Methods of Analysis - Essay Example

The purpose of this paper is to describe and analyze these three financial analysis techniques. Vertical analysis is utilized to analyze financial statements. Vertical analysis is a method that involves comparing each entry for each of the three major categories of account (assets, liabilities, and equity) in a balance sheet represented as a proportion of the total account (Answers, 2011). One of the advantages of this method is that is simple to implement and it can be applied to corporation of all sizes.

The method helps financial analyst easily visualize relative annual changes within one business (Investopedia, 2011). Horizontal or trend analysis compares two or more years of financial data. Horizontal analysis shows the changes between years in both dollar and percentage form. Showing the trend in dollar form can help an analyst focus on the key factors that have affected profitability or financial position (Garrison & Noreen, 2003). The use of percentage form can help provide perspective in regards to the significance of the changes that occurred.

For example a change of 30% in sales between one year and another is significant, while a change of 0.25% in sales is insignificant. When dealing with companies that move millions of dollars in revenues the use of percentage form can better measure the relative change that occurred. A financial technique that can be very useful to evaluate the financial performance of a company is ratio analysis. The reason ratio analysis is such an effective tool is because ratio analysis can measure different aspects of a firm’s performance.

There are different categories of ratios. The five major ratio analysis categories are liquidity, leverage, efficiency, and profitability, and market value ratios. Liquidity ratios measure the cash position of a firm. When a company is liquid the firm has enough money to pay off its short term and long term obligation. The current ratio measures the ability of a firm to pay its short term debts, while the debt ratio measures the ability of a company to pay off its long term obligations. The current ratio is calculated dividing current assets by current liabilities.

The debt ratio is calculated dividing total assets by total liabilities. Three profitability ratios are net margin, return on assets (ROA) and return on equity (ROE). Net margin is the ratio that best measures the profitability of a company. It is calculated dividing net income by total sales. Another important profitability ratio is gross margin percentage. This ratio is calculated dividing gross margin by sales. The return on assets ratio measures how well a company is using its assets to generate revenues.

Return on assets is calculated dividing net income by total assets. The return on equity metric measures how much revenues were generated in relation to its equity. The metric is calculated dividing net income by total equity. Two efficiency ratios are account receivable turnover and inventory turnover. The inventory turnover ratio measures how many times a company’s inventory has been sold and replaced during a year. The metric is calculated dividing cost of goods sold by average inventory balance.

The account receivable turnover is a measure of how many times a company’s account receivable