Interpretation of Financial Statements

Interpretation of Financial Statements

There are three main aids to the analysis of financial statements:

HORIZONTAL and TREND ANALYSIS

VERTICAL ANALYSIS

RATIO ANALYSIS

HORIZONTAL and TREND ANALYSIS

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Horizontal analysis involves a line by line comparison of one set of

data with another - for example, the current year's accounts with last

year's, or with this year's budget. It is based on the fact that

isolated figures are seldom of much use by themselves. Trend analysis

is horizontal analysis extended over several years, often indexing the

data to express the first set of figures as 100 and later periods

related to that base.

For example, profit is £10,000,000. Is this good or bad?

(a) Profit for the previous 4 years was:

£6,000,000 £7,000,000 £8,000,000 £9,000,000

(b) Profit for the previous 4 years was:

£14,000,000 £13,000,000 £12,000,000 £11,000,000

(c) Profit for the previous 4 years was:

£10,000,000 £10,000,000 £10,000,000 £10,000,000

The comparison shows fairly clearly how the company is doing - but

even this can be improved upon. One way is to calculate the percentage

increase/decrease from year to year:

(a) 16.7% 14% 12.5% 11%

(b) -7% -7.7% -8.3% -9%

(c) 0% 0% 0% 0%

Using indexation:

(a) 100 117 133 150 167

(b) 100 93 86 79 71

(c) 100 100 100 100 100

VERTICAL ANALYSIS

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This technique requires all of the profit and loss account and balance

sheet to be expressed as a percentage of critical components

(generally total sales and total assets respectively). This is also

called common sizing. For example, if debtors are £25 m and total

assets are £100m, then debtors represents 25% of total assets. If this

is compared with last year's figure of, say, 20%, it can be seen that

debtors are increasing in relative importance, and may indicate a

worsening credit control situation.

Example

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Profit and loss accounts 1997 1998 1999 2000

£000 £000 £000 £000