What Are Different Methods of Financial Statement Analysis?

Updated: November 20, 2010

Who Carries Out Analysis?

A business must rely on an accountant to prepare financial statements and carry out an important analysis based on these reports. An accountant compiles the information provided by business statements, reviews them with the help of business representatives, and audits the final reports to ensure their accuracy. So, the first task to ensure accurate financial analysis is to hire the services of an expert accountant.

Financial statement analysis involves the comparison of information of one entity over different periods of time or the comparison of information of different entities during the same period. The four main statements that are analyzed during the procedure include the balance sheet, income statement, statement of owner's equity, and statement of cash flows.

The remaining part of the discussion provides information on the three important methods of financial statement analysis-

Horizontal Analysis

With the help of horizontal financial analysis, you can compare a business entity over different months or defined periods within a fiscal year. For example, revenue generated over different months of a year can be compared to analyze the overall performance of business or a particular project.

An accountant can follow one of the two given below methods to conduct a horizontal financial analysis:

  • Dollar analysis is the first way method of horizontal financial analysis in which the amounts in absolute dollars of various items are compared for an entity over different periods of time. This type of analysis helps analyze the spending trend of a business. Besides, it also helps analyze the effects of external factors like rise in prices over business expenditures.
  • Percentage analysis is based on the change in different items over different periods of time calculated in terms of percentage. With the help of this type of analysis, the performance of a small business can be compared to that of a large business in the same industry.

Vertical Analysis

This involves the procedure of comparing different figures of separate entities to one specific figure of an entity for one specific period of time. This type of analysis is of great significance in carrying out the decision making process. An accountant can also expand the vertical analysis by comparing the figures of one specific period with those of another period.

Analysis of the balance sheet is one good example of carrying out vertical financial analysis. Each item of the balance sheet can be compared to the total assets calculated. Vertical analysis is useful for answering the questions related to business liabilities and equity. This type of analysis is also referred to as common-size analysis.

Ratio Analysis

This is the method in which the ratio between two or more variables related to the business is compared.

There are many ratios used to analyze financial statements:

  • Liquidity Analysis Ratio: For example, the net working capital ratio is calculated between net working capital and total assets.
  • Profitability Analysis Ratio: For example, return on assets ratio is calculated between net income and average total assets. Profit margin ratio is calculated between net income and sales. Earning per share is calculated between net income and number of outstanding shares.
  • Activity Analysis Ratio: For example, asset turnover ratio is calculated between sales and average total assets. Inventory turnover ratio is calculated between cost of goods sold and average inventories.
  • Capital Structure Analysis Ratio: The most important ratio is debt to equity ratio, which is calculated between total liabilities and total stockholder's equity.
  • Capital Market Analysis Ratio: For example, dividend ratio is calculated between annual dividends per common share and market price of common stock per share.

All these ratios are collectively used to carry out the financial analysis of business to assess growth, profitability, and solvency of a business. Remember that ratio analysis is as important as horizontal and vertical analysis and must not be overlooked.

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