Analysis for Decision Making

Article excerpt

When we prepare a set of financial statements for a client, we know it's likely those financial statements will be used by some interested outside party to evaluate the client's business. Such questions as: Did they make a profit? Did debts increase from last year? Did owners' equity change? are important and can be answered by the four basic statements. These statements are only the beginning, however, to the process of gathering information on which many business decisions will be made.

To better understand how a company is performing, a deeper analysis of these statements is required. A variety of techniques are available that show relationships and changes between and within the financial statements from year to year. Among the more widely used methods are horizontal analysis, trend analysis, vertical analysis and ratio analysis.

Horizontal analysis

Horizontal analysis begins with the typical comparative statement, showing data for the current year and the year just past and calculating both the dollar amount of the change and the percentage change from last year to this year. The percentage of change is calculated as follows:

100 x amount of the change/previous year amount

where the amount of the change is the current year amount less the previous year amount. Both dollar amounts and the percentage change must be considered, lest we give too much weight to one or the other.

Trend analysis

Trend analysis takes horizontal analysis one step further, since it presents data for several successive years rather than only two. The percentage changes are computed using the oldest year as the base year and expressing all succeeding years as percentages of that base year. The value of trend analysis is in its longer view of the firm, which can point out tendencies in the business's operations.

Vertical analysis

Relationships among the various components within a single statement can easily be seen if vertical analysis is used. Here a total figure (revenues or sales for the income statement, total assets for the balance sheet) is set equal to 100% and all other parts of the statement are expressed as a percentage of that total. These "common size" statements can point out significant changes in the make-up of the business from year to year. They can also be used to compare companies within an industry.

Even when the size of firms differs, common size statements allow the accountant to compare characteristics of the firms' financing and operating activities.

Ratio analysis

Finally, ratio analysis allows the interested accountant to explore meaningful relationships between components of a single financial statement or between different statements. A wide variety of ratios can be used to describe a firm's liquidity, profitability, long-term solvency and market strength.

Liquidity ratios help us evaluate the firm's ability to pay short-term debt. All liquidity ratios deal with working capital accounts, since it is from the working capital that payment for current debts and unexpected needs for cash are drawn. Frequently used are the current ratio (current assets divided by current liabilities) and the quick or acid test ratio (quick assets, such as cash, A/R and marketable securities divided by current liabilities). Less familiar are activity ratios such as:

* the receivables turnover (net sales divided by the average accounts receivables), which describes the speed with which the firm turns its receivables into cash;

* the average days sales uncollected (365 days divided by the receivables turnover) which tells how long the firm must wait to receive cash from credit sales;

* and the inventory turnover (cost of goods sold divided by average inventory) which measures how quickly the inventory is turned into sales. …