3.6 Analysis of Statement of Income and Statement of Changes in Equity

Financial statement analysis is an evaluative process of determining the past, current, and projected performance of a company. Financial statements report financial data; however, this information must be evaluated to be more useful to investors, shareholders, managers, and other stakeholders. Several techniques are commonly used for financial statement analysis. They were originally presented in the introductory accounting course. A summary review of these techniques follows.

Horizontal analysis compares two or more years of financial data in both dollar amounts and percentage form. An income statement and SFP/BS with comparative data from prior years are examples of where horizontal analysis is incorporated into the financial statements to enhance evaluation. Trends can emerge that are considered as either favourable or unfavourable in terms of company performance.

Vertical or common-size analysis occurs when each category of accounts on the in- come statement or SFP/BS is shown as a percentage of a total. For example, vertical analysis is used to evaluate the statement of income such as the percentage that gross profit is to sales or the percentages that operating expenses are to sales. Similarly, vertical analysis of the SFP/BS may be used to evaluate what percentage equity is to total assets. This ratio tells investors what proportion of the net assets is being retained by the company’s investors compared to the company’s creditors.

Ratio analysis calculates statistical relationships between data. Ratio analysis is used to evaluate various aspects of a company’s financial performance such as its efficiency, liquidity, profitability, and solvency. Gross profit ratio (gross profit divided by net sales and/or revenue) and earnings per share (EPS) are examples of key ratios used to evaluate income and changes in equity. One of the most widely used ratios by investors to assess company performance is the price-earnings (P/E) ratio (market price per share divided by EPS). The P/E ratio is the most widely quoted measure that investors use as an indicator of future growth and of risk related to a company’s earnings when establishing the market price of the shares. The trend of the various ratios over time is assessed to see if performance is improving or deteriorating. Ratios are also assessed across different companies in the same industry sector to see how they compare. Ratios are a key component to financial statement analysis.

Segmented Reporting

The statement of income can be segmented, or disaggregated, to enhance performance analysis. The statement can be segmented in various ways such as by geography or by type of product or service. As a point of interest, other segmented financial statements include the SFP/BS and the statement of cash flow covered in the next chapter.

For ASPE, there is currently no guidance regarding segmented reporting. For IFRS companies, a segment must meet several characteristics and quantitative thresholds to be a reportable segment for purposes of the published financial statements. Segmented reporting can set apart business components that have a strong financial performance from those that are weak or are negative “losing” performers. Management can use this information to make decisions about which components to keep and which components to discontinue as part of their overall business strategy. Keep in mind that not all business components that experience chronic losses should be automatically discontinued. There are strategic reasons for keeping a “losing” component. For example, retaining a borderline, or losing, segment that produces parts may guarantee access to these critical parts when needed for production of a much larger product to continue uninterrupted. If the parts manufacturing component is discontinued and disposed, this guaranteed access will no longer exist and production in the larger sense can quickly grind to a halt, affecting company sales and profits. Segmented reporting can also assist in forecasting future sales, profits, and cash flows, since different components within a company can have different gross margins, profitability, and risk.

There can be issues with segmented reporting. For example, accounting processes such as allocation of common costs and elimination of inter-segment sales can be challenging. A thorough knowledge of the business and the industry in which the company operates is essential when utilizing segmented reports; otherwise, investors may find segmentation meaningless or, at worst, draw incorrect conclusions about the performance of the business components. There can be reluctance to publish segmented information because of the risk that competitors, suppliers, government agencies, and unions can use this information to their advantage and to the detriment of the company.