Financial Statement Analysis Tools
ACC 281 Week 3 Assignment
Using your text and at least one scholarly source, prepare a two to three page paper, in APA format, and evaluate the three methods of analysis: Horizontal, vertical, and ratio as explained in your course textbook.
Summarize each method, and discuss how the financial information is used to make a particular decision.
Provide a scenario in a health care situation in which a given method of analysis might be used.
Carefully review the Grading Rubric (Links to an external site.) for the criteria that will be used to evaluate your assignment.
Financial Statement Analysis Tools: Horizontal, Vertical and Ratio
Organizations pursue business activities to earn returns. However, the profit alone cannot put the organization in the comfort zone since they can as well reach this goal when they have not performed adequately. As such, it is important to employ several financial statement analysis techniques to determine the effectiveness of the organization in the course of meeting its target goals. The common tools to analyze the organization’s financial statements are horizontal, vertical, and ratio analysis.
The application of horizontal analysis in the financial statement analysis relies on the use of historical data over various past accounting periods, for example, five years. Analyzing financial statements using this approach involves the use of percentage comparisons or absolute comparisons (DELTACPE LLC, 2014). The percentage comparison consists in converting the absolute figures into percentages and then comparing them with percentages for different accounting periods. The absolute comparison entails comparing the listed figures in the financial statements without first converting them into percentages, for example, comparing the total current assets of $500,000 for the 2014 accounting period to current assets of $650,000 for the 2015 accounting period. While using horizontal analysis, the figures in the succeeding accounting period are expressed as the percentage of the base year amount. The base year is always categorized as 100 percent. Horizontal analysis can be performed on the various items of the financial statements, including balance sheet, income statement, or cash flow statement. The example below demonstrates how horizontal analysis can be executed, using total current assets as an item.
|Increase or Decrease
In the example above, the earliest year (2014) has been used as the baseline, and it shows that current assets increased by $150,000 or 30 percent in 2015 upon comparing the two accounting periods (2014 and 2015).
The vertical analysis approach evaluates the items of the financial statements by using one item as the base figure (DELTACPE LLC, 2014). For example, the balance sheet might use total assets as the baseline figure, while the income statement might use sales. The other items in the financial statement are stated as the percentage of the baseline item. For example, balance items can be sated as a percentage of total assets, whereas income statement items can be stated as the percentage of sales. The application of vertical analysis helps the management in determining the performance of particular items against the baseline item. For example, in the income statement, the line expenses and various revenue items are stated as the percentage of the sales to determine their contribution to the total sales. The results reveal the items that might need management attention and the ones that could be ignored. For example, a revenue item contributing to a high percentage in the sales is worth management attention compared to the expense line item having a small percentage. Using the income statement’s first three items: sales, cost of goods sold, and gross profit, the vertical analysis can be executed as shown:
Ratio analysis is a commonly used financial statement analysis tool. Ratio analysis presents the financial health of the firm based on the current and past financial statements (DELTACPE LLC, 2014). It also helps in comparing the performance of the company over time to predict future performance. The ratio analysis tool is further used to establish the position of the organization in a particular industry. For example, it can be used to compare company financial ratios to the industry’s average ratios to gauge the performance of the organization against other firms in the same industry. The common financial ratios are liquidity ratios, profitability ratios, solvency ratio, efficiency ratios, leverage ratios, and market value ratios. The ratio analysis tool can be used in the health care context to help the management and investors in making decisions.
The health care sector comprises of various industries, including pharmaceutical, medical equipment, and hospital (Chang et al., 2013). As such, the sector usually attracts many investors. Given the broadness of this sector, investors need a tool that they can use to compare different companies in the industry. Ratio analysis is a popular tool that is used by investors. The leading categories of financial ratios considered by investors are profitability ratios, leverage ratios, and liquidity ratios. The profitability ratios, such as operating margin, help investors in evaluating the profitability of the organization. Similarly, leverage ratio, for example, the debt-to-capitalization ratio, will be used to determine the debt status of the health care organization before making an investment decision.
Chang, K., Chichernea, D., & Hassabelnaby, H. (2013). On the DuPont analysis in the health care industry. Journal of Accounting and Public Policy, 33(1), 1-21. https://doi.org/10.1016/j.jaccpubpol.2013.10.002
DELTACPE LLC. (2014). Analysis and Use of Financial Statements. DELTACPE LLC. Retrieved from https://www.apexcpe.com/%5Cpublications%5C171016.pdf