Financial statement analysis identifies the financial strengths and weaknesses of a company by establishing a relationship between the items of the balance sheet and the income statement.
Many methods or techniques can be used in analysis of financial statements. A company can use comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.
Companies prepare financial statements to meet internal and external reporting obligations and for use in decision making. The information provided in the financial statements must be combined with ratios and trend analysis to get a complete picture of the company’s operations for the information to be considered useful.
Horizontal and Vertical Analysis
Horizontal and vertical analysis and ratios analysis are a few of the techniques that companies can use to analyze operations.
Comparison of two or more years of financial data is known as horizontal analysis, or trend analysis. This method shows changes between years in both dollar amount and as a percentage.
Companies can also use trend percentage, in which financial data of several years is stated in terms of a base year. The base year equals 100 percent, with all other years stated in some percentage of this base.
Vertical analysis is a method of preparing and presenting common size statements. Common size statement shows the items as a percentage as well as in dollar amount. Each item is stated as a percentage of a total (total revenue on the income statement and total assets on the balance sheet). Key financial changes and trends can be seen through use of common size statements.
Ratio analysis is one of the most powerful tools of financial statement analysis. A ratio is one number expressed in terms of another. Ratios are a statistical benchmark that can be used to compare or measure performance. Ratios are calculated by dividing one number by another number.