Comparative analysis of financial statements, including balance sheets, allows management and investors to assess a company's performance over time and against its industry peers. Comparing the performance of the individual components of balance sheets -- assets, liabilities and shareholders' equity -- management can identify operational areas that require improvements and investors can make informed buy-sell decisions.
Horizontal analysis is the side-by-side comparison of financial statement data. For comparing balance sheets of the same company or of different companies in the same industry, this means tabulating the asset, liability and shareholders' equity information of multiple periods in adjacent columns. Public companies typically provide tables showing their financial performance over several quarters, in the case of quarterly filings, and over at least two years, in the case of annual filings. Data from successive periods can allow stakeholders, such as management and investors, to assess short- and medium-term performance, while the financial results from periods spanning several years provide insight into medium- and long-term performance. For example, if a company's total debt is shrinking over time, it means that the company is reducing its interest expenses and potentially driving margins higher. On the other hand, if a company's cash balance is shrinking or short-term borrowings are increasing, it could indicate slowing sales and higher operating expenses, which usually reduce profit margins.
Vertical analysis, sometimes known as common-size analysis, involves converting each component of a financial statement to a percentage of a base amount. The base amount is usually total assets for balance sheets. For example, if a company has total assets of $1 million, cash of $100,000 and short-term debt of $50,000, a vertical statement would show cash as $100,000 divided by $1 million, or 10 percent, and short-term debt as 5 percent. An increasing short-term debt percentage relative to total assets could be an early warning sign of impending cash flow problems. On the other hand, an increasing cash percentage could indicate improving financial strength. Investors can compare companies of different sizes in the same industry because the analysis involves comparing percentages instead of dollar amounts. For example, a company with a steady or shrinking debt percentage may be a more attractive investment opportunity than a company with higher sales volume but an increasing debt percentage.
Companies often show the percentage changes for financial statement items when they present comparative information. A percentage change is the difference in the dollar amount between two periods divided by the dollar amount of the base period and expressed as a percentage. Stakeholders can tabulate these percentage changes over successive periods to detect and analyze trends. For example, if the cash balance increases from $1 million in the first quarter to $1.2 million in the second quarter, the percentage change is ($1.2 million minus $1 million) divided by $1 million, or 20 percent. If a company is steadily increasing its cash balance over successive periods, it usually means that management is generating surplus cash by driving sales while managing costs. However, companies with large and growing cash balances may face pressure from investors to deploy the surplus cash into high-return projects or to return the cash to shareholders in the form of dividends or stock buybacks. On the other hand, rising inventory or accounts receivable could indicate that the company is facing increased competition in its markets, difficult industry conditions or poor management execution.
Key balance sheet ratios include the liquidity and leverage ratios. A common liquidity ratio is the current ratio, which is the ratio of current assets to current liabilities. A declining current ratio over time could indicate cash flow issues and difficulty meeting short-term obligations, such as payroll. Management remedies may include cutting operating costs and selling off assets to raise cash. Common leverage ratios include debt-to-asset, which is the ratio of total debt to total assets, and debt-to-equity, which is the ratio of total debt to total equity. These ratios indicate how effectively a company is using debt to finance its capital investments and the role debt plays in its capital structure. Companies with high or growing leverage ratios could be carrying too much debt on their balance sheets, which generally limits operational flexibility.
- financial report image by PaulPaladin from Fotolia.com