(ACT) Calculating and Interpreting Financial Ratios Lesson

Calculating and Interpreting Financial Ratios

Data contained in financial statements is analyzed and used by owners, managers, and investors to make decisions about a company. Financial analysis provides a number of tools to assist in decision making. In this lesson we will look at some of the basic ones.

Horizontal and Vertical Analysis

Just taking raw numbers from financial statements and comparing them can lead to skewed results. For instance, knowing that a company has operating expenses of $100,000 would be significant if the company had net sales of $200,000, but not so much so if the company had net sales of $1,000,000. In order to make financial statements more comparable, analysts use horizontal and vertical analysis to convert the statements to common size statements that report each item as a percent.

Horizontal Analysis

Horizontal Analysis is the comparison of dollar amount changes and percentage changes for the same items on a company's financial statements for two or more periods. For instance, suppose the net sales for a company on the comparative income statement looked like this:

The formula for the percentage of change in net sales using horizontal analysis would be:

(Later Year - Earlier Year)/Earlier Year * 100

Calculating:

(52,954-45,343)/45,343 * 100 = 16.79%

That is telling us that net sales for this company increased 16.79% from 2010 to 2011 (or between any two years). Horizontal analysis can be performed for every line item on the income statement and balance sheet.

Vertical Analysis

Vertical Analysis is the comparison of financial statements in which every dollar amount reported on a financial statement is also stated as a percentage of a base amount on the same statement. In this case, everything on an income statement is reported as a percentage of net sales, and everything on a balance sheet is reported as a percentage of total assets. Let's start with the income statement and use the information above plus the following information:

The formula for performing the vertical analysis would be:

(Line item for the year/Net sales for the year)*100

Calculating:

From this we can tell that while both net sales and operating expenses increased, operating as a percentage of net sales were 3% higher in 2011, showing that maybe costs were not watched as closely as they should have been.

With the balance sheet each line item should be calculated as a percentage of total assets. Consider the following information:

The formula for calculating each line item is

(Line item/Total Assets)*100

Calculating:

This tells us that the company was able to reduce its current liabilities (i.e. pay off some debt) in 2011.

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