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Accountancy > Analysis of Financial Statements > Statements and Limitations of Financial Analysis
Analysis of Financial Statements

Statements and Limitations of Financial Analysis

Financial Statement Analysis aka financial analysis is a process in which we review and analyze the company’s financial statements. Financial analysis is important for making the right financial decisions, and for improving the economic health of an organization. The financial statement contains a balance sheet, income statement, cash flow statement, and statement of changes. Tools of Financial Analysis are Comparative statements, Common size statements, Trend Analysis, Ratio Analysis, Cash Flow Analysis. Learn more about Financial Analysis and Limitation of Financial Analysis

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Tools of Financial Analysis

1. Comparative Statements

Such statements are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to get an idea about the position of the firm in two or more periods.

Firms and companies apply this with regard to only 2 financial statements viz. Balance Sheet and Income Statement. Hence, they prepare these 2 financial statements in the comparative form. Noteworthy, the firms need to use the same accounting principles to get a better result.

But if it is possible to use the same principles then the firm should mention the change in the footnote. It is known as ‘Horizontal Analysis’.

Browse more Topics under Analysis Of Financial Statements

Format of Comparative Statements

Particulars 1st Year 2nd Year Change [+ or -] % Change
 Column 1 2 3 4

Steps to prepare comparative statement:

1. Firstly, put the absolute figures from the financial statement in the relevant years.

2. Then, find the absolute change by deducting the values of the 1st year from the values of the 2nd year.

3. In order to find out the % change, use the given formula:

Absolute Change/Values of 1st year X 100

2. Common Size Statement

Financial Analysis

These are the statements which indicate the relationship of different items of a financial statement with some common item by showing each item as a percentage of the common item.

It enables the firms to do the inter-firm as well as an intra-firm comparison which is almost impossible in case of comparative statements. Hence, it is also known as ‘Vertical analysis‘. Its purpose is to study the key changes and trends in the financial position.

Format of Common Size Statement

Particulars 1st Year Percentage 2nd Year Percentage
Column 1 2 3 4

Steps to prepare Common Size Statements

1. Firstly, put the absolute figures in the relevant year columns. (Col. 2 and 4)

2. Then, select a Common Base as 100. In the case of Income Statements, take Sales Revenue as 100. In the case of Balance Sheet, take Total Assets or Liabilities as 100.

3. Find out the % value with the help of following formula:

Absolute Value/Common Base Value X 100

3. Trend Analysis

It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data, a business enterprise does trend analysis to observe the percentage changes over time for the selected data.

Trend analysis is important for the business because it points at the basic changes in the nature of the business. By looking at a trend in the particular ratio, firms may find whether the ratio is falling, rising or remaining constant. After due observation, relevant steps can be taken.

Year Particular like Sales Trend (in %) Particulars like Profit Trend (in %)

Steps to prepare trend analysis

1. Firstly, put the relevant absolute figures in the relevant columns.

2. Then, choose the base year which is mostly the first year and put it as 100 in trend. Otherwise, the question will specify.

3. Find out the trend with the given formula:

Absolute Value/Base Year Value X 100

4. Ratio Analysis

Ratio analysis is a process of analyzing and reviewing the company’s financial statement and performance. It is a quantitative analysis in which many factors of company financial performance is evaluated. Like solvency ratios, debt management ratios, liquidity, market value ratio, asset management ratio, profitability, etc.

As a technique of financial analysis, accounting ratios measure the comparative importance of the individual items of the income and position statements.  Hence, it helps to assess the profitability, solvency, and efficiency of an enterprise.

5. Cash Flow Analysis

It refers to the analysis of the actual movement of cash int and out of the organization. The flow of cash into the business is called as cash inflow and the flow of cash out of the firm is called as cash outflow or negative cash flow.

Hence, by preparing the cash flow statement, the firm is able to find out the various reason behind the inflow and outflow of the cash.

Limitations of Financial Analysis

Although there are many advantages of the financial statements, there are certain disadvantages of the same. As the analysis is done on the basis of data provided in the financial statements which can be incorrect.

Hence, it is necessary for the firms to consider in mind various limitations as well.

1. While doing the financial analysis, firms often fail to consider the price changes. When firms compare data from various time periods, they do it without providing the index to the figures. Hence, the firm does not show the inflation impact.

2. Intangible assets not recorded. Firms do not record many intangible assets. Instead, any expenditure made to create an intangible asset are immediately charged to expense.

3. Firms consider only the monetary aspects of the financial statements. They do not consider the non-monetary aspect.

4. Firms prepare the financial statements on the basis of on-going concept, as such, it does not reflect the current position.

5. The statements do not necessarily provide any value in predicting what will happen in the future.

Question For You

Calculate the trend percentages from the following figures of sales, stock, and profit of Harshit Ltd., taking 2001 as the base year.

Year Sales Stock Profit
2001 1881 709 321
2002 2340 781 435
2003 2655 816 458
2004 3021 955 527
2005 3768 1154 627

Solution:

Year Sales Trend(%) Stock Trend(%) Profit Trend(%)
2001 1881 100 709 100 321 100
2002 2340 2340/1881 X 100 = 124 781 781/709 X 100 = 110 435 435/321 X 100 = 136
2003 2655 2655/1881 X 100 = 141 816 816/709 X 100 = 115 458 458/321 X 100 = 143
2004 3021 3021/1881 X 100 = 161 955 955/709 X 100 = 133 527 527/321 X 100 = 164
2005 3768 3768/1881 X 100 = 200 1154 1154/709 X 100 = 163 627 627/321 X 100 = 195
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