Part 1: Financial Statements Analysis (Intro, Horizontal Analysis and Vertical Analysis)

Summary

This lecture series introduces the final stage of the accounting process: interpreting financial statements. It focuses on analyzing a firm's past performance, current condition, and future prospects. Key tools include horizontal analysis, comparing financial data over time, vertical analysis, expressing financial statement items as percentages of a base amount, and financial ratios. The lecture demonstrates these techniques using hypothetical financial data from Elisabeth Tayloring Materials Store, highlighting their importance in assessing profitability, liquidity, solvency, and management effectiveness.

Takeaways

• 📊 The final step in the accounting process is interpreting financial statements, which involves evaluating a firm's past performance, current condition, and future potential.
• 🔍 Financial statement analysis allows stakeholders to assess an entity's profitability, liquidity, solvency, and the effectiveness of management.
• 💡 Tools for interpreting financial statements include horizontal analysis, vertical analysis, and financial ratios or ratio analysis.
• 📈 Horizontal analysis compares financial data over time, showing trends by calculating the difference and percentage change between periods.
• 📉 Vertical analysis, also known as common size statements, expresses each item in a financial statement as a percentage of a base figure, such as total assets or net sales.
• 💼 An example of horizontal analysis is given, showing how to calculate the increase or decrease in amounts and percentages for various accounts over two consecutive years.
• 📋 The script provides a step-by-step guide on preparing financial statements for horizontal and vertical analysis, emphasizing the importance of using the earlier period as the base for comparison.
• 📊 When performing horizontal analysis, the total increase or decrease in amounts can be calculated by 'footing' or summing the amounts, but this is not applicable to percentage changes.
• 📉 Vertical analysis requires expressing every amount in the income statement as a percentage of net sales, which helps in understanding the proportionate contribution of each item to net sales.
• 💡 The script highlights the importance of checking calculations vertically in vertical analysis, noting that rounding differences may lead to slight discrepancies.
• 🔑 The insights gained from common size income statements can help identify areas for improvement, such as the proportion of sales returns and allowances or net income as a percentage of net sales.

Q & A

What is the fourth and final step in the accounting process discussed in the transcript?

The fourth and final step in the accounting process discussed is 'interpreting,' which involves evaluating or analyzing financial statements.

What does financial statements analysis allow stakeholders to determine about a firm?

Financial statements analysis allows stakeholders to determine an entity's profitability, liquidity, solvency, and the effectiveness of management, as well as the safety of investment in the firm.

What are the three main tools and methods used in interpreting financial statements mentioned in the transcript?

The three main tools and methods used in interpreting financial statements mentioned are horizontal analysis, vertical analysis, and financial ratios or ratio analysis.

How is horizontal analysis defined in the transcript?

Horizontal analysis is defined as evaluating a series of financial data over time by comparing figures in the financial statements of two or more consecutive periods.

What is the significance of the percentage change computed in horizontal analysis?

The percentage change in horizontal analysis indicates the increase or decrease in financial figures from one period to the next, using the earlier period as the base.

Why is the earlier period used as the base in horizontal analysis?

The earlier period is used as the base in horizontal analysis to provide a comparative measure of change over time.

Can you explain the process of computing the percentage increase or decrease in horizontal analysis as described in the transcript?

The process involves dividing the amount of increase or decrease by the earlier period's amount, then multiplying by 100 to express the change as a percentage.

What is the term used for adding all the numbers in a column when performing horizontal analysis?

The term used for adding all the numbers in a column when performing horizontal analysis is 'footing.'

Why can't the percent column be summed up like the amount column in horizontal analysis?

The percent column can't be summed up like the amount column because percentage changes are relative to the base period and are not additive across different line items.

What is vertical analysis, also known as, and how does it differ from horizontal analysis?

Vertical analysis is also known as common size statements. It differs from horizontal analysis in that it expresses each item in a financial statement as a percentage of a base figure, such as total assets or net sales, rather than comparing figures across periods.

What is the base amount used in the statement of financial position and income statement during vertical analysis?

In vertical analysis, the base amount used in the statement of financial position is total assets, and in the income statement, it is net sales.

How can stakeholders glean additional insights about a business from the horizontal and vertical analysis as mentioned in the transcript?

Stakeholders can glean insights about significant changes in financial figures, the proportion of sales returns and allowances, the percentage of net income relative to net sales, and identify areas for improvement or potential problems within the business.

