Analysis and Interpretation of Financial Statements
This chapter describes the objectives and sources of information for financial statement analysis, and explains how to measure change using horizontal analysis, vertical analysis, and trend analysis. It covers ratio analysis through liquidity ratios, long-term solvency ratios, profitability tests, and market tests, and the considerations that shape how analysts interpret the results.
Objectives and sources of financial statement analysis
Management analyzes financial statements to plan, evaluate, and control operations within the company, drawing on internally requested special-purpose reports. Investors, creditors, and regulatory agencies outside the firm instead rely on general-purpose statements, including the balance sheet, income statement, statement of stockholders’ equity, statement of cash flows, and the explanatory notes that accompany them. Although these users pursue different immediate goals, their shared objective is to use the information to predict a company’s future performance.
Horizontal, vertical, and trend analysis
Horizontal analysis compares financial statement items across two or more periods to measure the dollar and percentage change over time, while vertical analysis expresses each item as a percentage of a base figure, such as total assets or net sales, within a single period. Trend analysis extends horizontal analysis over a longer run of periods to reveal the direction a company’s results are moving, giving analysts a clearer picture of underlying performance than any single year’s figures alone.
Ratio analysis and its considerations
Ratio analysis relates one financial statement figure to another to assess a company from several angles: liquidity ratios test its ability to meet short-term obligations, long-term solvency ratios test its ability to meet long-term debt, profitability tests measure its capacity to generate income, and market tests relate its earnings and dividends to its share price. Because ratios are only as reliable as the statements behind them, analysts also weigh considerations such as comparability across periods and companies and the effects of estimates and accounting choices.