Analysis of

Financial
Statements:
17
Interpretation
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LEARNING OUTCOMES
After studying this chapter students should be able to:
 calculate and interpret a full range of accounting ratios;
 analyse financial statements in the context of information provided in the accounts and
corporate report to comment on performance and position;
 prepare a concise report on the results of the above form of analysis;
 prepare and interpret segemental analysis, inter-firm and international comparisons.

17.1 Introduction
This chapter covers the following areas: Section 17.2 extends the range of techniques
covered by Chapter 16 in looking at horizontal, vertical and common size analysis. Section
17.3 examines the steps involved in conducting the analysis and provides some pointers to
writing a good quality report. Section 17.4 looks at the types of question that could be
encountered in the Financial Analysis examination in this syllabus area. Then this section
proceeds to look in detail at the various steps involved in answering a 20 mark question that
was recently set in CIMA’s Financial Reporting examination. Section 17.5 examines the
provisions of IAS 14 Segment reporting. Students may have encountered segment reporting
previously. It adds, often significantly, to the body of information in as set of financial
statements and so it is also covered in this Learning System.

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415 2007.1
 416 STUDY MATERIAL P8

17.2 Horizontal, vertical and common

ANALYSIS OF FINANCIAL STATEMENTS: INTERPRETATION
size analysis
17.2.1 Horizontal analysis
Where at least 2 years’ worth of information is available, it is possible to conduct a
horizontal analysis of the figures. This involves tracking and explaining, as far as possible,
the changes between the two sets of figures, for example, making an observation that sales
have increased by more than the rate of inflation applicable to the industry.
Where several years’ information is available it is possible to conduct an analysis of trends
over time. Some entities provide 5- or 10-year summaries of the key figures in their financial
statements and where this information is available a trend analysis can offer some interesting
insights into the development of the business. The following example illustrates the technique:
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Example 17.A
XY produces a 5-year summary in its annual financial statements. The financial statements for the year ended 31 March
20X7 show the following key figures extracted from the income statement:

20X7 20X6 20X5 20X4 20X3

$m $m $m $m $m
Revenue 2,619.7 2,381.4 2,371.5 2,347.7 2,522.9
Operating profit 324.5 298.6 277.7 334.6 372.4
Interest costs 102.6 74.4 73.0 62.1 21.0

The annual report details make it clear that sales of XY’s principal product is under threat from new entrants to the market.
Heavy investment in intangible assets has been required in order to maintain market share.
Before rushing into calculations it is always sensible to start with a brief scrutiny of the figures to establish a factual
base on which to build the analysis. From the limited set of figures given above, we can see that revenue has increased
each year since 20X4, but that the 20X4 figure represented quite a significant drop on the figure reported in 20X3.
Operating profit reached a low point in 20X5 but has picked up since, although it is still not at 20X3/4 levels. This sug-
gests that the business’s margins have been squeezed, probably by competition, and/or that it is struggling to maintain
control over costs. Interest costs have increased, with big increases between 20X3/4 and between 20X6/7.
It is quite possible to discern all of these points from the data without touching a calculator, and the analysis above
could form quite a reasonable introductory paragraph to a report to an investor.
A few calculations will help to extend the analysis further. We can calculate the percentage rate of increase/decrease
over the years, as follows:
Annual percentage increases/(decreases) in a range of key figures for XY – 20X3 to 20X7

20X7 20X6 20X5 20X4

% % % %
Revenue 10.0 0.4 1.0 (6.9)
Operating profit 8.7 7.5 (17.0) (10.0)
Interest cost 37.9 1.9 17.6 295.7

The horizontal analysis reinforces the point that revenue dropped significantly between 20X3 and 20X4, and that it has
finally started to make a significant recovery in 20X7. The increase in 20X7 may be related directly to additional invest-
ment financed by borrowing. Operating profit performance overall looks even worse than sales performance. The fig-
ures appear to support the message picked up from elsewhere in the annual report, that the business faces a difficult
competitive environment, and that it has had to invest quite heavily to maintain market share.
So, provided with 15 different figures in three categories of income statement item, we have been able to identify
some quite important trends, and we have the makings of a credible report on the business for an interested party.
Of course, a limited range of figures like this does not tell us everything we need to know.
Questions prompted by the analysis might include the following:
How much has been borrowed, and what are the terms (e.g., interest rates, security provided, repayment conditions)?
●

What is the nature of the investment in non-current assets? What kind of intangibles has the business invested in?
●
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2007.1
 FINANCIAL ANALYSIS 417

Is there some information about costs that will allow us to see if the business has lost control over certain categories?

ANALYSIS OF FINANCIAL STATEMENTS: INTERPRETATION

●

● Is the business performing better in some markets than in others?

The financial statements should provide some information on all of these matters. Whether or not it’s sufficient informa-
tion to provide comprehensive answers is another matter.
There are some problems with horizontal analysis that should be borne in mind:
● Lack of comparability because of changes in the business. Many large businesses choose to grow through acqui-
sitions. Where there is a significant degree of mergers and acquisition activity, it can be difficult to identify true
underlying trends.
● Lack of comparability because of accounting policy changes and changes in financial reporting standards.
Sometimes, when presenting several years’ worth of data, businesses will adjust the figures so that they are all pre-
sented in accordance with its current accounting policies and currently valid financial reporting standards. This is,
obviously, helpful to the analyst. However, notes should be read very carefully to see whether or not such adjust-
ments have been made.
● Failure to take the effects of changing price levels into account. Usually, no adjustment is made, year on year, to take
changing price levels into account. However, even at a low rate of inflation in the economy, the effects of price
changes can be quite substantial over several years. In the example of XY above, it is quite likely that the very small
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increases in revenue in 20X5 and 20X6 were decreases in real terms, if price inflation were taken into account.

17.2.2 Vertical analysis

Vertical analysis is a simple, but potentially effective technique, that involves expressing
each figure in a primary financial statement as a percentage of one key figure.

Example 17.B
BB has the following summarised income statement for 20X5:

20X5
$’000
Revenue 1,377
Cost of sales (897)
Gross profit 480
Distribution costs (247)
Administration expenses (152)
Profit before tax 81

Taking the key figure of revenue as 100%, the statement can be vertically analysed as follows:

20X5 20X5
$’000 %
Revenue 1,377 100
Cost of sales (897) (65)
Gross profit 480 35
Distribution costs (247) (18)
Administration expenses (152) (11)
Profit before tax 81 6

On its own this analysis is not perhaps very helpful: it requires some kind of comparison which will attribute meaning.
If the data is available we can extend it over several periods in the form of common size analysis. Note that it is usual
to express figures in the income statement in relation to sales. Balance sheet figures would normally be expressed in
relation to total assets.

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2007.1
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