In this article, we will discuss the six important tools of financial analysis. Explanations of the Tools of Financial Analysis.
Financial analysis can be elaborately defined as an assessment on, how effective are the investments or funds engaged by the organization or business, To check the efficiency of funds used for operations, and lastly to secure debtors and claims against the business’s assets. Tools of Financial Analysis: Financial Analyst can use a variety of tools for the purposes of analysis and interpretation of financial statements particularly with a view to suit the requirements of the specific enterprise. The principal tools are as under:
- Comparative Financial Statements
- Common-size Statements
- Trend Analysis
- Cash Flow Statement
- Ratio Analysis
- Funds Flow statements
Comparative Financial Statements:
Comparative financial statements are those statements which have been designed in a way so as to provide time perspective to the consideration of various elements of financial position embodied in such statements. In these statements, figures for two or more periods are placed side by side to facilitate comparison. Both the Income Statement and Balance Sheet can be prepared in the form of Comparative
Comparative Income Statement
The comparative Income Statement is the study of the trend of the same items/group of items in two or more Income Statements of the firm for different periods. The changes in the Income Statement items over the period would help in forming an opinion about the performance of the enterprise in its business operations. The Interpretation of Comparative Income Statement would be as follows:
- The changes in sales should be compared with the changes in the cost of goods sold. If the increase in sales is more than the increase in the cost of goods sold, then the profitability will improve.
- An increase in operating expenses or decrease in sales would imply the decrease in operating profit and a decrease in operating expenses or increase in sales would imply the increase in operating profit.
- The increase or decrease in net profit will give an idea of the overall profitability of the concern.
Comparative Balance Sheet
The comparative Balance Sheet analysis would highlight the trend of various items and groups of items appearing in two or more Balance Sheets of a firm on different dates. The changes in periodic balance sheet items would reflect the changes in the financial position at two or more periods. The Interpretation of Comparative Balance Sheets are as follows:
- The increase in working capital would imply the increase in the liquidity position of the firm over the period and the decrease in working capital would imply deterioration in the liquidity position of the firm.
- An assessment of the long-term financial position can be made by studying the changes in fixed assets, capital, and long-term liabilities. If the increase in capital and long-term liabilities is more than the increase in fixed assets, it implies that a part of capital and long-term liabilities has been used for financing a part of working capital as well. This will be a reflection of the good fiscal policy. The reverse situation will be a signal towards increasing degree of risk to which the long-term solvency of the concern would be exposed to.
- The changes in retained earnings, reserves and surpluses will give an indication of the trend in profitability of the concern. An increase in reserve and surplus and the Profit and Loss Account is an indication of improvement in profitability of the concern. The decrease in these accounts may imply the payment of dividends, issue of bonus shares or deterioration in profitability of the concern.
Common-size Financial Statements:
Common-size Financial Statements are those in which figures reported are converted into percentages to some common base. In the Income Statement, the sale figure is assumed to be 100 and all figures are expressed as a percentage of sales. Similarly, in the Balance sheet, the total of assets or liabilities is taken as 100 and all the figures are expressed as a percentage of this total.
Common Size Income Statement
In the case of the Income Statement, the sales figure is assumed to be equal to 100 and all other figures are expressed as the percentage of sales. The relationship between items of Income Statement and the volume of sales is quite significant since it would be helpful in evaluating operational activities of the concern. The selling expenses will certainly go up with the increase in sales. The administrative and financial expenses may go up or may remain at the same level. In case of the decline in the sale, selling expenses should definitely decrease.
Common Size Balance Sheet
For the purpose of common size Balance Sheet, the total of assets or liabilities is taken as 100 and all the figures are expressed as the percentage of the total. In other words, each asset is expressed as the percentage to total assets/liabilities and each liability is expressed as the percentage to total assets/liabilities. This statement will throw light on the solvency position of the concern by providing an analysis of the pattern of financing both long-term and working capital needs of the concern.
The third tool of financial analysis is trend analysis. This is immensely helpful in making a comparative study of the financial statements for several years. Under this method, trend percentages are calculated for each item of the financial statement taking the figure of the base year as 100. The starting year is usually taken as the base year. The trend percentages show the relationship of each item with its preceding year’s percentages.
These percentages can also be presented in the form of index numbers showing relative change in the financial data of a certain period. This will exhibit the direction, (i.e., upward or downward trend) to which the concern is proceeding. These trend ratios may be compared with industry ratios in order to know the strong or weak points of a concern. These are calculated only for major items instead of calculating for all items in the financial statements.
