The analysis refers to the application of analytical
tools to the financial statements and related data for making business decisions. It involves transforming accounting data into more useful information It reduces decision makers reliance on hunches, guesses, and intuition as well as uncertainty. It provides an effective and systematic basis for making business decisions. Users of Accounting Information Internal users are those involved in strategically managing and operating the company. They include Managers, internal auditors, consultants, budget directors, and market researchers. External users are those who are not directly involved in running the company. They include: Shareholders, lenders, directors, customers, suppliers, regulators, brokers, the press, financial analysts (e.g., Dun & Bradstreet, Moodys, and Standard & Poors] and others (e.g., the public) Benchmarks To make good judgment using the measures obtained from the analysis. You need to have some benchmarks for comparisons. They could be: Internal to the company. Competitors performance Industry averages general guidelines (rule of thumb) Tools (Techniques) of Analysis Horizontal Analysis Vertical Analysis Ratio Analysis Statistical Models Other Models Horizontal Analysis This analysis refers to establishing relations between numbers, groups of numbers, and changes in these numbers across time. Examples include percentage change over different periods. We calculate the amount of change (increase or decrease) and divide it by the amount of the base year. Assume the following schedule of comparative current assets of West Corp is available. Year 2012 is the base year. We can calculate the percentage changes as follows: Horizontal Analysis (% change) Dec. 31 Dec. 31 Increase (Decrease) Percentage 2013 2012 Amount Amount Change Cash 15,000 10,000 5,000 50% Accounts Receivable 30,000 24,000 6,000 25% Prepaid Items 8,400 12,000 (3,600) (30%) Percentage change = difference between two periods/ base period For example for cash using 2012 as the base period The difference is 15,000-10,000 = 5,000 The percentage change is =5,000/10,000 = 50% Vertical Analysis Vertical analysis evaluates individual financial item or a group of items in terms of a specific base amount for the same period. Examples include Common-size statements and common-size graphs. For income statement we express each item as a percentage of sales. On a balance sheet, we express each item as a percentage of total assets. Solve Exercise 17-3, Problem 17-1A Ratio Analysis A ratio expresses a relationship between two numbers. Ratios are among the more widely used tools of financial analysis Several ratios are used to judge liquidity, solvency, profitability, and market propspects. Liquidity Ratios They include: Current ratio Acid-test ratio Accounts receivable turnover Inventory turnover Days sales uncollected Days sales in inventory Total asset turnover Solvency Ratios They include: Debt and Equity Ratio Debt-to-Equity Ratio Times Interest Earned
Profitability Ratios They include: Profit margin Return on total assets Return on common stockholders equity Market Prospects Ratios They include: Price-earnings ratio: Market price per share/EPS Dividend yield: Annual Cash Dividends/Market price per share Solve Problem 17-4A (1,2,3,12, 13,14,16,17) Use of analyzed Information Financial statement analyses are essential in a variety of tasks: Managing Investments Managing corporate finance Commercial lending Extension of credit Performance Evaluation
Limitations of Financial Statements These limitations include Information relates mainly to historical cost and does not portray market values of all items Some assets and liabilities for some firms are not shown on the balance sheet Use of alternative accounting methods that require making adjustments before performing the analysis