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.