Page 341 - Encyclopedia of Business and Finance

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Financial Statements

VERTICAL ANALYSIS acceptable, methods of accounting for inventories and
When using vertical analysis, the analyst calculates each other items. Making meaningful comparisons is also ham-
item on a single financial statement as a percentage of a pered when a company or its competitors have widely
total. The term vertical analysis applies because each year’s diversified operations.
figures are listed vertically on a financial statement. The The tools of financial statement analysis, ratio and
total used by the analyst on the income statement is net percentage calculations, are relatively easy to apply.
sales revenue, while on the balance sheet it is total assets. Understanding the content of the financial statements, on
This approach to financial statement analysis, also known the other hand, is not a simple task. Evaluating a com-
as component percentages, produces common-size finan- pany’s financial status, performance, and prospects using
cial statements. Common-size balance sheets and income analytical tools requires skillful application of the analyst’s
statements can be more easily compared, whether across judgment.
the years for a single company or across different compa-
SEE ALSO Accounting; Analytical Procedures; Financial
nies.
Statements
RATIO ANALYSIS
Ratio analysis enables the analyst to compare items on a Mary Brady Greenawalt
single financial statement or to examine the relationships
between items on two financial statements. After calcu-
lating ratios for each year’s financial data, the analyst can
then examine trends for the company across years. Since FINANCIAL
ratios adjust for size, using this analytical tool facilitates
intercompany as well as intracompany comparisons. STATEMENTS
Ratios are often classified using the following terms: Financial statements provide information of value to com-
profitability ratios (also known as operating ratios), liq- pany officials as well as to various outsiders, such as
uidity ratios, and solvency ratios. Profitability ratios are investors and lenders of funds. Publicly owned companies
gauges of the company’s operating success for a given are required to periodically publish general purpose finan-
period of time. Liquidity ratios are measures of the cial statements that include a balance sheet, an income
short-term ability of the company to pay its debts when statement, and a statement of cash flow. Some companies
they come due and to meet unexpected needs for cash. also issue a statement of stockholders’ equity and a state-
Solvency ratios indicate the ability of the company to ment of comprehensive income, which provide additional
meet its long-term obligations on a continuing basis and details on changes in the equity section of the balance
thus to survive over a long period of time. In judging sheet. Financial statements issued for external distribution
how well on a company is doing, analysts typically com- are prepared according to generally accepted accounting
pare a company’s ratios to industry statistics as well as to principles (GAAP), which are the guidelines for the con-
its own past performance. tent and format of the statements. In the United States,
the Securities and Exchange Commission (SEC) has the
CAVEATS legal responsibility for establishing the content of financial
Financial statement analysis, when used carefully, can pro- statements, but it generally defers to an independent
duce meaningful insights about a company’s financial body, the Financial Accounting Standards Board (FASB),
information and its prospects for the future. However, the to determine and promote accepted principles.
analyst must be aware of certain important considerations The balance sheet, also known as the statement of
about financial statements and the use of these analytical financial position or condition, presents the assets, liabili-
tools. For example, the dollar amounts for many types of ties, and owners’ equity of the company at a specific point
assets and other financial statement items are usually in time. The assets are the firm’s resources, financial or
based on historical costs and thus do not reflect replace- nonfinancial, such as cash, receivables, inventories, prop-
ment costs or inflationary adjustments. Furthermore, erties, and equipment. The total assets (balance) equal the
financial statements contain estimates of numerous items, sources of funding for those resources: liabilities (external
such as warranty expenses and uncollectible customer bal- borrowings) and equity (owners’ contributions and earn-
ances. The meaningfulness of ratios and percentages ings from firm operations). The balance sheet is used by
depends on how well the financial statement amounts investors, creditors, and other decision makers to assess
depict the company’s situation. Comparisons to industry the overall composition of resources, the constriction of
statistics or competitors’ results can be complicated external obligations, and the firm’s flexibility and ability to
because companies may select different, although equally change to meet new requirements.

318 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION