Financial statement analysis and industry comparison are essential in assessing a company’s financial status and operational effectiveness. Some of the methods of financial statement analysis are horizontal, vertical etc. This process includes comprehensive analysis of financial statements like the income statement, balance sheet, and cash flow statement to understand things like profitability, liquidity, efficiency, solvency, and overall financial health. Investors, creditors, analysts, and stakeholders rely on this analytical process to make sound decisions related to investments, credit risk, operational efficiency, and strategic planning. Financial statement analysis is a collection of methods and tools for analyzing financial statements.
What is Financial Statement Analysis?
Financial statement analysis is part of accounting and is an essential aspect of assessing the financial health of an organization. External stakeholders use it to assess the overall performance and business value of an organisation, while internal constituents consider it as a monitoring tool to manage the flow of funds.
Serving as the report card for a company’s financial health, it is a review of three main financial statements that each company must keep—the balance sheet, income statement, and cash flow statement.
It is a process of analysing financial conditions for decision-making purpose. It enables third parties to assess the financial health of the company and its value as a business.
Methods of Financial Statement Analysis
There are five types of widely used methods of financial statement analysis: horizontal analysis, vertical analysis, ratio analysis, Trend Analysis, and cost-volume profit analysis. Each method facilitates the construction of a more detailed and important financial portrait.
Horizontal analysis
Horizontal analysis looks at data over time (ratios, line items, etc.) and is often presented as a percentage increase over the same line item in the base time period. This numeric data allows financiers to trace trends and growth patterns and easily predict what is to come. Such a type of analysis also gives insight into an organization’s operational results and its level of efficiency and profitability and facilitates comparing growth rates among sector competitors.
Vertical analysis
Vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. For example, every line item on an income statement is a percentage of gross sales, while every line item on a balance sheet is a percentage of total assets. This gives analysts an understanding of overall performance in terms of revenue and expenses.
Ratio Analysis
Ratio analysis allows for meaningful comparison between the different elements of a financial statement and is used to reveal a general upward or downward trend. It’s a quick method to obtain an overview of a company’s financial health, more granular relationships between data, such as debt and equity or price versus earnings, and liability areas such as staff turnover. Once a ratio has been calculated, it can be compared against the previous period, which is crucial for setting performance targets.
Trend Analysis
Trend analysis uses historical data (such as price movements and trade volume) to forecast the long-term direction of market sentiment. It’s based on the idea that what has transpired in the past will occur again, which helps a business better predict and prepare for upward trends and reversals within particular market segments. Trend analysis is a valuable technique as moving with trends (and not against them) will result in profit for an investor.
Cost Volume Profit Analysis
This analysis technique helps businesses understand the relationship between sales, costs, and profit. It examines the fixed and variable costs and establishes the relationship between sales and variable costs to help business leaders better plan and project profit.
Types of Financial Statements
There are three significant financial statements that every company needs to maintain. the balance sheet, the income statement, and the cash flow statement. Let us discuss them one by one.
- Balance Sheet: A balance sheet is a report card that reveals a company’s worth in terms of book value at the end of a specific year. It consists of three main parts: assets, liabilities (debt), and shareholder’s equity. The most straightforward formula to arrive at book value or shareholder’s equity is to subtract debt from assets. The book value is an important performance metric, which rises or falls with increased or decreased financial activities of the company.
- Income Statement: A detailed account of the company’s revenue earnings and expenses in a particular past period, such as a financial year. Also known as the profit and loss statement, it provides the bottom line for decision-making, whether the company is making profit or loss.
- Cash Flow Statement: This accounts for how much liquid cash or cash equivalent circulates in the company. It is a report card that shows how well a company manages its cash position. A cash flow statement is important to evaluate a company’s financial health and complements the balance sheet and income statement.
Importance of Financial Statement Analysis
Financial statement analysis is not only important to comply with business laws and regulations, but the data can be beneficial for the organization in several ways.
A business owner can understand their financial strengths and weaknesses by determining how up-to-date they are on their debts and what their profit margins are by using financial statement analysis.
Financial statements are indispensable when looking for company partners and seeking investment capital. It’s up to data to see if a company is making a profit; not only that but it gives investors an idea of a fair share price. When pursuing both money and funds from lending entities, an impartial financial profile is just as important.
Business owners will, hence, see trends when analyzing the financial statement from quarter to quarter and year to year and formulate different strategies to cater for any threats posed to the wider market. In addition, the analysis guides measuring a company’s financial performance against the overall industry allowing business owners insight into how they stack up against their biggest competitors.
By being aware of these methodologies, stakeholders can make sound decisions related to investments, lending decisions, and strategizing for the future. Financial statement analysis equips you with the tools you need to navigate complex financial landscapes, whether you are an investor evaluating the financial health of a potential investment, a creditor assessing creditworthiness, or a manager striving to enhance operational efficiency.
Relevance to ACCA Syllabus
These are important in financial reporting (FR), strategic business reporting (SBR), and Financial Management (FM). Horizontal analysis, vertical analysis, and ratio analysis are some of the tools that ACCA students must implement to assess businesses’ performance and financial situation. These competencies aid in the interpretation, reporting, and strategic decision-making for users of financial statements, whether internal or external to an organization.