Outlines

00:00

📊 Introduction to Financial Statements Analysis

This paragraph introduces the final phase of the accounting process, which is interpreting financial statements. The lecture series focuses on evaluating a firm's past performance, current condition, and future potential through financial statement analysis. Stakeholders can assess profitability, liquidity, solvency, and the effectiveness of management. The paragraph outlines various tools and methods used in interpreting financial statements, such as cash flow analysis and ratio analysis. It then introduces horizontal analysis, which involves comparing financial data over time, and provides an example of how to perform horizontal analysis on the financial position of a hypothetical business.

05:04

🔍 Detailed Explanation of Horizontal Analysis

The paragraph delves deeper into horizontal analysis, explaining how to calculate the increase or decrease in financial figures over time. It provides a step-by-step guide on how to compute the percentage change using the earlier period as the base. The explanation includes an example with actual figures, showing how to calculate the increase in cash from one year to the next and how to express this change as a percentage. The paragraph emphasizes the importance of using the correct earlier period amount as the divisor when calculating percentage changes.

10:07

📈 Calculating Totals and Percentages in Horizontal Analysis

This paragraph continues the discussion on horizontal analysis, explaining how to calculate the total increase or decrease in amounts for a set of financial data, such as total current assets. It clarifies that while the total amount can be summed vertically, the percentage changes cannot be simply added together. The paragraph provides a method for calculating the overall percentage increase or decrease by using the total amount and the base period amount. It also touches on the importance of understanding the implications of these changes, such as questioning whether a significant increase in cash is necessary or if it could be better utilized.

15:35

📉 Vertical Analysis and Its Application

The paragraph introduces vertical analysis, also known as common size statements, which involves expressing each item in a financial statement as a percentage of a base figure. It explains how to perform vertical analysis on an income statement, using net sales as the base. The process involves dividing each income statement item by net sales and converting the result to a percentage. The paragraph provides an example of how to calculate these percentages and emphasizes the importance of vertical checks to ensure the accuracy of the calculations. It also highlights that the increase in total liabilities and owner's equity should match the increase in total assets, adhering to the basic accounting equation.

20:38

📋 Interpreting Vertical Analysis Results

This paragraph discusses the insights that can be gained from a common size income statement. It explains how to interpret the percentages derived from vertical analysis, such as the percentage of net sales that is comprised of sales returns and allowances, and the percentage of net sales that is net income. The paragraph suggests that these percentages can be used to evaluate the company's financial health and identify areas for improvement. It also notes that while the example provided is for a single period, vertical analysis can be performed for multiple periods to track changes over time.

25:42

📘 Extending Vertical Analysis to Multiple Periods

The final paragraph briefly mentions the process of extending vertical analysis to more than one period. It suggests that to do this, additional columns for amount and percentage would be needed for each period. This would allow for a comparison of financial performance across different time periods.

Keywords

💡Accounting Process

The accounting process refers to a systematic method of recording, classifying, summarizing, and interpreting financial transactions. In the video, this process is broken down into four stages, with the focus being on the final stage, 'interpreting,' which involves analyzing financial statements to understand a company's performance and financial health.

💡Financial Statements Analysis

Financial Statements Analysis is the evaluation or analysis of financial statements to assess a firm's past performance, present condition, and future potentials. The video emphasizes this concept as the core of the lecture series, highlighting how stakeholders use this analysis to determine profitability, liquidity, solvency, and the effectiveness of management.

💡Horizontal Analysis

Horizontal Analysis is a method of financial statement analysis that evaluates a series of financial data over time. It involves comparing figures from the financial statements of two or more consecutive periods. The video provides an example of horizontal analysis by comparing the financial position of a store in 2021 and 2022, calculating the increase or decrease in amounts and their percentage changes.

💡Vertical Analysis

Vertical Analysis, also known as common size statements, is a technique used to analyze financial statements where each item is expressed as a percentage of a base figure. In the video, vertical analysis is demonstrated by expressing every amount in the income statement as a percentage of net sales, which helps in understanding the proportionate relationship between different financial items.

💡Profitability

Profitability refers to the ability of a business to generate income (profit) relative to the revenue or cost. The video mentions that through financial statements analysis, stakeholders can determine an entity's profitability, which is crucial for assessing the financial success and potential of the business.

