Annual reports and financial statements

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MODULE 7 UNIT 3 Video Transcript

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Module 7 Unit 3 Video Transcript KHAMID IRGASHEV: Hello, everyone. Imagine that you would like to make an investment by buying shares in a business. You want to compare the financial statements of different businesses to identify the best one to invest in, but you have trouble comparing the statements to each other. Company A, for example, has 800,000 pounds in outstanding debt, while Company B has 500,000 pounds in outstanding debt.

It would be easy to assume that Company B is better investment, as the risk of bad debts is lower; however, Company B might be a smaller business, which would mean that the 500,000 pounds represents much bigger proportion of its operations than the outstanding debt of a Company A does.

To overcome this problem, you can make use of either horizontal or vertical analysis, which allows you to compare apples with apples, so to speak.

Horizontal analysis is used to identify trends and changes from one year to another. Look at the extracts from income statements of two businesses. Are you able to tell, just by looking at the amounts, which one of the two businesses is experiencing faster growth?

Using horizontal analysis will make it much clear which one of the businesses is experiencing faster growth. You simply calculate the percentage with which each amount increased compared to the same amount in the previous year. Let’s look at the example how this is done.

To calculate the increase in revenue for Company A from Year 1 to Year 2, you will calculate the difference between Year 1 and Year 2 amounts, and divide it by the Year 1 amount.

So, you would calculate the difference between 85,455 and 78,254, which gives you an amount of 7,201. You then divide this amount by 78,254, which gives you 0.092. Multiply this by hundred to get a percentage of 9.2%.

Using the same method for all the other amounts included in the table, your results will look like this.

It is now much easier to see that the Company B experienced better growth than Company A in Years 2 and 3, but that the Company A saw better growth than Company B in Year 4. You can now use this information to decide which company you would rather invest in.

Another method you can use to evaluate the results of two companies is vertical analysis. When using this method, you express each item in the income statement as a percentage of a revenue, and each item in the statement of financial position as a percentage of total assets.

Let’s look at an example of how this vertical analysis is performed on an income statement. We will once again use the information for Company A and Company B.

Revenue is regarded as the baseline, so that will be indicated as 100% across the board. You will calculate the percentage of gross profit for Year 1 of Company A by dividing gross

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profit of 34,331 by the revenue amount of 78,254 pounds. This will give you 0.4387. Multiply this by hundred and you will get a percentage of 43.9%. Following the same process for all other amounts, results will look as follows.

What does this information tell us? Looking at the results for Year 4, you can see that the Company B makes higher gross profit than Company A; however, Company A’s net profit is higher than that of Company B, which suggests that Company B’s expenses are higher.

In this video, you saw that vertical and horizontal analysis are useful tools to compare the financial statements of different businesses. Looking at absolute values included in financial statements often doesn’t tell you much, but once you start expressing trends and relationships as percentages, the real story behind the business results emerge.

Vertical and horizontal analysis are tools that can be used with great effect during the benchmarking exercises. Benchmarking is the practice of comparing business performance with other businesses in the same industry.

What do you think management can do with the information obtained during benchmarking?

If you would like to revisit any of the concepts covered in this video, please select the appropriate chapter.

MODULE 7 UNIT 3

Video Transcript

Module 7 Unit 3 Video Transcript