Following are the most important tools and techniques of financial statement analysis:

1. Horizontal and Vertical Analysis

2. Ratios Analysis

1. Horizontal and Vertical Analysis:

Horizontal Analysis or Trend Analysis:
Comparison of two or more year's financial data is known as horizontal analysis, or trend
analysis. Horizontal analysis is facilitated by showing changes between years in both dollar
and percentage form.
Horizontal analysis is facilitated by showing changes between years in both dollar and
percentage form as has been done in the example below. Showing changes in dollar form
helps the analyst focus on key factors t hat have affected profitability or financial position.
Observe in the example that sales for 2002 were up $4 million over 2001, but that this
increase in sales was more than negated by a $4.5million increase in cost of goods sold.
Showing changes between years in percentage form helps the analyst to gain perspective
and to gain a feel for the significance of the changes that are taking place. For example a $1
million increase in sales is much more significant if the prior year's sales were $2 million
than if the prior year's sales were $20 million. In the first situation, the increase would be
50% that is undoubtedly a significant increase for any firm. In the second situation, the
increase would be 5% that is just a reflection of normal progress.

Example of Horizontal or Trend Analysis:

Balance Sheet:
Comparative Balance Sheet
December 31, 2002, and 2001
(dollars in thousands)

Current Assets:
Cash
Accounts receivable
Inventory
Prepaid Expenses

Total current assets

Property and equipment:

Land
Building
Total property and equipment

Total assets

Current liabilities:
Accounts payables
Accrued payables
Notes payables

Total current liabilities

Long term liabilities:

Bonds payable 8%

Total long term liabilities

Total Liabilities
Stock holders equity:
Preferred stock, 100 par, 6%, $100 liquidation value
Common stock, $12 par
Additional paid in capital

Total paid in capital

Retained earnings

Total stockholders' equity

Total liabilities and stockholders' equity

*Since we are measuring the change between 2001 and 2002, the dollar amounts for 2001
become the base figure for expressing these changes in percentage form. For example, cash
decreased by figures $1,150 between 2001 and 2002. This decrease expressed in
percentage form is computed as follows:
$1,150 $2,350 = 48.9%
Other percentage figures in this example are computed by the same formula.

Income Statement:
Comparative income statement and reconciliation of retained earnings
For the year ended December 31, 2002, and 2001
(dollars in thousands)
Sales
Cost of goods sold

Gross margin

Operating expenses:
Selling expenses
Administrative expense

Total operating expenses

Net operating income

Interest expense

Net income before taxes

Less income taxes (30%)

Net income

Dividends to preferred stockholders, $6 per share (see balance sheet above)

Net income remaining for common stockholders

Dividend to common stockholders, $1.20 per share

Net income added to retained earnings

Retained earnings, beginning of year

Retained earnings, end of year

Horizontal analysis of financial statements can also be carried out by computing trend
percentages.
Trend Percentage:
Horizontal analysis of financial statements can also be carried out by computingtrend
percentages. Trend percentage states several years' financial data in terms of a base year.
The base year equals 100%, with all other years stated in some percentage of this base.

Example:
Consider McDonald's Corporation, the largest global food service retailer, with more than
26,000 restaurants worldwide. McDonalds enjoyed tremendous growth during the 1990s, as
evidenced by the following data:

2000

Sales(millions) $14,24
 Income(millions) $1,97

By simply looking at these data, one can see that sales increased every year. But how
rapidly sales have been increasing, and have the increases in net income kept pace with the
increase in sales? It is difficult to answer these questions by looking at the raw data alone.
The increases in sales and the increases in net income can be put into better perspective by
stating them in terms of trend percentages, with 1990 as the base year. These percentages
(all rounded) appear as follows:
2000

Sales 215%

Income 247%

The trend analysis is particularly striking when the data are plotted as above. McDonald's
growth was impressive through the entire 11-year period, but it was out paced by even
higher growth in the company's net income. A review of the company's income
statement reveals that the dip in net income growth in 1998 was attributable, in part, to the
$161.6 million that McDonalds spent to implement its "Made for you" program and a special
charge of $160 million that related to ahome office productivity initiative.
Vertical Analysis:
Vertical analysis is the procedure of preparing and presenting common size
statements. Common size statement is one that shows the items appearing on it in
percentage form as well as in dollar form.
Each item is stated as a percentage of some total of which that item is a part. Key financial
changes and trends can be highlighted by the use of common size statements.
Common size statements are particularly useful when comparing data from different
companies. For example, in one year, Wendy's net income was about $110 million, whereas
McDonald's was $1,427 million. This comparison is somewhat misleading because of the
dramatically different size of the two companies. To put this in better perspective, the net
income figures can be expressed as a percentage of the sales revenues of each company,
Since Wendy's sales revenue were $1,746 million and McDonald's were $9,794 million,
Wendy's net income as a percentage of sales was about 6.3% and McDonald's was about
14.6%.

