The following are the important tools of financial analysis which can be appropriately used by the financial analysts:
Common-size financial statements
Comparative financial statements
Funds flow analysis
Cash flow analysis
In this type of statements, figures in the original financial statements
are converted into percentages in relation to a common base. The common base
may be sales in the case of income statements (profit and loss account) and
total of assets or liabilities in the case of balance sheet. For e.g. In the
case of common-size income statement, sales of the traditional financial
statement are taken as 100 and every other item in the income statement is
converted into percentages with reference to sales. Similarly, in the case of
common-size balance sheet, the total of asset/liability side will be taken as
100 and each individual asset/liability is converted into relevant percentages.
Comparative Financial Statements:
This type of financial statements are ideal for carrying out horizontal
analysis. Comparative financial statements are so designed to give them
perspective to the review and analysis of the various elements of profitability
and financial position displayed in such statements. In these statements,
figures for two or more periods are compared to find out the changes both in
absolute figures and in percentages that have taken place in the latest year as
compared to the previous year(s). Comparative financial statements can be
prepared both for income statement and balance sheet.
Analysis of one year figures or analysis of even two years figures will
not reveal the real trend of profitability or financial stability or otherwise
of any concern. To get an idea about how consistent is the performance of a
concern, figures of a number of years must be analysed and compared. Here comes
the role of trend percentages and the analysis which is done with the help of
these percentages is called as trend analysis.
Is a useful tool for the management since it reduces the large amount of
absolute data into a simple and easily readable form. The trend analysis is
studied by various methods. The most popular forms of trend analysis are year
to year trend change percentage and index-number trend series. The year to year
trend change percentage would be meaningful and manageable where the trend for
a few years, say a five year or six year period is to be analysed.
Generally trend percentage are calculated only for some important items
which can be logically related with each other. For e.g. Trend ratio for sales,
though shows a clear-cut increasing tendency, becomes meaningful in the real
sense when it is compared with cost of goods sold which might have increased at
a lower level.
Of all the tools of financial analysis available with a financial
analyst the most important and the most widely used tool is ratio analysis.
Simply stated ratio analysis is an analysis of financial statements done with
the help of ratios. A ratio expresses the relationship that exists between two
numbers and in financial statement analysis a ratio shows the relationship
between two interrelated accounting figures. Both the accounting figures may be
taken from the balance sheet and the resulting ratio is called a balance sheet
ratio. But if both the figures are taken from profit and loss account then the
resulting ratio is called as profit and loss account ratio. Composite ratio is
that ratio which is calculated by taking one figure from profit and loss
account and the other figure from balance sheet. A detailed discussion on ratio
analysis is made available in the pages to come.
The purpose of this analysis is to go beyond and behind the information
contained in the financial statements. Income statement tells the quantum of
profit earned or loss suffered for a particular accounting year. Balance sheet
gives the assets and liabilities position as on a particular date. But in an
accounting year a number of financial transactions take place which have a
bearing on the performance of the concern but which are not revealed by the
financial statements. For e.g. A concern collects finance through various
sources and uses them for various purposes. But these details could not be
known from the traditional financial statements. Funds flow analysis gives an
opening in this respect. All the more, funds flow analysis reveals the changes
in working capital position. If there is an increase in working capital what
resulted in the increase and if there is a decrease in working capital what
caused the decrease, etc. Will be made available through funds flow analysis.
While funds flow analysis studies the reasons for the changes in working
capital by analysing the sources and application of funds, cash flow analysis
pays attention to the changes in cash position that has taken place between two
accounting periods. These reasons are not available in the traditional
financial statements. Changes in the cash position can be
analysed with the help of a statement known as cash flow statement. A cash flow
statement summarises the change in cash position of the concern. Transactions
which increase the cash position of the concern are labelled as `inflows’ of
cash and those which decrease the cash position as `outflows’ of cash.