The past does not always predict the future. Horizontal analysis can also be used to misrepresent results. This type of analysis enables the financial manager to view the in a percentage format, making it easier to interpret. Ratio analysis uses relative percentages rather than dollar amounts, allowing for ease of comparison across periods. A user of financial statements can gain an incorrect view of the financial results or of a business by only looking at one. In relation to other companies, the given business may not be performing as well as it could be.
Percentage change financial statement analysis gets a little more complicated. Thus the financial position disclosed by these statements is not correct and accurate. Common-size financial statement analysis involves analyzing the balance sheet and using percentages. It is the difference between total assets owned by a firm and total liabilities outstanding. Advantages and Disadvantages of Vertical Analysis Vertical analysis only requires financial statements for a single reporting period. As financial statements are prepared in order to meet requirements, the second step in the process is to analyze them effectively so that future profitability and cash flows can be forecasted.
. These users are elaborated on below: 1. Not a Substitute of Judgement An analysis of financial statement cannot take place of sound judgement. When making lending and underwriting decision, a financial institution must have an understanding of the company's financial statements. The financial ratios of two different companies may be compared to see how they match up against each other, but each company may aggregate all their information different from each other in order to draw up their accounting statements.
A balance sheet is a statement of a firm's financial condition at a point in time. To make ratio analysis mean something, different industry averages need to be used for each different division. So; an analyst should keep in view these points while making analysis and interpretation otherwise the results would be misleading. For example, a business could report excellent results in one month, and no sales at all in the next month, because a contract on which it was relying has ended. Economic and social factors are left out. If companies are compared that use , the comparisons won't be accurate. Management The managers of the company use their financial statement analysis to make intelligent decisions about their performance.
However, as long as you are aware of these problems and use alternative and supplemental methods to collect and interpret information, ratio analysis is still useful. Hence, the figures of different financial statements lose the characteristic of comparability. If you calculate for a business firm, you'll want to calculate at least two years of ratios to compare side-by-side to provide any meaningful information. Many accounting concepts and conventions are used for preparing financial statement and these concepts and conventions are accepted for analysis. It is important to consider all ratios in relation to one another. Creditors Creditors are interested in knowing if a company will be able to honor its payments as they become due.
A diversified company may be difficult to fit into a particular classification of companies. Mislead the user The accuracy of financial information largely depends on how accurately financial statements are prepared. It is important as it provides meaningful information to the shareholders in taking such decisions. We know that all business transactions are first recorded in the books of original entries and thereafter posted to relevant ledger accounts. Only quantitative factorsare taken into account.
Working capital uses both the current asset and the current liabilities in its calculation and tells the user how well the company is positioned to meet its current financial obligations. The followinglimitations may be noted: 1. For example, a of 2:1 might appear to be excellent, until you realize that the company just sold a large amount of its to bolster its cash position. This disparity can result in unusual ratio results. Using consistent comparison periods can address this problem. Problem in Comparability The size of business concern is varying according to the volume of transactions. The limitations of are those factors that a user should be aware of before relying on them to an excessive extent.
If there are frequent changes, the figures of different periods will be different and incomparable. Positional statement is another term used for Balance Sheet. Limitations of the Tools Application for Analysis There are different tools applied by an analyst for an analysis. Another important purpose of the analysis of financial statements is to identify potential problem areas and troubleshoot those. Trend analysis helps a firm's financial manager determine how the firm is likely to perform over time, based on trends shown by past history. Debt may be financed through various subsidiaries or off-balance sheet accounts.