💡Liquidity

Liquidity is the ability of a company to pay its short-term obligations. The script discusses liquidity in the context of assessing a firm's ability to meet its current liabilities, which is an important aspect of financial health and stability.

💡Solvency

Solvency refers to the ability of a company to meet its long-term obligations. The video script uses solvency as a measure to evaluate the financial strength of a firm and its capacity to survive over the long term.

💡Management Effectiveness

Management Effectiveness pertains to how well the management of a company is performing its role in running the business. The video script suggests that through financial statement analysis, one can assess the effectiveness of management, which is critical for investors and stakeholders to gauge the company's operational efficiency.

💡Investment Safety

Investment Safety is the concept of evaluating the risk associated with investing in a firm. The video script implies that financial statement analysis can help assess the safety of investment, which is a key consideration for investors to minimize their risk.

💡Footing

Footing is the process of summing amounts in a column to get a total. The video script mentions footing in the context of horizontal analysis, where the total increase or decrease in current assets is calculated by adding the individual changes in each account.

💡Ratio Analysis

Ratio Analysis is a form of financial analysis that involves comparing two or more figures which are related to each other to evaluate a company's financial health. The video script refers to ratio analysis as one of the tools used in interpreting financial statements, although it is not the main focus of the lecture series.

Highlights

Introduction to the final stage of the accounting process - interpreting financial statements.

Emphasis on the importance of financial statements analysis for assessing a firm's past performance, present condition, and future potential.

Explanation of how stakeholders use financial analysis to evaluate profitability, liquidity, solvency, and the effectiveness of management.

Introduction to various tools and methods used in interpreting financial statements, such as cash flow analysis and statement of changes in equity.

Focus on horizontal analysis, vertical analysis, and financial ratios as primary tools for interpreting financial statements.

Definition and process of horizontal analysis, which involves comparing financial data over time.

Illustration of how to perform horizontal analysis with a practical example involving Elisabeth's Tayloring Materials Store.

Explanation of how to calculate the increase or decrease in amounts and percentages for horizontal analysis.

Importance of using the earlier period as the base for calculating percentage changes in horizontal analysis.

Procedure for preparing financial statements for horizontal analysis, including the creation of balance sheets for two consecutive years.

The concept of footing or summing amounts vertically in horizontal analysis, with an example of total current assets.

Clarification that percentage increases cannot be summed vertically, unlike amounts, in horizontal analysis.

Introduction to vertical analysis, also known as common size statements, which expresses financial figures as percentages of a base amount.

Demonstration of how to perform vertical analysis on an income statement, using net sales as the base.

Explanation of how to calculate percentages for each item in the income statement and the importance of rounding off.

Discussion on the potential discrepancies due to rounding off when checking percentages vertically in vertical analysis.

Insights that can be gained from a common size income statement, such as the percentage of net sales attributed to sales returns and allowances.

Final thoughts on the importance of vertical analysis for evaluating the company's financial health and identifying areas for improvement.

