What is financial statement analysis? Explain their various techniques of analysis of financial statements.
Analysis of financial statements
Analysis of financial statements is basically a study of the relationship among various facts and figures stated in a set of financial
Comparative Statement or Comparative Financial and Operating Statements.
Common Size Statements.
Trend Ratios or Trend Analysis.
Statement of Changes in Working Capital.
Fund Flow Analysis.
Cash Flow Analysis.
Cost Volume Profit Analysis
A brief explanation of the tools or techniques of financial statement analysis presented below.
1. Comparative Income Statement
Three important pieces of information are obtained from the Comparative Income Statement. They are Gross Profit, Operating Profit and Net Profit. The changes or the improvement in the profitability of the business concern is found over a period of time.
2. Comparative Balance Sheet
The financial condition of the business concern can be found by preparing comparative balance sheet.
The various items of the Balance sheet for two different periods are used. The assets are classified as current assets and fixed assets for comparison. The term shareholders’ net worth includes Equity Share Capital, Preference Share Capital, Reserves and Surplus and the like.
3. Common Size Statements
A vertical presentation of financial information is followed for preparing common-size statements. Besides, the rupee value of financial statement contents are not taken into consideration.
But, only percentages are considered for preparing common size statements. The total assets or total liabilities or sales is taken as 100 and the balance items are compared to the total assets, total liabilities or sales in terms of percentage.
Thus, a common size statement shows the relation of each component to the whole. Separate common size statement is prepared for profit and loss account as Common Size Income Statement and for balance sheet as Common Size Balance Sheet.
4. Trend Analysis
The ratios of different items for various periods are find out and then compared under this analysis. The analysis of the ratios over a period of years gives an idea of whether the business concern is trending upward or downward. This analysis is otherwise called as Pyramid Method.
5. Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared with industry average. These both trends can be presented on graph paper also in the shape of curves. This presentation of facts in the shape of pictures makes the analysis and comparison more comprehensive and impressive.
5. Statement of Changes in Working Capital
The extent of increase or decrease of working capital is identified by preparing the statement of changes in working capital. The amount of net working capital is calculated by subtracting the sum of current liabilities from the sum of current assets. It does not detail the reasons for changes in working capital.
6. Fund Flow Analysis
Fund flow analysis deals with detailed sources and application of funds of the business concern for a specific period. It indicates where funds come from and how they are used during the period under review. It highlights the changes in the financial structure of the company.
7. Cash Flow Analysis
Cash flow analysis is based on the movement of cash and bank balances. In other words, the movement of cash instead of movement of working capital would be considered in the cash flow analysis. There are two types of cash flows. They are actual cash flows and notional cash flows.
8. Ratio Analysis
Ratio analysis is an attempt of developing meaningful relationship between individual items (or group of items) in the balance sheet or profit and loss account. Ratio analysis is not only useful to internal parties of business concern but also useful to external parties. Ratio analysis highlights the liquidity, solvency, profitability and capital gearing.
9. Cost Volume Profit Analysis
This analysis discloses the prevailing relationship among sales, cost and profit. The cost is divided into two. They are fixed cost and variable cost. There is a constant relationship between sales and variable cost. Cost analysis enables the management for better profit planning.