Unit 1 Intellipath Notes Evaluating Trends in Financial Statements

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Colorado Technical University *

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615

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Finance

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Jan 9, 2024

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Introduction Financial statements are the primary source of information about a company and are used to evaluate a company’s performance. Although a single set of financial statements will provide a lot of information, comparing the financial statement numbers to other data inside or outside of the company or looking at trends in a company’s financial statements over time will provide an even clearer picture of a company’s performance. This lesson discusses the following four evaluation techniques used in the analysis of financial statements: 1. Comparative analysis 2. Horizontal analysis 3. Vertical analysis 4. Common-size statement analysis Learning Materials Comparative Analysis Comparative analysis is used to assess the financial performance of a company. Investors are interested in the core or sustainable earnings of a company. They also are interested in making comparisons from period to period. There are three types of comparisons to improve the decision usefulness of financial information, and they are indicated as follows:

Financial performance analysis is used to examine the viability, profitability, liquidity, and ultimately, the solvency and stability of a project, strategic business unit (SBU), or enterprise as a whole. Generally, management wants to answer questions, such as whether to continue or discontinue a business or project, make or purchase materials used in manufacturing of a product, rent or lease premises, lend or invest capital, issue stock or bonds, borrow money from a commercial bank and acquire another company, or to divest an existing subsidiary company. The financial analyst must make decisions that affect the future of the organization (Horngren & Harrison, 2007). The methods used by the financial analyst include past performance, pro forma examination of future performance, and comparison of the performance of the company with industry performance standards and industry leaders to benchmark overall performance. Past performance can be examined by looking at previous quarters, annual performance trends over time, and past performance during similar economic cycles. Ratio analysis, trending, and vertical and horizontal analysis can be used as part of the areas of examination and evaluation. Financial planning follows a process whereby long-term, strategic plans are used to formulate short-term operating plans. Short-term operating plans then are turned into operating budgets for implementation. Forecasts of future earnings are used to formulate the pro forma financial statements , which are the end product of financial planning for businesses. Of the three basic tools (horizontal analysis, vertical analysis, and ratio analysis) used in financial statement analysis, this node will focus only on horizontal analysis. Horizontal Analysis Horizontal analysis is a study of percentage changes in comparative statements; it also is known as trend analysis, and it is a technique for evaluating a series of financial statement data over a period of time The purpose of horizontal analysis is to determine the increase or decrease that has taken place. Those changes can be expressed as either an amount or a percentage. Horizontal analysis uses two financial statements (for example, two year-end statements) to determine percentage changes based on dollar changes. Horizontal analysis compares each amount with a base amount for a selected base year. For example, if sales were $100,000 in 2011 and $150,000 in 2012, then sales increased to 150 percent of the 2011 level, an increase of 50 percent. Comparing each income statement line item for 2012 and 2011 with the same line items for 2010 allows you to see the growth in revenue and growth in expenses by line item. For example, 2012 revenue is 135.9 percent of 2010 revenue (Horngren & Harrison, 2007). Trend percentages are a form of horizontal analysis. They show the trend in a particular financial statement item (such as net income) over a period of years. It works in the following way (Horngren & Harrison, 2007):

 Select a number of years to gain a realistic view of where the company is headed.  Select a base year (the earliest year), and compare each year to the base year. The base year percentage will always be 100 percent.  Divide each year’s dollar amount by the base year dollar amount to calculate a percentage.  It is often useful to study several trend percentages together, such as net sales, cost of goods sold, and gross margin.  Trend analysis is used widely to predict future results. Formula: Change since base period = (Change since base period – Base year amount) / Base year amount Example 1 Assume the following sales data for a company: 2015 $910,000 2014 $770,000 2013 $700,000 If 2013 is the base year, then the percentage increase in sales from 2013 to 2014 is ($770,000 – $700,000) / $700,000 = 10 percent. Example 2 Assume the following sales data for a company: 2015 $960,000 2014 720,000 2013 600,000 If 2013 is the base year, then the percentage increase in sales from 2013 to 2014 is ($720,000 – $600,000) / $600,000 = 20 percent. Vertical Analysis Vertical analysis shows the relationship of each item to a base amount on the financial statement.