Example:
Balance Sheet:
One application of the vertical analysis idea is to state the separate assets of a company as
percentages of total sales. A common type statement of an electronic company is shown
below:
Common Size Comparative Balance Sheet
December 31, 2002, and 2001
(dollars in thousands)

Current assets:
Cash
Accounts receivable, net
Inventory
Prepaid expenses

Total current assets

Property and equipment:

Land
Building and equipment

Total property and equipment

Total assets

Current liabilities:
Accounts payable
Accrued payable
Notes payable, short term

Total current liabilities

Long term liabilities:

Bonds payable, 8%

Total liabilities

Stockholders' equity:
Preferred stock, $100, 6%, $100 liquidation value
Common stock, $12 par
Additional paid in capital

Total paid in capital

Retained earnings

Total stockholders equity

*Each asset in common size statement is expressed in terms of total assets, and each liability and equity account is
expressed in terms of total liabilities and stockholders' equity. For example, the percentage figure above for cash in 2002 is
 computed as follows:
[$1,200 / $31,500 = 3.8%]
Notice from the above example that placing all assets in common size form clearly shows
the relative importance of the current assets as compared to the non-current assets. It also
shows that the significant changes have taken place in the composition of the current assets
over the last year. Notice, for example, that the receivables have increased in relative
importance and that both cash and inventory have declined in relative importance. Judging
from the sharp increase in receivables, the deterioration in cash position may be a result of
inability to collect from customers.
The main advantages of analyzing a balance sheet in this manner is that the balance sheets
of businesses of all sizes can easily be compared. It also makes it easy to see relative
annual changes in one business.

Income Statement:
Another application of the vertical analysis idea is to place all items on the income
statement in percentage form in terms of sales. A common size statement of this type of an
electronics company is shown below:

Common-Size Comparative income statement

For the year ended December 31, 2002, and 2001
(dollars in thousands)

Sales
Cost of goods sold

Gross margin

Operating expenses:
Selling expenses
Administrative expense

Total operating expenses

Net operating income

Interest expense

Net income before taxes

Income tax (30%)

Net income
 *Note that the percentage figures for each year are expressed in terms of total sales for the year. For example, the
percentage figure for cost of goods sold in 2002 is computed as follows:
[($36,000 / $52,000) 100 = 69.2%]
By placing all items on the income statement in common size in terms of sales, it is possible
to see at a glance how each dollar of sales is distributed among the various costs, expenses,
and profits. And by placing successive years' statements side by side, it is easy to spot
interesting trends. For example, as shown above, the cost of goods sold as a percentage of
sales increased from 65.6% in 2001 to 69.2% in 2002. Or looking at this form a different
view point, the gross margin percentage declined from 34.4% in 2001 to 30.8% in 2002.
Managers and investment analysis often pay close attention to the gross margin percentage
since it is considered a broad gauge of profitability. The gross margin percentage is
computed by the following formula:
Gross margin percentage = Gross margin / Sales
The gross margin percentage tends to be more stable for retailing companies than for
other service companies and for manufacturers. Since the cost of goods sold in retailing
exclude fixed costs. When fixed costs are included in the cost of goods sold figure, the gross
margin percentage tends to increase of decrease with sales volume. The fixed costs are
spread across more units and the gross margin percentage improves.
While a higher gross margin percentage is considered to be better than a lower gross
margin percentage, there are exceptions. Some companies purposely choose a strategy
emphasizing low prices and (hence low gross margin). An increasing gross margin in such a
company might be a sign that the company's strategy is not being effectively implemented.
Common size statements are also very helpful in pointing out efficiencies and inefficiencies
that might other wise go unnoticed. To illustrate, selling expenses, in the above example of
electronics company, increased by $500,000 over 2001. A glance at the common-size
income statement shows, however, that on a relative basis, selling expenses was not higher
in 2002 than in 2001. In each year they represented 13.5% of sales.

2. Ratios Analysis:
Accounting Ratios Definition, Advantages, Classification and Limitations:
The ratios analysis is the most powerful tool of financial statement analysis.Ratios simply
means one number expressed in terms of another. A ratio is a statistical yardstick by means
of which relationship between two or various figures can be compared or measured. Ratios
can be found out by dividing one number by another number. Ratios show how one number
is related to another.

Definition of Accounting Ratios:

The term "accounting ratios" is used to describe significant relationship between figures
shown on a balance sheet, in a profit and loss account, in a budgetary control system or in
any other part of accounting organization.Accounting ratios thus shows the relationship
between accounting data.
Ratios can be found out by dividing one number by another number. Ratios show how one
number is related to another. It may be expressed in the form of co-efficient, percentage,
proportion, or rate. For example the current assets and current liabilities of a business on a
particular date are $200,000 and $100,000 respectively. The ratio of current assets and
current liabilities could be expressed as 2 (i.e. 200,000 / 100,000) or 200 percent or it can
be expressed as 2:1 i.e., the current assets are two times the current liabilities. Ratio
 sometimes is expressed in the form of rate. For instance, the ratio between two numerical
facts, usually over a period of time, e.g. stock turnover is three times a year.

