Page 676 - Accounting Principles (A Business Perspective)

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loan to a company would want to know the company's projected short-term liquidity. Of course, the company's
predicted ability to repay the 90-day loan is likely to be based at least partially on its past ability to pay off debts.
Long-term creditors are interested in a company's long-term solvency, which is usually determined by the

relationship of a company's assets to its liabilities. Generally, we consider a company to be solvent when its assets
exceed its liabilities so that the company has a positive stockholders' equity. The larger the assets are in relation to
the liabilities, the greater the long-term solvency of the company. Thus, the company's assets could shrink
significantly before its liabilities would exceed its assets and destroy the company's solvency.
Investors perform several types of analyses on a company's financial statements. All of these analyses rely on
comparisons or relationships of data that enhance the utility or practical value of accounting information. For
example, knowing that a company's net income last year was USD 100,000 may or may not, by itself, be useful

information. Some usefulness is added when we know that the prior year's net income was USD 25,000. And even
more useful information is gained if we know the amounts of sales and assets of the company. Such comparisons or
relationships may be expressed as:
• Absolute increases and decreases for an item from one period to the next.
• Percentage increases and decreases for an item from one period to the next.
• Percentages of single items to an aggregate total.
• Trend percentages.
• Ratios.

Earlier chapters have discussed and illustrated many of these analysis techniques. However, in this chapter we
apply all of these techniques in analyzing Synotech, Inc.'s performance. This was the company introduced in
Chapter 16.
Items 1 and 2 make use of comparative financial statements. Comparative financial statements present the
same company's financial statements for one or two successive periods in side-by-side columns. The calculation of
dollar changes or percentage changes in the statement items or totals is horizontal analysis. This analysis detects
changes in a company's performance and highlights trends.

Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical
analysis (item 3) consists of the study of a single financial statement in which each item is expressed as a
percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as
the percentage of cost of goods sold to sales.
Financial statements that show only percentages and no absolute dollar amounts are common-size
statements. All percentage figures in a common-size balance sheet are percentages of total assets while all the
items in a common-size income statement are percentages of net sales. The use of common-size statements
facilitates vertical analysis of a company's financial statements.
Trend percentages (item 4) are similar to horizontal analysis except that comparisons are made to a selected

base year or period. Trend percentages are useful for comparing financial statements over several years because
they disclose changes and trends occurring through time.
Ratios (item 5) are expressions of logical relationships between items in the financial statements of a single
period. Analysts can compute many ratios from the same set of financial statements. A ratio can show a relationship
between two items on the same financial statement or between two items on different financial statements (e.g.

Accounting Principles: A Business Perspective 677 A Global Text