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MA5-12: FINANCIAL STATEMENT ANAIYSIS

FS I\NALYSIS rrrvolves tlre evaluation of an entity's past perfarmancet present condition, and busr'ness
potentials by way of analyzing the financial statements to obtain information about (among
other s) i

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Safety r:f investment in the business
" ffffectiveness of rr-]anagement in running the firm

VARIOUS MODES o, Or*o*arol STATEMENT ANALYSIS

1" l-lorizontal analysis
2. Vertic;rl analysis
3. Gross profit variation analysis
4. Cash flow analysis
5. f:inancial retios ,

HORIZONTAL ANAI-YSIS
Horizontal analysis (also called 'trend' or'index' analysis) involves comparison of amounts shown in the
FS of tvvo nr tnore consecutive periods. The difference and percentage change of the amounts are
calculated using the earlier period as the base period. Considerthe following formula:

Percentage Changer (Aolo) I$ !E!,&eg.en!*Uel-ue*:-gg!e Peri od \rAlue

=
Base Period Value

Comparisons carr be made between an actual amount compared against a budgeted amount, with the
'btrdget' ser vinq as llre basis or pattern of performance.

LIMITA'|IO|\: if a negative or a zero amount appears in the base year, percentage change cannot be
conrprrted.

VERTICAL ANALYSIS
Vertical analysis is the process of"eomparing figures-ir,rthe€$of a single period. It involves conversion
of arnoirrtts ,n l.ire'f'S to a common base. This is acconrplished by expressing all figures in the FS as
percent3qe..of ar rr:rportant item such as total assets (in the balance sheet) or net sales (in the income
statement) Ihese converted statements are called common-size statements or percentage composition
statemertts.
Percentaqe cr:mpr:sition statements are used for comparing:
1, l',lultiple years of data from the same firm
2. Companies that are different in size
.
.1 Company to industry averages

FINANCIAL RATIO$
. Financial ratios involve development of mathematical relationships among accounts found in-the FS.
Financial ratios provide relevant information abr:ut the firm's liquidity, solvency, stability, profitability and
other aspects of an entity's financial situation and potential.

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r Whert calculating a ratio using balance sheet amounts only, the numerator and denominator should
be basecl on amounts as of the sarne balance sheet date" The same is true for ratios using only
incorne stertement numbers. Exception: calculation 6f growth ratios.
r If an incorre statement amourrt and a balance sheet amount are used at the same time t0 calculate
a rati<1, the iralance sheet ltmount should be expressed as an average for the time period
represented by the income statement amount.
r If the br:qinning balance of a balance sheet accor.rnt is not avbilable and cannot be computed from
the given clata, the ending balance of the account is used to represent the average baiance.
. If sales and/or purchases are given without making distinction as to whether made in cpsh or on
credit, assrrmptions are made depending on the ratio being calculated:
la l-urnover ratios: Sales and purchases are made on credit-
'i Cash flow ratios; Sales and purchases are made in cash.
' As a r-ule, art cperating year is assumed to have 360 days, unless specified otherwise.
'/; A 36t)"day year is generaliy preferred as this is consistent with a 12-month year and a 30-day
rtronth;
rt' Alternatively/ a year may be comprised of 365 calendar days, 300 warkinq clays or any
.tpproprate number of days.

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