While calculating trend percentages, the following precautions maybe are taken:
- The accounting principles and practices must be followed constantly over the period for which the analysis is made. This is necessary to maintain consistency and comparability.
- The base year selected should be normal and representative year.
- Trend percentages should be calculated only for those items which have the logical relationship with one another.
- Trend percentages should also be carefully studied after considering the absolute figures on which these are based. Otherwise, they may give misleading conclusions.
- To make the comparison meaningful, trend percentages of the current year should be adjusted in the light of price level changes as compared to base year.
Cash Flow Statement
A cash flow statement shows an entity’s cash receipts classified by major sources and its cash payments classified by major uses during a period. It provides useful information about an entity’s activities in generating cash from operations to repay debt, distribute dividends or reinvest to maintain or expand its operating capacity; about its financing activities, both debt and equity; and about its investment in fixed assets or current assets other than cash.
In other words, a cash flow statement lists down various items and their respective magnitude which bring about changes in the cash balance between two balance sheet dates. All the items whether current or non-current which increase or decrease the balance of cash are included in the cash flow statement. Therefore, the effect of changes in the current assets and current liabilities during an accounting period in cash position, which is not shown in a fund flow statement is depicted in a cash flow statement.
The depiction of all possible sources and application of cash in the cash flow statement helps the financial manager in short-term financial planning in a significant manner because the short term business obligations such as trade creditors, bank loans, interest on debentures and dividend to shareholders can be met out of cash only. The preparation of the cash flow statement is also consistent with the basic objective of financial reporting which is to provide information to investors, creditors and others which would be useful in making rational decisions.
The basic objective is to enable the users of information to make the prediction about cash flows in an organization since the ultimate success or failure of the business depends upon the amount of cash generated. This objective is sought to be met by preparing a cash flow statement.
A ratio is a simple arithmetical expression of the relationship of one number to another. According to Accountant’s Handbook by Wixon, Kelland bedboard, “a ratio” is an expression of the quantitative relationship between two numbers”. In simple language, the ratio is one number expressed in terms of the other and can be worked out by dividing one number into the other. This relationship can be expressed as (i) percentages, say, net profits are 20 percent of sales (assuming net profits of Rs. 20,000 and sales of Rs. 1,00,000), (ii) fraction (net profit is one-fourth of sales) and (iii) proportion of numbers (the relationship between net profits and sales is 1:4). The rationale of ratio analysis lies in the fact that it makes related information comparable.
A single figure by itself has no meaning but when expressed in terms of a related figure, it yields significant inferences. Ratio analysis helps in financial forecasting, making comparisons, evaluating the solvency position of a firm, etc. For instance, the fact that the net profits of a firm amount to, say, Rs. 20 lakhs throw no light on its adequacy or otherwise. The figure for net profit has to be considered in relation to other variables. How does it stand in relation to sales? What does it represent by way of return on total assets used or total capital employed?
In case net profits are shown in terms of their relationship with items such as sales, assets, capital employed, equity capital and so on, meaningful conclusions can be drawn regarding their adequacy. Ratio analysis, thus, as a quantitative tool, enables analysts to draw quantitative answers to questions such as: Are the net profits adequate? Are the assets being used efficiently? Can the firm meet its current obligations and so on? However, ratio analysis is not an end in itself. Calculation of mere ratios does not serve any purpose unless several appropriate ratios are analyzed and interpreted.
The following are the four steps involved in the ratio analysis:
- Selection of relevant data from the financial statements depending upon the objective of the analysis.
- Calculation of appropriate ratios from the above data.
- Comparison of the calculated ratios with the ratios of the same firm in the past, or the ratios developed from projected financial statements or the ratios of some other firms or the comparison with ratios of the industry to which the firm belongs.
- Interpretation of the ratio.
Funds Flow statements
The term ‘flow’ means movement and includes both ‘inflow’ and ‘outflow’. The term ‘flow of funds’ means transfer of economic values from one asset or equity to another. The flow of funds is said to have taken place when any transaction makes changes in the number of funds available before happening of the transaction. If the effect of the transaction results in the increase of funds, it is called a source of funds and if it results in the decrease of funds, it is known as an application of funds.
Further, in case the transaction does not change funds, it is said to have not resulted in the flow of funds. According to the working capital concept of funds, the term ‘flow of funds’ refers to the movement of funds in the working capital. If any transaction results in the increase in working capital, it is said to be a source or inflow of funds and if it results in the decrease of working capital, it is said to be an application or outflow of funds.