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On the income statement, each item is expressed as a percentage of net sales (the base amount) by dividing each number on the income statement by net sales. The net sales percentage always will be 100 percent. On the balance sheet, each item is expressed as a percentage of total assets (the base amount) by dividing each number on the balance sheet by total assets. The total asset percentage will always be 100 percent. Vertical analysis shows the relative size of financial statement items and can help uncover any deviations from normal. Common-Size Statements Common-size statements are a type of vertical analysis that reports only percentages. Common- size statements also are useful when benchmarking a company against industry averages or key competitors. Such a comparison to other companies who are leaders in the industry often helps a company improve its performance (Horngren & Harrison., 2007). Example 1 The following is the vertical analysis for 2013 for the income statement: Example 2

The following is a balance sheet for at December 2013: The following is the vertical analysis for 2013 for the balance sheet for 2013: Summary This lesson discussed four evaluation techniques used in the analysis of financial statements— comparative analysis, horizontal analysis, vertical analysis, and common-size statement analysis.

Q: ____ analysis shows the relation of each item to one that is based on the amount in the financial statement. A: vertical Q: ____ analysis is the study of percentage changes in comparative statements. A: horizontal Q: Apex Printing, Inc. is a private domestic United States printer of periodicals, newspaper inserts, and advertising materials that accompany distributions of Sunday and weekday circulations of large metropolitan newspapers. As the newly hired VP of finance, you report to the CFO. In this capacity, your responsibilities include analyzing trends in financial statements to provide recommendations to management. Financial decisions made by Apex may include which of the following? A: lend or invest capital A: continue or discontinue a project X best benefits to offer to employees X open the business for the day X best candidate for management position X hire or fire an employee Q: Apex Printing, Inc. is a private domestic United States printer of periodicals, newspaper inserts, and advertising materials that accompany distributions of Sunday and weekday circulations of large metropolitan newspapers. As the newly hired VP of finance, you report to the CFO. In this capacity, your responsibilities include analyzing trends in financial statements to provide recommendations to management. The management team wants you to perform a comparative analysis for the firm. Of the following information, what can be gained from this type of analysis of the Apex financial statements? A: intracompany comparisons A: Relative position within the industry X limitations X future projections X past errors in reporting

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Q: Apex Printing, Inc. is a private domestic United States printer of periodicals, newspaper inserts, and advertising materials that accompany distributions of Sunday and weekday circulations of large metropolitan newspapers. As the newly hired VP of finance, you report to the CFO. In this capacity, your responsibilities include analyzing trends in financial statements to provide recommendations to management. Which of the following methods could be used to gain information about the future for Apex? A: company performance compared to industry standards A: analysis of past performance X only past performance X customer satisfaction X only future performance Q: Comparative analysis is used to assess the financial performance of a company in which of the following ways? A: to evaluate financial relationships X to evaluate non-financial information X to evaluate employee hours within the organization X to evaluate benefits offered by the organization Q: Comparison of financial statements provides which of the following? A: assesses financial performance of a company X information about employees for use by human resources X minimum information about the organization X comparison of data only inside the organization Q: Common-size statements are a type of ____ analysis that reports only percentages. A: vertical Q: Comparison of financial statements provides which of the following?

A: provides a clearer picture of company performance X minimum information about the organization X comparison of data only inside the organization X comparison of data only outside of the organization Q: Apex Printing, Inc. is a private domestic United States printer of periodicals, newspaper inserts, and advertising materials that accompany distributions of Sunday and weekday circulations of large metropolitan newspapers. As the newly hired VP of finance, you report to the CFO. In this capacity, your responsibilities include analyzing trends in financial statements to provide recommendations to management. Which of the following would be an appropriate analysis tool for reviewing the financial statements of Apex? A: vertical analysis X financial advisor analysis X traditional analysis X research analysis Q: Apex Printing, Inc. is a private domestic United States printer of periodicals, newspaper inserts, and advertising materials that accompany distributions of Sunday and weekday circulations of large metropolitan newspapers. As the newly hired VP of finance, you report to the CFO. In this capacity, your responsibilities include analyzing trends in financial statements to provide recommendations to management. Which of the analysis tools can be used by Apex to examine past performance? A: ratio analysis X current month payroll X only current financial statements X approved procedures Q: Which of the following is an evaluation technique used in the analysis of financial statements? A: vertical analysis X complex analysis X standard analysis X review

Q: Vertical analysis provides analysis of financial statements in which of the following ways? A: through analysis of relative size of financial statements X uncovering employee thef X evaluation of employee information X showing the relationship of employees to managers Q: Horizontal analysis views percentage changes in comparative statements in which of the following ways? A: comparing each income statement line item with the same line for a prior period X evaluating relative position within the industry X through an intercompany basis X by providing insight into the competitive position of the company

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