4.4 Analysis of Financial Statements - 4.4 Analysis of Financial Statements

Key Concepts

• Horizontal Analysis
• Vertical Analysis
• Ratio Analysis
• Common-Size Statements

Horizontal Analysis

Horizontal Analysis, also known as trend analysis, involves comparing financial data over a series of reporting periods. This method helps in identifying trends and changes in financial performance and position. It is typically expressed as a percentage change from the base year.

Example: If a company's revenue was $100 million in 2020 and $120 million in 2021, the horizontal analysis would show a 20% increase in revenue.

Vertical Analysis

Vertical Analysis involves expressing each item on a financial statement as a percentage of a base figure within the statement. For the income statement, this base figure is usually total revenue, and for the balance sheet, it is total assets.

Example: If a company's cost of goods sold (COGS) is $60 million and its total revenue is $100 million, the vertical analysis would show COGS as 60% of total revenue.

Ratio Analysis

Ratio Analysis involves calculating and interpreting financial ratios to evaluate a company's performance, liquidity, profitability, and solvency. Common ratios include the current ratio, return on equity (ROE), and debt-to-equity ratio.

Example: A current ratio of 2.5 indicates that a company has $2.50 in current assets for every $1 of current liabilities, suggesting strong short-term liquidity.

Common-Size Statements

Common-Size Statements are financial statements where each item is expressed as a percentage of a base figure, making it easier to compare companies of different sizes or the same company over different periods. This method combines elements of both horizontal and vertical analysis.

Example: A common-size income statement might show that a company's operating expenses are 30% of total revenue, allowing for easy comparison with previous years or industry peers.