Online Financial Courses - Evaluating Financial PerformanceProvided by : Matt H. Evans
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Course 1: Evaluating Financial Performance
Chapter 7: Comparing Financial StatementsOne final way of evaluating financial performance is to simply compare financial statements from period to period and to compare financial statements with other companies. This can be facilitated by vertical and horizontal analysis.
Vertical AnalysisVertical analysis compares line items on a financial statement over an extended period of time. This helps us spot trends and restate financial statements to a common size for quick analysis. For the Balance Sheet, we will use total assets as our base (100%) and for the Income Statement, we will use Sales as our base (100%). We will compare different line items on the financial statements to these bases and express the line items as a percentage of the base.
By expressing balances as percentages, we can easily notice that G & A Expenses are trending up while Cost of Goods Sold is moving down. This may require further analysis to determine what is behind these trends.
Horizontal AnalysisHorizontal analysis looks at the percentage change in a line item from one period to the next. This helps us identify trends from the financial statements. Once we spot a trend, we can dig deeper and investigate why the change occurred. The percentage change is calculated as: (Dollar Amount in Year 2 - Dollar Amount in Year 1) / Dollar Amount in Year 1
SummaryWe started our look at ratio analysis with Return on Equity since this one ratio is at the heart of financial management; namely we want to maximize returns for the shareholders of the company. Secondly, we have three ways of influencing Return on Equity. We can change our profit margins, we can change our turnover of assets, or we can change our use of financial leverage. Next, we looked at how we can influence the three components of Return on Equity.
There are several detail ratios that we can monitor, such as acid test, inventory turnover, and debt to equity. Detail ratios help us monitor specific financial conditions, such as liquidity or profitability.
Ratios are best used when compared or benchmarked against another reference, such as an industry standard or "best in class" within our industry. This type of comparison helps us establish financial goals and identify problem areas.
We also can use vertical and horizontal analysis for easy identification of changes within financial balances.
It should be noted that ratios do have limitations. After all, ratios are usually derived from financial statements and financial statements have serious limitations. Additionally, comparisons are usually difficult because of operating and financial differences between companies. None-the-less, if you want to analyze a set of financial statements, ratio analysis is probably one of the most popular approaches to understanding financial performance.
Chapter 7 pointsVertical Analysis