ACCOUNTING FOR ‘DUMMIES’ 2.0

As a self acclaimed ‘demi-rookie’ in Accounting, I am enjoying the application of the principles learnt these past weeks.

The awareness of the different financial statements is pertinent. However, it is inconsequential unless paired with the knowledge of how to conduct analysis of financial statements.

What is Financial Statement Analysis

Financial statement analysis is the process of evaluating data in a company’s financial statements. Consequently, this analysis is used to determine the financial position of the company for decision making. Furthermore, it can be utilized to make recommendations for the future development of a company. Generally, financial statement analysis is conducted by internal and external stakeholders for a variety of reasons.

Methods of Financial Statement Analysis

Horizontal Analysis

Horizontal analysis is a method of examining a company’s financial statements over time. A line item from one period is compared to an item from another period. It is useful for determining trends and growth patterns in financial statements.

Unfortunately, the current period can be altered to appear better, if certain periods of poor performance are chosen as a comparison.

Vertical Analysis

In the vertical analysis, each line item in the financial statement is calculated as a percentage of another item. It is also referred to as the Common size analysis. For example, on the income statement, each line item is normally calculated as a percentage of revenue. Whereas each balance sheet line item is expressed as a proportion of total assets. Furthermore, the technique is useful for a comparative analysis of one company’s performance to that of another, as well as across industries.

Trend Percentage

This technique is used to compare and analyze financial statements spanning three or more years. In trend analysis, the most recent year is utilized as the base year. Accordingly, it is utilized to establish trends in financial data. These patterns include rising (or dropping) sales, seasonal inclinations, fluctuating expenses, and other patterns.

A company’s income statement can reveal a lot about its health. Markedly, examining trend analysis in a company’s income statement over time, provides crucial information about the company’s capacity for growth. A good analysis will emphasize areas that need to be improved.

Ratio Analysis

Ratio analysis is a statistical tool for determining a company’s liquidity, operational efficiency, leverage, and profitability by evaluating its financial statements.

This approach can also be used to compare a company’s financial status to industry averages and to assess how it stacks up against its peers.

Some examples of ratio analysis include:

• Liquidity ratios: These are used to assess a company’s ability to repay short-term loans as they mature, using current assets. They determine if the company can continue to be a going concern.
• Operational efficiency ratios: Efficiency ratios are a great indication of the quality of the management of a company because they indicate how well the company’s resources are utilized.
• Leverage ratios: They indicate how much a company relies on debt to fund its operations, as well as its ability to repay its debts.
• Profitability ratios: These ratios are used to determine a company’s profitability.

Whilst the ratio analysis provides the most advanced of the methods of analyzing financial statements, it should be combined with other methods of analyzing financial statements for a robust analysis of the company’s financial health.

That’s all I’ve got for now. See you in the next post.