Advantages of Ratios Analysis:

Ratio analysis is an important and age-old technique of financial analysis. The following are
some of the advantages / Benefits of ratio analysis:

1. Simplifies financial statements: It simplifies the comprehension of financial

statements. Ratios tell the whole story of changes in the financial condition of the business
2. Facilitates inter-firm comparison: It provides data for inter-firm comparison.
Ratios highlight the factors associated with with successful and unsuccessful firm. They also
reveal strong firms and weak firms, overvalued and undervalued firms.
3. Helps in planning: It helps in planning and forecasting. Ratios can assist
management, in its basic functions of forecasting. Planning, co-ordination, control and
communications.
4. Makes inter-firm comparison possible: Ratios analysis also makes possible
comparison of the performance of different divisions of the firm. The ratios are helpful in
deciding about their efficiency or otherwise in the past and likely performance in the future.
5. Help in investment decisions: It helps in investment decisions in the case of
investors and lending decisions in the case of bankers etc.

Limitations of Ratios Analysis:

The ratios analysis is one of the most powerful tools of financial management. Though ratios
are simple to calculate and easy to understand, they suffer from serious limitations.

1. Limitations of financial statements: Ratios are based only on the information

which has been recorded in the financial statements. Financial statements themselves are
subject to several limitations. Thus ratios derived, there from, are also subject to those
limitations. For example, non-financial changes though important for the business are not
relevant by the financial statements. Financial statements are affected to a very great
extent by accounting conventions and concepts. Personal judgment plays a great part in
determining the figures for financial statements.
2. Comparative study required: Ratios are useful in judging the efficiency of the
business only when they are compared with past results of the business. However, such a
comparison only provide glimpse of the past performance and forecasts for future may not
prove correct since several other factors like market conditions, management policies, etc.
may affect the future operations.
3. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as
final regarding good or bad financial position of the business. Other things have also to be
seen.
4. Problems of price level changes: A change in price level can affect the validity of
ratios calculated for different time periods. In such a case the ratio analysis may not clearly
indicate the trend in solvency and profitability of the company. The financial statements,
therefore, be adjusted keeping in view the price level changes if a meaningful comparison is
to be made through accounting ratios.
5. Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There
are no well accepted standards or rule of thumb for all ratios which can be accepted as
norm. It renders interpretation of the ratios difficult.
6. Limited use of single ratios: A single ratio, usually, does not convey much of a
sense. To make a better interpretation, a number of ratios have to be calculated which is
likely to confuse the analyst than help him in making any good decision.
7. Personal bias: Ratios are only means of financial analysis and not an end in itself.
Ratios have to interpreted and different people may interpret the same ratio in different
way.
8. Incomparable: Not only industries differ in their nature, but also the firms of the
similar business widely differ in their size and accounting procedures etc. It makes
comparison of ratios difficult and misleading.

Classification of Accounting Ratios:

Ratios may be classified in a number of ways to suit any particular purpose. Different kinds
of ratios are selected for different types of situations. Mostly, the purpose for which the
ratios are used and the kind of data available determine the nature of analysis. The various
accounting ratios can be classified as follows:

Classification of Accounting Ratios / Financial Ratios

(A
Traditional Classificatio
Profit and loss account ratios or revenue/income statement ratios
Balance sheet ratios or position statement ratios
Composite/mixed ratios or inter statement ratios

Profitability Ratios:

Profitability ratios measure the results of business operations or overall performance and
effectiveness of the firm. Some of the most popular profitability ratios are as under:

Gross profit ratio

Net profit ratio
Operating ratio
Expense ratio
Return on shareholders investment or net worth
Return on equity capital
Return on capital employed (ROCE) Ratio
Dividend yield ratio
Dividend payout ratio
Earnings Per Share (EPS) Ratio
 Price earning ratio

Liquidity Ratios:

Liquidity ratios measure the short term solvency of financial position of a firm. These ratios
are calculated to comment upon the short term paying capacity of a concern or the firm's
ability to meet its current obligations. Following are the most important liquidity ratios.

Current ratio
Liquid / Acid test / Quick ratio

Activity Ratios:

Activity ratios are calculated to measure the efficiency with which the resources of a firm
have been employed. These ratios are also called turnover ratiosbecause they indicate the
speed with which assets are being turned over into sales. Following are the most important
activity ratios:

Inventory / Stock turnover ratio

Debtors / Receivables turnover ratio
Average collection period
Creditors / Payable turnover ratio
Working capital turnover ratio
Fixed assets turnover ratio
Over and under trading

Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and
payment schedules of its long term obligations. Following are some of the most important
long term solvency or leverage ratios.

Debt-to-equity ratio
Proprietary or Equity ratio
Ratio of fixed assets to shareholders funds
Ratio of current assets to shareholders funds
Interest coverage ratio
Capital gearing ratio
Over and under capitalization
Financial-Accounting- Ratios Formulas:
A collection of financial ratios formulas which can help you calculate financial ratios in a
given problem.