Question

Describe the three types of financial statement analysis. How do you do them? what do they tell you? Which method provides the best information to the entrepreneur? Justify answer.

Answer 1

Answer:-

The three types of financial statement analysis are

1) Horizontal analysis

The company's financial statements are compared for two or more than two years in horizontal analysis.The analysis can be done from going through the data across many years. The differences across different years is termed as trend analysis. The trend is measured by taking the first year as the base year and is considered as 100% and the changes in the subsequent years are measured as increase or decrease in percentage terms.

2) Vertical analysis

When the financial data is listed vertically in the form of financial figures then it is known as vertical analysis. In vertical analysis the financial figures data is taken from the financial statements ie. balance sheet and income statement of the company.

3) Ratio analysis

The ratio analysis is done by calculating the different ratios like liquidity ratios, profitability ratios and leverage ratios.
The liquidity ratios are the current ratio, quick ratio and the cash ratio which shows the ability of the company to meet the short term obligations of the company like the liquidity needs. The profitability ratios are the ratios which gives us information about how the company is profitable at different levels and the examples are net profit margin. EBIT margin and in most of the cases in profitability ratios the denominator is revenue or sales. The leverage ratios gives us picture about the financial health of the company as a whole. The are debt to equity ratio and debt to capital ratio. There are other ratios like inventory ratio, receivables ratio and payables ratio which gives us idea of how efficient a company is in cash conversion.

The entrepreneur can use Ratio analysis to gauge the differences in the trends followed by the company over a period of time. The entrepreneur can analyse the ratios and it will be useful for decision making that will help improve the revenues and profitability in the long run. The entrepreneur will not get the complete picture just by using the horizontal and vertical analysis. The ratio analysis will also help the entrepreneur in knowing the peer group analysis in the industry, and can compare with the industry average ratios.