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# Ch19 - Chapter 19 Financial statement analysis CHAPTER...

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Chapter 19 - Financial statement analysis CHAPTER OVERVIEW Financial statements are the primary means an outsider uses to evaluate a particular company. Once completed, the results can be compared with other companies. There are a variety of tools used to evaluate performance. In this chapter you are introduced to some of these techniques. The learning objectives for the chapter are to: 1. Perform a horizontal analysis of comparative financial statements 2. Perform a vertical analysis of financial statements 3. Prepare common-size financial statements 4. Calculate the standard financial ratios used for decision-making 5. Measure economic value added by a company’s operations CHAPTER REVIEW Financial statement analysis is based on information taken from the annual report, reports lodged with the ASIC, articles in the business press, and so on. The objective of financial statement analysis is to provide information to creditors and investors to help them 1) predict future returns and 2) assess the risk of those returns. Past performance is often a good indicator of future performance. Three categories of financial statement analysis are horizontal, vertical, and ratio analysis. Objective 1 - Perform a horizontal analysis of comparative financial statements. The study of percentage changes in comparative statements is called horizontal analysis . Horizontal analysis highlights changes over time. Calculating a percentage change in comparative statements requires two steps: 1) calculate the dollar amount of the change from the base period to the later period, and 2) divide the dollar amount of the change by the base period amount. The base period for horizontal analysis is the year prior to the year being considered. Suppose there are three years of data. The change from Year 1 to Year 2 is: \$ YEAR 2 - \$ YEAR 1 \$ YEAR 1 and the change from Year 2 to Year 3 is: \$ YEAR 3 - \$ YEAR 2 \$ YEAR 2 No percentage changes are calculated if the base-year amount is zero or negative. Exhibits 19-1 and 19-2 illustrate horizontal analysis on an income statement and balance sheet. Trend percentages are a form of horizontal analysis. They indicate the direction of business activities by comparing numbers over a span of several years. Trend percentages are calculated by selecting a base year and expressing the amount of each item for each of the following years as a percentage of the base year’s amount. That sounds complicated - what it means is you are taking, say, sales in year four and divide it by sales in year one and that shows sales in the fourth year as a percentage of sales of the first year. See the example on page 735 of your textbook. Financial statement analysis 1

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Objective 2 - Perform a vertical analysis of financial statements. Vertical analysis of a financial statement reveals the percentage of the total that each statement item represents. Percentages on the comparative income statement are calculated by dividing all amounts by net sales. Percentages on the comparative balance sheets are shown as either 1) a percentage of total assets or 2) a percentage of total liabilities and shareholders’ equity.
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