Financial Statement Analysis Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Financial statement analysis is a methodology that enables stockholders, potential investors, creditors, and managers to evaluate past, current, and future performance of a company by examining relationships among financial statement elements. It involves examining trends, making industry comparisons, and analyzing the financial health and growth prospects of a company. Financial statement analysis can be performed independently by interested parties, by companies themselves, or by financial analysts who study certain industries and provide information so that investors can make informed decisions with respect to the purchase and sale of stocks, bonds, and other financial instruments. Financial statement analysis is comprised of three types of analyses: ratio analysis, horizontal analysis, and vertical analysis.

Ratio analysis is the most popular form of financial statement analysis. It is used to express relationships among selected items on financial statements and is useful for intracompany, intercompany, and industry average comparisons. Intracompany analysis compares a company’s prior year with the current year, intercompany analysis compares a company with its competition, and industry averages compare a company with industry benchmarks or norms (e.g., those provided by organizations such as Moody’s, Standard and Poor’s, or Dun and Bradstreet).

Ratio analysis can be expressed as a percentage, rate, or proportion and is generally classified into four categories. Liquidity ratios (e.g., current ratio, acid test ratio, inventory turnover ratio, working capital) measure a company’s ability to meet it current obligations, i.e., those due within a year. These ratios are of interest to short-term creditors (e.g., bankers, suppliers). Solvency ratios (e.g., debt-to-equity ratio, times interest earned ratio) gauge a company’s ability to meet long-term obligations and survive over the long term. These ratios are of interest to stockholders and long-term creditors. Profitability ratios (e.g., return on assets, asset turnover ratio, return on equity, gross profit ratio) provide an indication of a company’s operating success. These ratios are of interest to creditors and investors. Finally, market indicator ratios (e.g., price earnings ratio, dividend yield ratio) relate the market price of a share of stock to what investors would be willing to pay.

Horizontal or trend analysis involves analyzing financial statement data by comparing both dollar and percentage changes for a given company over time to determine the increase or decrease that has taken place. Although this type of analysis can be used for comparison between two years, it is more informative when several years can be compared and a trend can be depicted. Horizontal analysis can be detailed (e.g., comparison of each line item on the financial statements). Alternatively, selected items may be extracted (e.g., sales, net income) to analyze trends for specific financial statement items.

Horizontal analysis requires restating financial statement items as a percentage of some selected base year. For example, if a 10-year period (e.g., 1997–2006) is being considered, each item in the analysis could be restated as a percentage of the corresponding item in 1997. Information is presented with the most recent year appearing first (e.g., 2006, 2005, … 1997). Horizontal analysis is primarily used for intracompany comparisons.

Vertical analysis evaluates financial statement data at a given point in time by expressing each financial statement item as a percent of some base amount. This approach produces what is referred to as common-size financial statements. Balance sheet items are commonly expressed as a percentage of total assets (e.g., Cash Percentage = Cash/Total Current Assets) while income statement items are commonly expressed as a percentage of sales (e.g., Net Income Percentage = Net Profit/Sales).

Vertical analysis is particularly useful for comparisons between companies of different sizes. Comparisons that ignore size can be quite misleading. For example, if Company A has a higher net income than Company B, this is not an indication that Company A is performing better than Company B, unless both companies have the same sales revenue. To realistically assess the performance of each company, the net income of each entity would need to be expressed as a percentage of the sales revenue of each entity. This conversion to common-size financial statements reduces bias when comparisons are made between companies of differing sizes. Vertical analysis is used for both intracompany and intercompany comparisons.

Financial statement analysis that is used carefully can provide valuable information about a company’s financial health and future growth prospects. However, the following caveats should be noted: (1) Financial statements are based on historical costs. Thus, they do not reflect replacement costs or inflation; (2) Companies use different accounting policies (e.g., depreciation valuation and inventory valuation). Footnotes to financial statements should therefore be carefully reviewed to ascertain the accounting policies used. When policies differ, it will be necessarily to restate the data for the companies being analyzed using a common policy in order to make a meaningful comparison; (3) Ratios can be calculated using different variations. The composition of items that are used in the calculations should therefore be investigated in order to make a valid comparison; (4) Financial statements contain many estimates (e.g., uncollectible receivables, contingent losses). Users should therefore be wary that inaccurate estimates will provide inaccurate ratios and percentages.

Bibliography:

Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer, Managerial Accounting, 12th ed. (McGraw-Hill, 2008);
Paul D. Kimmel, Jerry J. Weygandt, Donald E. Kieso, Financial Accounting: Tools for Business Decision Making, 5th ed. (Wiley, 2009);
Jane L. Reimers, Financial Accounting: A Business Approach, 2nd ed. (Pearson Educational Ltd., 2008).

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