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# Common Size & Vertical Analysis and Limitations of Ratios

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1) An alternative approach to assessing the financial health and performance of a firm is to conduct a common size analysis or percent change analysis. Define each of these methods of evaluating firm performance.

2) Finally, present a few (i.e., three or four) of the limitations of uses of ratios and financial statement analysis

#### Solution Preview

Hello Student,

Before you begin to answer this question, the first thing you may want to note is that there are several ways in which the financial health and/or performance of a company may be assessed. It can be done by either conducting a horizontal analysis (also called a trend analysis and part of which is considered as a percentage change analysis) and/or a vertical analysis (also called a common size analysis). Please see information below on each of these methods.

Horizontal Analysis

A horizontal analysis may be defined as an analysis in which a comparison is made between two or more years of financial data. It is also referred to as trend analysis and it is facilitated by showing changes between years in both dollar and percentage form. By showing the changes in dollar form, this helps an analyst to focus on key factors that have affected the profitability or the financial position of a firm. It is not just good enough to focus on the dollar value however; it is claimed that "showing changes between years in percentage form helps an analyst to gain perspective and to gain a feel for the significance of the changes that are taking place." (Source: http://www.accountingformanagement.com/horizontal_analysis_or_trend_analysis.htm#Horizontal and Vertical Analysis)

Preparing the horizontal analysis is pretty simple and straight forward. All ...

#### Solution Summary

This solution provides you with information about common size and vertical analysis. It also tells what are some of the limitations of the uses of ratios and financial statement analysis.

\$2.19

## Financial Statement Analysis, Flexible Budget

See Attachment.

R.J. Falk is the chief executive officer of Ventura Electronics. Falk is an expert engineer but a Novice in accounting. Falk asks you, as an accounting major, to explain a) the bases for comparison in analyzing Ventura financial statements and (b) the limitations, if any, in financial statement analysis.
Write a memo to R.J. Falk that explains the basis for comparison and the factors affecting quality of earnings. Include a 350-700-word memo addressing the problem

Preparing a Flexible Budget
The flexible budget at the 70,000-unit and the 80,000-unit levels of activity is shown below.
70,000 Units 80,000 Units 90,000 Units
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \$1,400,000 \$1,600,000 \$
Cost of goods sold . . . . . . . . . . . . . . . . . . . . 840,000 960,000
Gross profit on sales . . . . . . . . . . . . . . . . . . . \$ 560,000 \$ 640,000 \$
Operating expenses (\$90,000 fixed) . . . . . . . 370,000 410,000
Operating income . . . . . . . . . . . . . . . . . . . . . \$ 190,000 \$ 230,000 \$
Income taxes (30% of operating income) . . . 57,000 69,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . \$ 133,000 \$ 161,000 \$
Complete the flexible budget at the 90,000-unit level of activity. Assume that the cost of goods sold and variable operating expenses vary directly with sales and that income taxes remain at 30 percent of operating income.

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