Analyzing Financial Statements

Do You Needs Some Tips for Analyzing Financial Statements?

As a small business owner you are going to need to know about analyzing financial statements, or you will have no idea just how successful your business is!

The Need for Analysis

The information reported in your financial statements are primarily expressed in monetary terms and represent activity for a given period of time.

Many of the significant relationships between the components of your financial statements are not apparent when the information is presented in absolute dollar terms.

For example, just knowing that your business made a profit of $50,000 for the current year is of limited use to you unless you can compare that figure to other factors, like profits in previous years or the average profit earned by similar firms.

Without a basis of comparison the figure doesn't tell you much about your business, except that you made a profit.

By converting the absolute dollar values into percentages of a base item (eg sales), can help to identify significant changes in the relationship between items reported in your financial statements. In most cases, the relationship between two variables or items can be expressed as a ratio.

As indicated above there are a number of different ways to analzye your financial statements including:

• Horizontal Analysis,
• Trend Analysis,
• Vertical Analysis, and
• Ratio Analysis.

Horizontal Analysis

Horizontal analysis is a method that is used to compare the results of two or more different accounting periods. In this method the individual items or groups of items on comparative financial statements are placed side by side and difference is converted into a percentage.

Trend Analysis

When data is available for three or more years, trend analysis can be used to assess the growth prospects of the business.

I this method the first or earliest year is used as a base year and the results of all subsequent periods are compared to the base.

Vertical Analysis

Unlike horizontal or trend analysis, vertical analysis can be done on the financial results for a single year. In this method each item or group of items reported in the statement is converted into a percentage of a specific item on the same statement (eg sales or owners equity).

Ratio Analysis

A financial statement ratio is calculated by dividing the dollar amount of one item by another. The purpose of these ratios is to express a relationship between two relevant items that is easy to interpret and compare with other information. For example the relationship of current assets to current liabilities (working capital) is quite interesting as it is a measure of the ability of the business to pay its short term debts.

Financial ratios are generally grouped into:

• Profitability Ratios,
• Liquidity Ratios, and
• Financial Stability Ratios.

Before you move on to more detailed explanations of these financial analysis methods, you might like to download or print this copy of this summary of key financial ratios.

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