OCW041: Next Steps in Financial Statement Analysis

Interpreting Ratios and Other Sources of Company Information

Financial statement analysis uses comparisons and relationships of data to enhance the utility or practical value of accounting information.

Learning Objectives

Explain how a company would use one of the four financial statement analysis methods to interpret their data

Key Takeaways

Key Points

• In financial statement analysis, comparisons and relationships can be shown in the following ways: vertical analysis, horizontal analysis, trend percentages, and ratios.
• The vertical method is used on a single financial statement, such as an income statement, and involves each item being expressed as a percentage of a significant total.
• The horizontal method is comparative, and shows the same company’s financial statements for one or two successive periods in side-by-side columns. The side-by-side display reveals changes in a company’s performance and highlights trends.
• Trend percentages make comparisons to a selected base year or period. Trend percentages are useful for comparing financial statements over several years, because they disclose changes and trends occurring through time.
• Ratios are expressions of logical relationships between items in the financial statements from a single period. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g. balance sheet and income statement).

Key Terms

• ratio: A number representing a comparison between two things.
• trend: an inclination in a particular direction
• analysis: a process of dismantling or separating an object of inquiry into its constituent elements in order to study the nature, function, or meaning of the object

Financial Statement Analysis

Financial statement analysis, also known as financial analysis, is the process of understanding the risk and profitability of a company through the analysis of that company’s reported financial information. This information includes annual and quarterly reports, such as income statements, balance sheets, and statements of cash flows.

All financial analysis relies on comparing or relating data in a way that enhances the utility or practical value of the information. For example, when analyzing a particular company, it is helpful to know that they had a net income of \$100,000 for the year, but it is even more helpful to know that, in a previous year, they only had \$25,000 in net income. As more information is added, such as the total amount of sales, the number of assets, and the cost of goods sold, the initial information becomes increasingly valuable, and a more complete picture of a company’s financial activity can be derived.

In financial statement analysis, comparisons and relationships can be shown in the following ways:

• Absolute increases and decreases for an item from one period to the next
• Percentage increases and decreases for an item from one period to the next
• Percentages of single items to an aggregate total
• Trend percentages
• Ratios

Methods for Financial Statement Analysis

There are four methods for making these types of comparisons: vertical analysis, horizontal analysis, ratios, and trend percentages.

The vertical method is used on a single financial statement, such as an income statement. In a vertical analysis, each item is expressed as a percentage of a significant total. This type of analysis is especially helpful in analyzing income statement data.

The horizontal method is a comparative, and presents the same company’s financial statements for one or two successive periods in side-by-side columns. This comparative display shows dollar changes or percentage changes in the statement items or totals across given periods of time. Horizontal analysis detects changes in a company’s performance and highlights various other trends.

The trend percentages method is the same as horizontal analysis, except that in the former, comparisons are made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years, because they reveal changes and trends occurring over time.

Ratios are expressions of logical relationships between items in financial statements from a single period. It is possible to calculate a number of ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g.balance sheet and income statement). The only limiting factor in choosing ratios is that the items used to construct a ratio must have a logical relationship to one another.

Analyzing the Income Statement: In vertical analysis each item is expressed as a percentage of a significant total.

Source: Accounting