analyse the financial statements.The usage of all these methods are depends upon the data available and the information that we are seeking.In all situations all these methods are not applicable.So according to the purpose and type of information available,we can choose the method of analysis.The fundamental objective of any analytical method is to simplify the data to more understandable terms.