Transcripts

up until this point

you have learned and performed

the first three paces of the accounting

process

namely recording

classifying and summarizing

in this lecture series

you will learn about the last space

interpreting

which is the evaluation or analysis of

the financial statements

hence the title of this series financial

statements analysis

which consists of the assessment of a

firm's past performance present

condition and future potentials

through financial statements analysis

stakeholders or the users of accounting

information are able to determine an

entity's profitability

liquidity or its ability to pay

short-term obligations and solvency or

its ability to meet long-term

obligations

in addition

one is able to assess management's

effectiveness in running the business

as well as the safety of investment in

the firm

there are various tools and methods used

in interpreting financial statements

such as analysis of the cash flow

statement

of the statement of changes in equity

and of the variation in gross profit and

net income

however

the just mentioned

techniques deserve their own separate

lectures

in this video series we will focus on

horizontal analysis

vertical analysis and financial ratios

or ratio analysis

horizontal analysis evaluates a series

of financial data over time

in other words it involves comparing

figures in the financial statements of

two or more consecutive periods

the difference between the amounts of

the two periods and the percentage

change from one period to the next using

the earlier period as the base are

computed

horizontal analysis is often described

as trend ratios and percentages

let's have this problem

given the following accounts perform

horizontal analysis on the statements of

financial position of elisabeth

tayloring materials store

obviously this is not a formal statement

of financial position but only statement

of financial position accounts

therefore from this information we must

first prepare the entities statements of

financial position or balance sheets

as of the years ended

december 31 2021 and 2022

as follows

with the assets section on the one hand

and the liabilities and owner's equity

section on the other hand

the liabilities are divided into current

and

non-current

just like the assets

of course by this time

you already know how to prepare this

right

to be able to do a horizontal analysis

we need two additional columns

for the increase or decrease

in amount

and

percent

for cash

from the earlier years 850 000 pesos

to the following year's 1 million two

hundred eighty one thousand six hundred

pesos

there is obviously an increase

of how much

the difference between these two figures

and that is

431

600 pesos

since this is an increase

no open and close parenthesis

if there is an increase in terms of

amount

then in terms of percent there is also

an increase of course

but how many percent is the increase

the amount of increase which is 431

600

divided by the earlier periods

amount which is

850 000 pesos then multiplied by 100

equals

50.78

rounded off

okay

why do we multiply by 100 because we are

computing for the increase or decrease

in terms of percent if we don't multiply

by 100 the figure would still be in

terms of decimal

that is why to compute for this percent

it's 431

600 divided by 850 000 then multiplied

by 100

or if you prefer

simply

431 600 divided by 850 000

then move the decimal point two places

to the right

now please be very careful in the amount

you use as divisor

in this instance

850 thousand not this one million two

hundred eighty one thousand six hundred

because we have to use the earlier

period in this case

2021 which is earlier than 2022 as the

base

recall this slide which we encountered

a while ago

the difference between the amounts of

the two periods and the percentage

change from one period to the next

using the earlier period as base are

computed

that's why again

to get the increase or decrease in

percent

the amount of increase

divided by the earlier periods amount

then multiplied by 100

next trading securities

from 2021's

thousand pesos

to twenty twenty two's higher amount of

eight hundred eighty thousand

there is an increase or decrease

increase of

460 000

for the increase in percent

460 000 divided by what

by 880 000 or by four hundred twenty

thousand

four hundred twenty thousand the amount

of the year twenty twenty one

which is the earlier period then

multiplied by one hundred equals

109.52

next is accounts receivable net

net

meaning the allowance for doubtful

amounts has already been deducted

from these figures

from the earlier years 750 000

to 670 000 the following year

there is a decrease this time

the amount

became smaller

by

80 000

with parenthesis

to emphasize decrease

please don't forget that that is very

important

decrease of 80 000

or negative 80 000 divided by the

earlier year's amount of 750 000

multiplied by 100

equals

negative 10.67

rounded off

again if the amount decreased

then the percent also decreased

so don't forget

the parenthesis

for merchandise inventory

same procedures

the difference between the two amounts

is the increase or decrease in pesos

the amount of increase or decrease

divided by the earlier year's amount

multiplied by 100

equals the increase or decrease in terms

of percent

for prepaid expenses

increase of 90 000 pesos and

32.14

now please listen carefully here

how about for the total current assets

we may do the same procedures as we have

been doing

comparing figures

horizontally anyway that is why this is

known as horizontal analysis

we compare these two figures

along a row which is horizontal

but please know that for the amount

not percent but amount

of the increase or decrease

of these total current assets

we may also do it vertically

meaning

we may add these amounts

in this column

what do you call that term again which

means getting the sum of the amounts or

adding all the numbers in a column

i mentioned that in my lecture about

chart of accounts posting to general

ledger and trial balance

what do we call that term

footing

so we may compute this six hundred fifty

one thousand six hundred this way

four hundred thirty one thousand six

hundred plus four hundred sixty thousand

minus eighty thousand

minus two hundred fifty thousand plus

