Chapter 12 horizontal analysis

I'll provide a comprehensive explanation of horizontal analysis, vertical analysis, and the key financial ratios you've mentioned. I'll break this down step by step to help you understand these financial analysis techniques.

Financial Analysis Techniques:

1. Horizontal Analysis (Trend Analysis) Horizontal analysis involves comparing financial statement items over time to identify trends and changes in a company's performance. This method looks at how specific line items change from one period to another, typically expressed as:

• Absolute dollar changes

• Percentage changes

Example: If Revenue was $100,000 in Year 1 and $150,000 in Year 2, the horizontal analysis would show:

• Absolute change: +$50,000

• Percentage change: +50%

2. Vertical Analysis (Common Size Statements) Vertical analysis expresses each line item on financial statements as a percentage of a base figure:

• On Income Statement: Each item is shown as a percentage of total revenue

• On Balance Sheet: Each item is shown as a percentage of total assets or total liabilities and equity

Detailed Ratio Analysis:

1. Current Ratio Formula: Current Assets ÷ Current Liabilities

• Measures a company's ability to pay short-term obligations

• Ideal range: 1.5 to 3.0

• Higher ratio = Better short-term financial health

• Below 1 = Potential liquidity problems

2. Inventory Turnover Formula: Cost of Goods Sold ÷ Average Inventory

• Measures how quickly a company sells and replaces inventory

• Higher ratio = More efficient inventory management

• Low ratio might indicate:

  • Overstocking

  • Obsolete inventory

  • Weak sales

3. Days Inventory Outstanding (DIO) Formula: (Average Inventory ÷ Cost of Goods Sold) × 365

• Measures average days to sell inventory

• Lower number = More efficient inventory management

• Helps understand inventory liquidity and management efficiency

4. Accounts Receivable Turnover Formula: Net Credit Sales ÷ Average Accounts Receivable

• Measures how effectively a company collects receivables

• Higher ratio = More efficient collection process

• Low ratio might indicate:

  • Difficulty collecting payments

  • Lenient credit policies

5. Debt Ratio Formula: Total Liabilities ÷ Total Assets

• Measures the proportion of a company's assets financed by debt

• Higher ratio = More financial risk

• Typical ranges:

  • 0-0.4: Conservative

  • 0.4-0.6: Moderate

  • 0.6+: High risk

6. Times-Interest-Earned Ratio Formula: Earnings Before Interest and Taxes (EBIT) ÷ Interest Expense

• Measures a company's ability to meet interest payments

• Higher ratio = Better ability to cover interest expenses

• Below 1.5 = Potential difficulty meeting interest obligations

7. Return on Assets (ROA) Formula: Net Income ÷ Total Assets

• Measures how efficiently a company uses its assets to generate profits

• Higher percentage = More efficient asset utilization

• Compares performance across different company sizes

8. Return on Common Shareholders' Equity (ROE) Formula: Net Income ÷ Common Shareholders' Equity

• Measures profitability from shareholders' perspective

• Higher percentage = More efficient use of shareholders' investment

• Ideal range varies by industry