Week 10: Chapter 8 -Financial Statement Analysis (pp.

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LO1: Identify why different user groups require financial statements to be analysed and interpreted.
Users and decision making The users of financial statements can be categorised as resource providers (for example, creditors, lenders, shareholders, employees); recipients of goods and services (for example, customers, debtors): and parties performing an overview or regulatory function (for example, the tax office, corporate regulators). User groups are interested in different aspects of the entity, and various information sources are available to interested parties to facilitate their decision making. Such information sources include the financial press, trade-related magazines, and research reports from broking houses, industry publication, online databases, and government statistics. Another important source of information is financial statements. With a knowledge and understanding of information contained in financial statements, financial analysis can provide information specific to users needs. Financial analysis is an analytical method in which reported financial numbers are used to form opinions as to the entitys past and future performance and position. The decisions that users make vary. Statement users generally share one common objective: to evaluate past decisions and make informed decisions about future events. In this sense, reported financial numbers have a role to play. The financial statements depict historical information. When making predictions about future events, an evaluation of past events is often the most useful starting point. Profitability is defined as an entitys performance (profit) during the reporting period or over a number of reporting periods measured in relative terms. Financial analysis involves expressing the reported numbers in relative terms rather than relying on the absolute numbers, and can highlight the strengths and weaknesses of entities. It is an important decision-making tool for evaluating the historical health of an entity and predicting an entitys future financial wellbeing.

LO2: Understand the nature and purpose of financial analysis.

Nature and purpose of financial analysis 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 entitys past decisions and predicting future rewards and risks. There is an emphasis on the need to express the reported number in relation to other numbers, enabling the relationships to be revealed and the financial statements to tell a story about the entitys financial 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.

LO3: Appreciate the analytical methods of horizontal, trend, vertical and ratio analysis.
Analytical methods 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 in a two-column format containing the figures for the current reporting period and the figures for the previous reporting period. This permits the user to readily calculate the absolute dollar change and the percentage change in the reported numbers between periods. The dollar change is calculated as shown in the equation below: Accounting number in current reporting period Less accounting number in previous reporting period The percentage change is calculated as shown in the following equation: Accounting number in current reporting period Less accounting number in previous reporting period Accounting number in previous reporting period The percentage change cannot be calculated if the equivalent reported figure for the previous year was zero. Care must also be exercised when ascertaining and interpreting the direction of the change. Trend analysis Trend analysis tries to predict the future direction of various items on the basis of the direction of the items in the past. To calculate a trend, it is necessary to have at least three years of data. A public company often provides a historical summary of various financial items in its annual report. x 100