BUS103 Study Guide

Unit 5: Financial Reporting and Financial Statement Analysis

5a. Conduct horizontal and vertical analyses of a company's financial statements 

  • What are the benefits of analyzing financial statements using horizontal and vertical analyses?
  • What type of analysis allows you to compare a company with other companies of different sizes?

Many stakeholders look to a company's financial statements to determine its current value and health and attempt to predict its future performance. Since the financials of a company change over time and companies are of different sizes, comparisons can be difficult. Analysts use horizontal and vertical analyses to more easily compare a company over time and to its competitors. A horizontal analysis refers to calculating the total changes and percent changes in various financial statement items over multiple periods. To evaluate the performance of the company, an analyst would look at how each item has changed over time and compare those results with the percentages from other companies. This allows comparisons to be useful, even if the companies are of different sizes. A horizontal analysis provides valuable trend data and highlights trends that management needs to pay attention to.
 
Vertical analysis is when you take a financial statement and calculate all the items on it as a percentage of a significant total. For example, on the income statement, all line items would be expressed as a percentage of sales. This allows the analyst to see trends in terms of the relationships of financial statement accounts to each other (for example, if administrative costs as a percentage of sales are increasing). Most often, balance sheet items are expressed as a percentage of total assets.
 
When financial statements are shown as percentages of a line item, they are known as common-size statements.
 
To review, see:

 

5b. Calculate key ratios from financial statement data including liquidity, profitability, efficiency, and leverage ratios 

  • Why are financial ratios needed to analyze a company's financial health?
  • What are the main categories of financial ratios?

A financial ratio is a relationship between financial statement amounts. Financial ratios help examine the relationship among financial statement numbers and help show the trends with those numbers over time. When you utilize a formula to calculate a ratio, you are able to express a relationship as a percentage and are then able to compare the ratio over time and across companies. For example, a company may have Net Income of $1.2 billion; how do you know if that is good? If you know that $1.2b is a 5.4% net profit margin, you can compare that percentage to the company over time and to other companies to judge the performance of the company. Without ratios, stakeholders aren't able to make comparisons about a company over time or against other companies.
 
Financial ratios are generally broken down into the categories of liquidity, profitability, efficiency, and leverage ratios, although you can consider many more categories. Liquidity ratios analyze a company's ability to pay its short-term debt. Profitability ratios look at the overall financial return the company generates on its sales. Efficiency ratios examine how well a company manages various assets, such as inventory and accounts receivable. Leverage ratios analyze the amount of debt a company has, typically in comparison to assets or equity.
 
To review, see Analysis and Interpretation of Financial Statements and Calculating Financial Ratios.

 

5c. Analyze competitor and industry data for financial comparisons 

  • Where can analysts get competitor or industry data to make comparisons?
  • Why is it important to utilize industry-specific averages?

Once financial ratios are calculated, they must be compared over time and to industry standards and competitors to provide meaningful conclusions. Industry information can be found in a variety of sources: databases including Den & Bradstreet, Hoovers, and IBIS World, industry associations and research sources, and by studying public financial information and sources. When comparing company data utilizing these sources, it is important that the various calculations are consistent. An analyst should look at the underlying formula used to calculate averages and ratios to ensure that they are reported the same. It is also important to understand the context of the ratios – economic events, company events, and others – that will affect the industry or a particular company.
 
It is important to utilize industry-specific averages, as acceptable standards vary by industry. What is considered poor performance in one industry (such as a low profit margin in a luxury goods manufacturer) may be normal in another industry (such as big-box retail). Even within an industry, variations may exist due to unique geographical issues, business systems, or market strategies.
 
To review, see Analysis and Interpretation of Financial Statements.
 

5d. Interpret results of financial analyses to make decisions 

  • What ratios are most important to which stakeholders when analyzing financial statements?
  • What are some of the potential pitfalls when using the results of financial analyses to make decisions?
  • What other sources of information should management consider when making decisions based on their financial analysis?

Stakeholders will focus on different categories of financial ratios based on the reason for their analysis. Lenders, who are most concerned with the ability to be repaid, often look most closely at liquidity ratios. Investors hone in on profitability ratios. In addition to being concerned with all ratios, a company's management looks very closely at efficiency ratios, and the Board looks very closely at overall leverage.
 
When using financial analyses to make decisions, it is important to understand the potential pitfalls. One is that a company's financial statements do not contain all the relevant information needed about the company. A great financial analysis typically leaves the analyst with many questions to ask management and others – about upcoming projects, customer loyalty, employee retention, etc. It also is sometimes difficult to find direct comparisons for the ratios. Benchmarking is difficult when companies are conglomerates (composed of many different divisions) or are in a new industry. Analysts must also remember that all the ratios have been calculated using historical data. Historical data does not always predict future results.
 
When making decisions based on their financial analyses, management must go beyond the numbers to look at what the individuals responsible for those numbers say about them and their plans for the future. While quantitative data is critically important, we must remember that qualitative data provides an additional layer of value to our analysis.
 
To review, see Analysis and Interpretation of Financial Statements.
 

Unit 5 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • common-size statement
  • conglomerates
  • efficiency ratios
  • financial ratio
  • horizontal analysis
  • leverage ratios
  • liquidity ratios
  • profitability ratios
  • vertical analysis