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

Solution:-

Pros

There are some distinct advantages of performing a financial statement analysis. If the financial statements have been audited and an unqualified opinion has been issued by the auditor, additional comfort can be gained that the financial statements have been prepared in accordance with Generally Accepted Accounting Principles (“GAAP”) – that the accounting rules have been followed and that there is a good basis for performing the analysis. A financial statement analysis also provides a historical and factual perspective. The results will represent facts - not assumptions or future projections. Multiple year financial results provide valuable trends as a basis for analyzing a business. And in some cases, the past results may be a good indicator of future results – if a company has a track record of generating profits, it may continue to do so.

Cons

While the apparent disadvantages of a financial statement analysis are few, there are disadvantages of performing ONLY a financial statement analysis. If a company is operating in an ever- changing or highly competitive environment, its past results, as reflected in historical financial statements, may not be an indicator of future results. Analysis of historical financial statements will not identify operational issues or inefficiencies or any favorable or unfavorable changes in the environment. There are other non-GAAP measures (such as EBITDA – earnings before interest, taxes, depreciation and amortization), which are excluded from audited financial statements but may provide valuable insights into the financial results of a business.

Financial statement analysis is used to identify the trends and relationships between financial statement items. Both internal management and external users (such as analysts, creditors, and investors) of the financial statements need to evaluate a company's profitability, liquidity, and solvency. The most common methods used for financial statement analysis are trend analysis, common‐size statements, and ratio analysis. These methods include calculations and comparisons of the results to historical company data, competitors, or industry averages to determine the relative strength and performance of the company being analyzed.