ninety thousand

how about for the increase or decrease

in percent

can we also food or add these figures

no

we can only put the amount column

not the percent column

that is the reason why if you notice

these horizontal lines

extend only up to this

third money column

it does not cover this last column

this column for the percent

okay

this horizontal line does not extend

here

therefore

we cannot

put

these figures

to get the percent increase or decrease

in

total current assets

meaning the only way to get the increase

or decrease in percent

is to divide 651 600 by

three million five hundred thousand then

multiply by 100

and that gives us

18.62 percent

for the non-current assets

we may perform the same procedures we

have done before

in order to get these figures

for the total

non-current assets

same procedures

but again

we can also get this 630 000

by

footing

or adding these figures

total assets now compare these two

figures

there is

an increase

of one million two hundred eighty one

thousand six hundred

we can check vertically

total current assets

of 651 600

plus

total non-current assets

of six hundred thirty thousand

equals this same amount of one million

two hundred eighty one thousand six

hundred

one million two hundred eighty one

thousand six hundred

divided by eighteen million three

hundred thousand

multiplied by one hundred equals

seven percent increase in total assets

for the liabilities and owner's equity

section

you should already know how to get the

following increases or decreases

in amount and percent

please take note

that the increase in total liabilities

and owner's equity

both in terms of amount and percent

is the same as the increase in

total assets

because remember the basic accounting

equation

assets equals liabilities plus equity

with horizontal analysis additional

information about the business may be

obtained

which may point out certain problems or

areas for improvement

for instance

the cash

increased by

50.7

that percentage is significant

does the company really need to have

additional cash for its operations

or is it better to put some cash to work

in order to earn more profit

if horizontal analysis

compares figures in the financial

statements of two or more consecutive

periods

critical analysis involves comparing

figures in the financial statements of a

single period

evaluates financial items in relation to

a base amount

in the statement of financial position

the base amount is that of the total

assets while in the income statement the

basis is the net sales

meaning to say

each figure

in the statement of financial position

is expressed as a percentage of total

assets while in the income statement

every amount is expressed as a

percentage of

net sales

vertical analysis is also known as

common size statements

given the following accounts perform

vertical analysis on the income

statement of elisabeth tayloring

materials store

like the previous problem we are not

given a financial statement here

but only financial statement accounts

specifically

statement accounts

therefore to do the requirement of the

problem we need to prepare the income

statement of the business first

this way

for the purpose of performing vertical

analysis

we have to provide another column for

the percentages

and because this is an income statement

every amount should be expressed

as a percentage of

net sales

in other words

the net sales is

100

and every other amount you see here

should be divided by this

net sales amount of 12 million

120 000

and then to convert the quotient to

decimal multiply by 100 or simply move

the decimal point two places to the

right

so

twelve million three hundred thousand

divided by twelve million one hundred

twenty thousand

multiplied by one hundred equals

101.49 percent

180 000 divided by 12 million 120 000

multiplied by one hundred equals

one point forty nine percent

one million two hundred thousand divided

by twelve million one hundred twenty

thousand multiplied by one hundred

equals

nine point ninety percent

three million eight hundred thousand

divided by twelve million one hundred

twenty 000 multiplied by 100 equals

31.35

5 million divided by 12 million 120 000

multiplied by 100

equals

41.25 percent

950 000 divided by 12 million 120 000

multiplied by 100 equals

seven point eighty four percent

four million fifty thousand

divided by twelve million one hundred

twenty thousand multiplied by one

hundred

equals

33.82

percent

and so on and so forth

up to this

bottom line

of the income statement

now if you noticed

this verse

or horizontal lines

to emphasize

mathematical operations

extend up to this last column or percent

column

that means

we may check our percentages vertically

for instance

101.49 percent

less

1.49

equals 100 percent

9.90

add

31.35

equals

41.20

percent

and so on and so forth

keep in mind however

that because these percentages are not

exact

but are rounded off

there could be differences of 0.01

when you check vertically

a case in point is this

41.25 percent

less

7.84

is actually equal to

33.41

but what we have here is

33.42 percent so there is a difference

of 0.01

but then that is okay that is not a

problem because

that is just due to

rounding off

for instance

12 million three hundred thousand

divided by twelve million one hundred

twenty 000 multiplied by 100 is not

exactly 101.49

it's 101.4

something and something and something

okay we just rounded off

two places after the decimal point

same with the other

percentages here

except for this 100 percent

okay that's why you can expect

differences when you check

the percentages vertically

at least for some

now what can we glean from this common

size income statement

for one

1.49

of the amount of net sales

is sales returns and allowances

another is

net income

is

13.37 percent of

net sales

is a specific percentage good enough for

the company or not

acceptable or not if not then it must

determine

the process of problems

and do something to improve in the

future

now notice also that this income

statement

is only for

one period

for the year 2022

if you are asked to prepare a vertical

analysis or common size statement for

more than one year or more than one

period

you just need to add two volumes for

each period

column for amount and another column for

percent