Page 340 - Encyclopedia of Business and Finance

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Financial Statement Analysis

financial well-being. The 2004 survey showed that Amer- FINANCIAL MARKETS
icans were getting better at knowing what they need to do
SEE Capital Markets
to achieve financial well-being, but they did not always act
on their knowledge.
Bankruptcy is one of the severe consequences of a
lack of financial literacy. In reaction to the number of
bankruptcies declared after the Bankruptcy Reform Act of FINANCIAL STATEMENT
1978, in 2005 the U.S. government tightened bankruptcy ANALYSIS
laws.
Financial statement analysis is the process of examining
Financial literacy is a long-term solution to consumer relationships among financial statement elements and
problems with finances. In the Bankrate survey, individu- making comparisons with relevant information. It is a
als who were “financially literate” earned more, paid less valuable tool used by investors and creditors, financial
for loans, used credit cards more wisely, had savings for analysts, and others in their decision-making processes
emergencies, had prepared a will, lived by a monthly related to stocks, bonds, and other financial instruments.
budget, and were more constant and careful shoppers for The goal in analyzing financial statements is to assess past
financial services. “Financially literate consumers” performance and current financial position and to make
accepted the key concepts that: predictions about the future performance of a company.
Investors who buy stock are primarily interested in a
• Money management is a long-term responsibility
company’s profitability and their prospects for earning a
• Consumers should be savers instead of spenders and return on their investment by receiving dividends and/or
must live within a budget increasing the market value of their stock holdings. Cred-
itors and investors who buy debt securities, such as
• Comparison shopping pays off
bonds, are more interested in liquidity and solvency: the
• Smart consumers pay bills on time, read their bank company’s short- and long-run ability to pay its debts.
statements regularly, and shop for the best rates on Financial analysts, who frequently specialize in following
credit certain industries, routinely assess the profitability, liq-
• Buying on a whim and snap decisions about buying uidity, and solvency of companies in order to make rec-
must be avoided ommendations about the purchase or sale of securities,
such as stocks and bonds.
• Individuals must regularly save and invest for retire-
Analysts can obtain useful information by comparing
ment
a company’s most recent financial statements with its
These concepts are part of the foundation for financial lit- results in previous years and with the results of other com-
eracy. panies in the same industry. Three primary types of finan-
cial statement analysis are commonly known as horizontal
analysis, vertical analysis, and ratio analysis.
BIBLIOGRAPHY
Bankrate.com. (2004, April 6). Bankrate survey: Americans
nearly flunk financial literacy. Retrieved December 1, 2005, HORIZONTAL ANALYSIS
from http://www.bankrate.com/brm/news/financial-liter- When an analyst compares financial information for two
acy2004/grade-home.asp
or more years for a single company, the process is referred
Jump$tart Coalition for Personal Financial Literacy. to as horizontal analysis, since the analyst is reading across
http://www.jumpstart.org the page to compare any single line item, such as sales rev-
Mandell, Lewis (2005). Financial literacy—Does it matter? Wash- enues. In addition to comparing dollar amounts, the ana-
ington, DC: Jump$tart Coalition for Personal Financial Lit- lyst computes percentage changes from year to year for all
eracy.
financial statement balances, such as cash and inventory.
National Endowment for Financial Education. (2005). Educa- Alternatively, in comparing financial statements for a
tion programs. Retrieved December 1, 2005, from number of years, the analyst may prefer to use a variation
http://www.nefe.org/pages/educationalprograms.html
of horizontal analysis called trend analysis. Trend analysis
U.S. Courts. (2005). Bankruptcy statistics. Retrieved December involves calculating each year’s financial statement bal-
1, 2005, from http://www.uscourts.gov/bnkrpctystats/ ances as percentages of the first year, also known as the
bankruptcystats.htm
base year. When expressed as percentages, the base year
figures are always 100 percent, and percentage changes
Betty J. Brown from the base year can be determined.

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 317