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Week 10: Chapter 8 -Financial Statement Analysis(pp. 303
322)
LO1: Identify why different user groups require financial
statements to be analysed and interpreted.
Users and decision making
The users of financial statements can be categorised as resource
providers (forexample, creditors, lenders, shareholders,
employees); recipients of goods and services(for example,
customers, debtors): and parties performing an overview or
regulatoryfunction (for example, the tax office, corporate
regulators). User groups are interestedin different aspects of the
entity, and various information sources are available tointerested
parties to facilitate their decision making. Such information
sources includethe financial press, trade-related magazines, and
research reports from broking houses,industry publication, online
databases, and government statistics. Another importantsource of
information is financial statements. With a knowledge and
understanding ofinformation contained in financial statements,
financial analysis can provideinformation specific to users needs.
Financial analysis is an analytical method in whichreported
financial numbers are used to form opinions as to the entitys past
and futureperformance and position. The decisions that users make
vary.Statement users generally share one common objective: to
evaluate past decisions andmake informed decisions about future
events. In this sense, reported financial numbershave a role to
play. The financial statements depict historical information.
Whenmaking predictions about future events, an evaluation of past
events is often the mostuseful starting point.Profitability is
defined as an entitys performance (profit) during the reporting
period
or over a number of reporting periods measured in relative
terms. Financial analysisinvolves expressing the reported numbers
in relative terms rather than relying on theabsolute numbers, and
can highlight the strengths and weaknesses of entities. It is
animportant decision-making tool for evaluating the historical
health of an entity andpredicting an entitys future financial
wellbeing.
LO2: Understand the nature and purpose of financialanalysis.
Nature and purpose of financial analysis
Financial analysis involves expressing reported numbers in
financial statements inrelative terms. Relying on the absolute
values contained in the financial statements isnot meaningful when
trying to evaluate an entitys past decisions and predicting
futurerewards and risks.
There is an emphasis on the need to express the reported number
in relation to othernumbers, enabling the relationships to be
revealed and the financial statements to tella story about the
entitys financial health. This process typically involves
comparingfigures to:
The equivalent figures from previous years
Other figures in the financial statements.
The process of comparison can be categorised as horizontal
analysis, trend analysis,vertical analysis and ratio analysis.
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LO3: Appreciate the analytical methods of horizontal,
trend,vertical and ratio analysis.
Analytical methods
All analytical methods involve comparing one item in the
financial statements withanother.
Horizontal analysis
Horizontal analysis compares the reported numbers in the current
period with theequivalent numbers for a previous period, usually
the immediate preceding period.Financial statements are usually
presented in a two-column format containing thefigures for the
current reporting period and the figures for the previous
reportingperiod. This permits the user to readily calculate the
absolute dollar change and thepercentage change in the reported
numbers between periods. The dollar change is
calculated as shown in the equation below:
Accounting number in current reporting periodLess accounting
number in previous reporting period
The percentage change is calculated as shown in the following
equation:
Accounting number in current reporting periodLess accounting
number in previous reporting period x 100
Accounting number in previous reporting period
The percentage change cannot be calculated if the equivalent
reported figure for theprevious year was zero. Care must also be
exercised when ascertaining andinterpreting the direction of the
change.
Trend analysis
Trend analysis tries to predict the future direction of various
items on the basis of thedirection of the items in the past. To
calculate a trend, it is necessary to have at leastthree years of
data. A public company often provides a historical summary of
variousfinancial items in its annual report.
