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Accountancy > Analysis of Financial Statements > Tools of Financial Analysis
Analysis of Financial Statements

Tools of Financial Analysis

Financial statements are prepared to have complete information regarding assets, liabilities, equity, reserves, expenses and profit and loss of an enterprise. To analyze & interpret the financial statements, commonly used tools are comparative statements, common size statements etc. Let us take a look.

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Comparative Statements

Also known as ‘horizontal analysis, are financial statements showing financial position & profitability at different periods of time. These statements give an idea of the enterprise financial position of two or more periods. Comparison of financial statements is possible only when same accounting principles are used in preparing these statements.

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Comparative Balance Sheet

The progress of the company can be seen by observing the different assets and liabilities of the firm on different dates to make the comparison of balances from one date to another. To understand the comparative balance sheet, it must have two columns for the data of original balance sheets. A third column is used to show increases/decrease in figures. The fourth column gives percentages of increases or decreases.

By comparing the balance sheets of different dates, one can observe the following aspects

  • Current financial position and Liquidity position
  • Long-term financial position
  • Profitability of the concern

Comparative Income Statement

Traditionally known as trading and profit and loss A/c. Net sales, cost of goods sold, selling expenses, office expenses etc are important components of an income statement. To compare the profitability, particulars of profit & loss are compared with the corresponding figures of previous years individually. To analyze the profitability of the business, the changes in money value and percentage is determined.

By comparing the profits of different dates, one can observe the following aspects:

  • The increase/decrease in gross profit.
  • The study of operational profits.
  • The increase or decrease in net profit
  • Study of the overall profitability of the business.

Common Size Statements

Common size statements are also known as ‘Vertical analysis’. Financial statements, when read with absolute figures, can be misleading. Therefore, a vertical analysis of financial information is done by considering the percentage form. The balance sheet items are compared:

  • to the total assets in terms of percentage by taking the total assets as 100.
  • to the total liabilities in terms of percentage by taking the total liabilities as 100.

Therefore the whole Balance Sheet is converted into percentage form. And such converted Balance Sheet is known as Common-Size Balance Sheet. Similarly profit & loss items are compared:

  • to the total incomes in terms of percentage by taking the total incomes as 100.
  • to the total expenses in terms of percentage by taking the total expenses as 100.

Therefore the whole Profit & loss account is converted into percentage form. And such converted profit & loss account is known as Common-Size Profit & Loss account. As the numbers are brought to a common base, the percentage can be easily compared with the results of corresponding percentages of the previous year or of some other firms.

 Trend Analysis

Also known as the Pyramid Method. Studying the operational results and financial position over a series of years is trend analysis. Calculations of ratios of different items for various periods is done & then compared under this analysis. Whether the enterprise is trending upward or backward, the analysis of the ratios over a period of years is done. By observing this analysis, the sign of good or poor management is detected.

Ratio Analysis

Quantitative analysis of information contained in a company’s financial statements is ratio analysis. It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm.

To assess the profitability, solvency, and efficiency of a business, management can go through the technique of ratio analysis. It is an attempt at developing a meaningful relationship between individual items (or group of items) in the balance sheet or profit and loss account.

Cash Flow Analysis

The actual movement of cash into and out of a business is cash flow analysis. The flow of cash into the business is called the cash inflow. Similarly, the flow of cash out of the firm is called cash outflow. The difference between the inflow and outflow of cash is the net cash flow.

Cash flow statement is prepared to project the manner in which the cash has been received and has been utilized during an accounting year. It is an important analytical tool. Analysis of cash flow explains the reason for a change in cash. It helps in assessing the liquidity of the enterprise and in evaluating the operating, investment & financing decisions.

Tools of Financial Analysis: Common Size Statements, Trend Analysis etc.

Solved Example for You

Question: State any four tools which are commonly used for analyzing and interpreting financial statements.

Answer:

  • Comparative statements
  • Common size statements
  • Trend analysis
  • Ratio analysis
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