322 Accounting: Business Reporting for Decision Making
VALUE TO BUSINESS• Financial statements are employed by a range of users making a variety of decisions. The purpose
of financial statements is to provide the information useful for decision making concerning the
allocation of scarce resources.
• Financial analysis is an analytical tool that involves expressing the reported financial numbers in
relative terms.
• Financial analysis helps statement users to evaluate an entity’s past decisions and form an opinion
as to the entity’s future financial health.8.2 Nature and purpose of financial analysis
LEARNING OBJECTIVE 8.2 Describe the nature and purpose of financial analysis.
We have identified that financial analysis involves expressing reported numbers in financial statements
in relative terms. Relying on the absolute values contained in the financial statements is not meaningful
when trying to evaluate an entity’s past decisions and predict future rewards and risks. For example, if
you are examining an entity’s statement of profit or loss and note that the profit figure has increased from
$200 000 in the previous year to $300 000 in the current year, does this mean that the entity has become
more profitable? Similarly, if the entity’s interest-bearing liabilities have increased from $1 million to
$2 million, does this mean that the entity has become more reliant on external funding? The answer to
both of these questions is ‘not necessarily’. The entity’s absolute dollar values of profit and external
debt have increased, but this does not necessarily mean that the entity is more profitable or more reliant
on debt. For example, if the entity’s asset base increased twofold over the comparative period — from
$2 million to $4 million — then the profit generated when expressed per dollar of investment in assets
would have fallen. Likewise, if an increase in assets of $2 million was funded by only $500 000 of
interest-bearing liabilities, the entity’s reliance on external debt relative to equity would have fallen.
Similar analogies can be drawn when comparing two entities. For example, just because Entity A
reports a profit of $50 000 and Entity B reports a profit of $10 000, this does not necessarily make
Entity A more profitable relative to Entity B. Entity A’s absolute dollar value of profit is indeed larger,
but it is not possible to make an informed judgement on the relative profitability without comparing the
profit generated to the resources available to generate it (e.g. the investment in assets).
These examples emphasise the need to express the reported numbers in relation to other numbers,
enabling relationships to be revealed and the financial statements to tell a story about the entity’s finan-
cial health. This process typically involves comparing figures to:
- the equivalent figures from previous years
- other figures in the financial statements.
The process of comparison can be categorised as horizontal analysis, trend analysis, vertical analysis
and ratio analysis. These are described in the next section.
8.3 Analytical methods
LEARNING OBJECTIVE 8.3 Apply the analytical methods of horizontal, trend, vertical and ratio analysis.
In this section we introduce the analytical techniques of horizontal, trend, vertical and ratio analysis.
This chapter focuses on ratio analysis, but horizontal, trend and vertical analysis are important com-
plementary tools to ratio analysis. All analytical methods involve comparing one item in the financial
statements with another.
Horizontal analysis
Horizontal analysis compares the reported numbers in the current period with the equivalent numbers
for a previous period, usually the immediate preceding period. Financial statements are usually presented