Question

Discuss the pros and cons of these methods of financial statement analysis: ratio analysis, vertical analysis, and horizontal analysis. What do they tell us? Why do we need so many different methods?

Answer 1

An organization operating a business in today's competitive economic market needs to record and analyze financial statements to meet profitability objectives and sustain. Financial statement analysis methods, along with their pros and cons, are listed down:

Ratio Analysis- Ratio Analysis helps an organization determine and analyze the financial position and management and acts as a comparison tool with competitors in the same business/industry over time.

Pros: Facilitates in comparison of data over time, Simple to prepare and analyze in ratio form.

Cons: Focuses more on past data to establish relationship and management of data and not future-oriented, Not useful when competitors follow different accounting financial framework when comparing fiscal position.

Vertical Analysis- Vertical Analysis helps an organization to determine and compare line items as a percentage of the base figures.

Pros: Simple to understand company's financial position, Easier to compare data with previous year data.

Cons: Fails to provide information on the organization's liquidity.

Horizontal Analysis- Horizontal analysis helps an organization determine and compare current year data with the organization's data over time.

Pros: Comprehensive information and easy to interpret; Growth and financial patterns can be determined over the organization's operating accounting period.

Cons: Any change in financial policy can interrupt its recording and management; management can distort data and make changes in order to show growth patterns by choosing favourable years.

Financial statement analysis facilitates an organization's financial planning and management by drawing relationships and fiscal patterns to build strong internal and external users' confidence in the organization and avoid losses in the future.

Different methods are applied to obtain overall data and information encompassing an organization's assets, liabilities; profit made or loss incurred, etcetera to determine or locate growth patterns and fiscal position in order to run an organization successfully adhering to required policies and regulations established by the government and different boards.