Financial Statement Analysis
Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of changes to equity, balance sheet, and statement of cash flows, among other financial information, can be analyzed. The information obtained from this analysis can benefit decision-making for internal and external stakeholders and can give a business valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues and future capital investment opportunities.
When considering the outcomes from analysis, it is important for a business to understand that the data produced needs to be compared to others within the industry and close competitors. The business should also consider its past experience and how it corresponds to current and future performance expectations. Three common analysis tools are used for decision-making; horizontal analysis, vertical analysis, and financial ratios.
Horizontal Analysis
Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A business will look at one period (usually a year) and compare it to another period. For example, a business may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a business valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year.
HR Example
HR managers will want to know the difference in salary costs year over year (dollar value and percentage). This can provide them with information that is useful for budgeting purposes and for decision-making in labour efficiency.
Vertical Analysis
Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a business may compare cash to total assets in the current year. This allows a business to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations.
The business will need to determine which line item they are comparing all items to within that statement and then calculate the percentage makeup. These percentages are considered common size because they make businesses within the industry comparable by taking out fluctuations for size. It is typical for an income statement to use revenue (or sales) as the comparison line item. This means revenue will be set at 100% and all other line items within the income statement will represent a percentage of revenue.
HR Example
HR managers will want to know how much salary costs are as a percentage of revenue to compare year over year, as well as to compare to other companies in the same industry. This number will help in budget preparation.
Financial Ratios
Financial ratios help both internal and external users of information make informed decisions about a business. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability.
Liquidity Ratios
Liquidity ratios show the ability of the business to pay short-term obligations if they came due immediately with assets that can be quickly converted to cash. This is done by comparing current assets to current liabilities. Lenders, for example, may consider the outcomes of liquidity ratios when deciding whether to extend a loan to a company. A business would like to be liquid enough to manage any currently due obligations but not too liquid where they may not be effectively investing in growth opportunities. Three common liquidity measurements are working capital, current ratio, and quick ratio.
Solvency Ratios
Solvency implies that a business can meet its long-term obligations and will likely stay in business in the future. To stay in business the company must generate more revenue than debt in the long-term. Meeting long-term obligations includes the ability to pay any interest incurred on long-term debt. Two main solvency ratios are the debt-to-equity ratio and the times interest earned ratio.
Efficiency Ratios
Efficiency shows how well a business uses and manages its assets. Areas of importance with efficiency are management of sales, accounts receivable, and inventory. A business that is efficient typically will be able to generate revenues quickly using the assets it acquires. Let’s examine four efficiency ratios: accounts receivable turnover, total asset turnover, inventory turnover, and days’ sales in inventory.
Profitability Ratios
Profitability considers how well a business produces returns given its operational performance. The business needs to leverage its operations to increase profit. To assist with profit goal attainment, business revenues need to outweigh expenses. Let’s consider three profitability measurements and ratios: profit margin, return on total assets, and return on equity.
Examples
HR manager….
HR and Financial Professionals Understanding Each Other
HR needs to understand numbers and financial data, master the data and facts to support the strategic decision making of a company. By using facts and figures they can change how decisions are made about a company’s people.
As explained by Jeff Higgins “imagine for a moment that you could clearly show that investing an additional $1 million in training would reduce voluntary turnover by 10 percent, save $1.5 million and increase productivity by 5 percent. This means the organization could increase revenue, production or customers served by 5 percent, with only minimal increases in workforce cost. For a company with $1 billion in annual revenue, this would be worth up to $50 million in ROI to the organization as increased revenue, improved profit margins and reduced costs. Those numbers are a language that even the most skeptical finance professional could understand (Higgins, 2014).
HR has access to data through its HR systems. By harnessing this data they can analyze and report not only on their own analytics such as Human Resources Information Systems (HRIS). As well, they can apply financial information,and provide insights for executives in language (financial language) they understand.
“Horizontal and Vertical Analysis” and “Financial statement Analysis and Ratio Analysis” from Accounting and Accountability by Mitchell Franklin, Patty Graybeal, Dixon Cooper, and Amanda White is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.