Methods of Financial Statement Analysis ACCA Questions
Q1: Which of the following does horizontal analysis compare?
A) Same year different departments at the same company
B) Financial data for more than one period
C) Competitors profit margins
D) The cash flow only
Ans: B) Financial information across several periods
Q: Vertical analysis expresses each item in the financial statement as a percentage of:
A) Total sales
B) Net profit
C) A base number within the same quote
D) Last year’s balance
Ans: C) A base figure within the same statement
Q3: Which of the following is a profitability ratio?
A) Current ratio
B) Quick ratio
C) Return on equity
D) Debt-to-equity ratio
Ans: C) Return on equity
Q4: Current ratio measures what aspect of a company?
A) Is highly leveraged
Section B) May not be able to meet its short-term obligations
C) Strong short-term liquidity
D) Is expanding its investments in fixed assets
Ans: C) Has good short term solvency
Q5: When assessing a company’s finances, what does the debt-to-equity ratio evaluate?
A) Liquidity position
B) Profitability
C) Financial leverage
D) Inventory turnover
Ans: C) Financial leverage
Relevance to US CMA Syllabus
Financial statement analysis methods are crucial in US CMA Part 1: Financial Planning, Performance, and AnalyticsThe article demonstrates how financial statement analysis methods assist in evaluating business performance. Above, the CMAs use ratio analysis, trend analysis and common-size statements for understanding the financial health, risk assessment, and to make strategic decisions. In management accounting, these tools also facilitate forecasting, variance analysis, and performance reviews.
Methods of Financial Statement Analysis CMA Questions
Q1: What kind of analysis focuses on historical data to identify trends over time?
A) Vertical analysis
B) Horizontal analysis
C) Dupont analysis
D) Ratio analysis
Ans: B) Horizontal analysis
Q2: Common-size financial statements are traditionally prepared using which analysis?
A) Vertical analysis
B) Horizontal analysis
C) Trend analysis
D) Regression analysis
Ans: A) Vertical analysis
Q3: What kind of analysis is the gross profit margin?
A) Efficiency ratio
B) Market ratio
C) Profitability ratio
D) Leverage ratio
Ans: C) Profitability ratio
Q4: What is the element of current ratio thats excluded from quick ratio?
A) Accounts payable
B) Inventory
C) Cash
D) Accounts receivable
Ans: B) Inventory
Q5: A sharp reduction in the return on assets might signal:
A) More efficient operations
B) Excessive debt financing
C) Reduced asset utilization
D) Increase in liabilities
Ans: C) Lower utilization of assets
Relevance to CFA Syllabus
Financial statement analysis is a major topic in the CFA Level I and II curriculum, including horizontal analysis, vertical analysis, ratio analysis, and cash flow analysis. CFA candidates apply these methods to analyze corporate financial health, company valuation, and industry performance comparison. These tools are vital for artful investing, as well as for gauging the ramifications of various monetary policies.
Methods of Financial Statement Analysis CFA Questions
Q1: What is the most useful ratio for measuring how efficiently a company makes use of its assets?
A) Return on equity
B) Current ratio
C) Asset turnover ratio
D) Gross profit margin
Ans: C) Asset turnover ratio
Q2: In vertical analysis of an income statement, each item is typically stated as a percentage of:
A) Operating expenses
B) Sales revenue
C) Net profit
D) Total equity
Ans: B) Sales revenue
Q3: What is being evaluated by the interest coverage ratio?
A) Liquidity position
B) Ability to meet interest expenses
C) Equity growth
D) Asset utilization
Ans: B) Interest paying capacity
Q4: The base year in horizontal analysis is used to:
A) Identify current profit
B) Look at relative shifts over time
C) Consolidate financials in common currency
D) Company valuation determination
Q5: Which ratio is of maximum use for an equity investor?
A) Dividend payout ratio
B) Inventory turnover
C) Working capital ratio
D) Debt-to-assets ratio
Ans: A) Dividend payout ratio
Relevance to US CPA Syllabus
The US CPA exam also tests candidates on methods of financial statement analysis in the Financial Accounting and Reporting (FAR) and Business Environment and Concepts (BEC) sections. CPAs have to rely on ratio analysis, vertical and horizontal analysis to determine: liquidity, solvency, profitability, and operational efficiency. It informs audit methodologies, ensures financial reporting accuracy, and provides business advisory services.
Methods of Financial Statement Analysis CPA Questions
Q1: What is the message of the current ratio?
A) Profit growth
B) Long-term solvency
C) Short-term liquidity
D) Shareholder equity
Ans: C) Short-term liquidity
Q2: What is the financial analysis method that benchmarks a company’s performance against industry average?
A) Vertical analysis
B) Benchmarking
C) Variance analysis
D) Forecasting
Ans: B) Benchmarking
Q3: An increase in a company’s debt-to-equity ratio may indicate:
A) Lower borrowing costs
B) Higher financial risk
C) More efficient operations
D) Reduced liabilities
Ans: B) Higher financial risk
Q4: A vertical analysis of the balance sheet usually displays each item as a percentage of:
A) Net income
B) Total revenue
C) Total assets
D) Total equity
Ans: C) Total assets
Q5: Which part of CPA exam discusses financial ratio analysis and reporting standards?
A) REG
B) AUD
C) BEC
D) FAR
Ans: D) FAR
