MS-12: FINANCIAL STATEMENT ANALYSIS
FS ANALYSIS involves the evaluation of the firm’s past performance, present condition, and
business potentials by way of careful analysis of its financial statements pertaining
to matters like:
Profitability of the business firm
Ability to meet company obligations
Safety of investment in the business
Effectiveness of management in running the firm
VARIOUS MODES OF FINANCIAL STATEMENT ANALYSIS
1) Horizontal analysis 4) Gross profit variation analysis
2) Vertical analysis 5) Cash flow analysis
3) Financial ratios
HORIZONTAL ANALYSIS
Horizontal analysis (sometimes called ‘trend’ or ‘index’ analysis) involves comparison of amounts
shown in the FS of two or more consecutive periods. The difference and percentage change of the
amounts are calculated using the earlier period as the base period. Consider the following formula:
Most Recent Value − Base Period Value
Percentage Change (∆% ) =
Base Period Value
Comparisons can be made between an actual amount compared against a budgeted amount, with the
‘budget’ serving as the basis or pattern of performance.
LIMITATION: If a negative or a zero amount appears in the base year, percentage change cannot be
computed.
VERTICAL ANALYSIS
Vertical analysis is the process of comparing figures in the FS of a single period. It involves
conversion of amounts in the FS to a common base. This is accomplished by expressing all figures in
the FS as percentages of an important item such as total ass ets (in the balance sheet) or net sales (in
the income statement). These converted statements are called common-size statements or percentage
composition statements.
, MS-12: FINANCIAL STATEMENT ANALYSIS
Percentage composition statements are used for comparing:
1) Multiple years of data from the same firm
2) Companies that are different in size
3) Company to industry averages
FINANCIAL RATIOS
Financial ratios involve development of mathematical relationships among accounts found in the
FS. Financial ratios provide relevant information about the firm’s liquidity, solvency, stability,
profitability and other aspects of an entity’s financial situation and potential.
BASIC RULES IN COMPUTING FINANCIAL RATIOS:
When calculating a ratio using balance sheet amounts only, the numerator and denominator should
be based on amounts as of the same balance sheet date. The same is true for ratios using only
income statement numbers. Exception: Calculation of growth ratios
If an income statement amount and a balance sheet amount are used at the same time to calculate
a ratio, the balance sheet amount should be expressed as an average for the t ime period
represented by the income statement amount.
If the beginning balance of a balance sheet account is not available and cannot be computed from
the given data, the ending balance of the account is used to represent the average balance.
If sales and/or purchases are given without making distinction as to whether made in cash or on
credit, assumptions are made depending on the ratio being calculated:
- Turnover ratios: Sales and purchases are made on credit.
- Cash flow ratios: Sales and purchases are made in cash.
As a rule, an operating year is assumed to have 360 days, unless specified otherwise.
- A 360-day year is generally preferred as this is consistent with a 12-month year and a
30-day month;
- Alternatively, a year may be comprised a 365 calendar days, 300 working days, or any
appropriate number of days.
FS ANALYSIS involves the evaluation of the firm’s past performance, present condition, and
business potentials by way of careful analysis of its financial statements pertaining
to matters like:
Profitability of the business firm
Ability to meet company obligations
Safety of investment in the business
Effectiveness of management in running the firm
VARIOUS MODES OF FINANCIAL STATEMENT ANALYSIS
1) Horizontal analysis 4) Gross profit variation analysis
2) Vertical analysis 5) Cash flow analysis
3) Financial ratios
HORIZONTAL ANALYSIS
Horizontal analysis (sometimes called ‘trend’ or ‘index’ analysis) involves comparison of amounts
shown in the FS of two or more consecutive periods. The difference and percentage change of the
amounts are calculated using the earlier period as the base period. Consider the following formula:
Most Recent Value − Base Period Value
Percentage Change (∆% ) =
Base Period Value
Comparisons can be made between an actual amount compared against a budgeted amount, with the
‘budget’ serving as the basis or pattern of performance.
LIMITATION: If a negative or a zero amount appears in the base year, percentage change cannot be
computed.
VERTICAL ANALYSIS
Vertical analysis is the process of comparing figures in the FS of a single period. It involves
conversion of amounts in the FS to a common base. This is accomplished by expressing all figures in
the FS as percentages of an important item such as total ass ets (in the balance sheet) or net sales (in
the income statement). These converted statements are called common-size statements or percentage
composition statements.
, MS-12: FINANCIAL STATEMENT ANALYSIS
Percentage composition statements are used for comparing:
1) Multiple years of data from the same firm
2) Companies that are different in size
3) Company to industry averages
FINANCIAL RATIOS
Financial ratios involve development of mathematical relationships among accounts found in the
FS. Financial ratios provide relevant information about the firm’s liquidity, solvency, stability,
profitability and other aspects of an entity’s financial situation and potential.
BASIC RULES IN COMPUTING FINANCIAL RATIOS:
When calculating a ratio using balance sheet amounts only, the numerator and denominator should
be based on amounts as of the same balance sheet date. The same is true for ratios using only
income statement numbers. Exception: Calculation of growth ratios
If an income statement amount and a balance sheet amount are used at the same time to calculate
a ratio, the balance sheet amount should be expressed as an average for the t ime period
represented by the income statement amount.
If the beginning balance of a balance sheet account is not available and cannot be computed from
the given data, the ending balance of the account is used to represent the average balance.
If sales and/or purchases are given without making distinction as to whether made in cash or on
credit, assumptions are made depending on the ratio being calculated:
- Turnover ratios: Sales and purchases are made on credit.
- Cash flow ratios: Sales and purchases are made in cash.
As a rule, an operating year is assumed to have 360 days, unless specified otherwise.
- A 360-day year is generally preferred as this is consistent with a 12-month year and a
30-day month;
- Alternatively, a year may be comprised a 365 calendar days, 300 working days, or any
appropriate number of days.
