FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

CHAPTER 5: FINANCIAL STATEMENT ANALYSIS 1

Financial Statement Analysis

Financial statements inform the readers of a company's financial position, results of

operations, cash flows and changes in equity. However, these information are not sufficient to
help readers make decisions about the business.

Financial statement analysis is the process of evaluating risks, performance, financial

health, and future prospects of a business using computational and analytical techniques with
the objective of making economic decisions'.

Horizontal Analysis

Horizontal analysis is also known as trend analysis. It is a technique that involves the
comparison of a line item (account) over a number of periods. Imagine comparative financial
statements are laid down side by side. One line will contain the account and its reported
balances over time. The technique borrowed its name from the horizontal direction of the
analysis.

Horizontal analysis uses financial statements of two or more periods. Horizontal analysis
may be performed on all financial statements, specifically for both the SFP and SCI. Changes
can be expressed in monetary value (peso) or percentages computed by using the following
formulas:

Peso change = Balance of Current Year - Balance of Prior Year

Vertical Analysis

Vertical analysis is the preparation of common-size financial statements. It is a technique

that expresses each financial statement line item as a percentage of a base amount. For the
SFP, the base amount used is total assets. On the other hand, sales or net sales is used as
base amount for the SCI.

A common-size SFP shows each line account as a percentage of total assets. From the
asset side, we can infer the composition of assets. On the other side, we can determine the
company's financing mix- the percentage of asset financed by liability and equity.

A common-size SCI expresses each line as a percentage of sales. This way, it can see
how sales is "used up" by various expenses. Effectively, net income is the portion of sales not
eaten up by expenses.

By expressing the line items as a percentage of the base amount, common size financial
statements show standardized or relative amounts.