Users of financial statements can apply several analytical tools in order to mak

Question

Users of financial statements can apply several analytical tools in order to make intracompany and intercompany comparisons related to balance sheet information. Common-size analysis, rate of change analysis, and various ratios can be used to evaluate information on the balance sheet. Choose at least one analytical tool and discuss it in detail. Explain what the tool measures. Describe the steps involved in using the tool. Discuss the usefulness of the information that the tool provides the user. What are the pros and cons associated with the measure? Are there better ways to measure the performance under review?

Explanation / Answer

There are many analytical tools like Common Size Analysis, Horizontal or Trend Analysis, Ratio analysis for profitability , liquidity, Turnover ratios etc to make intercompany and intracompany analysis.

Let us discuss the Horizontal Analysis. This analysis is a great tool for intracompany analysis. Here the chnages in a particular parameter is tracked over a few years to understand the trend of change. As an example, The table produced below shows the changes in sales and net profit over last 5 years.

We can track how the company's sales has grown over the periods and can analyse the factors of change in growth rate by deep diving into the factors of change.

The pros associated with the measure are:

1. We can get the trend of every parameters and get valuable inputs regarding the trend of that parameter.

2. Valuable insights can be obtained from the analysis of the trends.

3. We can benchmark the performance of the company on various different parameters vis-a-vis the industry or competitor's performnance.

The cons of the horizontal measure are ;

1. The comparison of firms having different sizes cannot be done in this method. It is purely for the trend analysis of a particular company and only trends of similar companies can be compared.

2. There may be different reasons for changes of one parameter and that may be correalted to many varied external and internal factors. It may be difficult to analyze the trend results in a generalistic way.

3. The trend analysis does not throw light into the changes of different parameters and their link together as it is given by vertical analysis.

The horizontal analysis is an important tool and is widely used. A combination of Horizontal and Vertical analysis may be used to bring out more significant information in a meaningful way.

Horizontal Analysis Year 1 Year 2 Year 3 Year 4 Year 5 Sales                300,000            350,000       380,000             420,000          445,000 % Increase 16.67% 8.57% 10.53% 5.95% Net Profit                 12,000               15,000         16,500               18,000            21,000 % Increase 25.0% 10.0% 9.1% 16.7%

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