The following are the important tools of financial analysis which can be appropriately used by the financial analysts:
1. Common-size financial statements
2. Comparative financial statements
3. Trend percentages
4. Ratio analysis
5. Funds flow analysis
6. Cash flow analysis
Common-Size Financial Statements:
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.
Funds Flow Analysis:
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.
Cash 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.