TECHNIQUES OF ANALYSIS OF FINANCIAL STATEMENTS

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A Financial Statement is an organized collection of data according to logical and consistent accounting procedures. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show assets position at a moment of time as in the case of balance sheet, or may reveal a series of activities over a given period of times, as in the case of an income statement.

Financial Analysis is defined as being the process of identifying financial strength and weakness of a business by establishing relationship between the Elements of balance sheet and income statement. The information pertaining to the financial statements is of great importance through which interpretation and analysis is made.

The income statement, having been termed as profit and loss account is the most useful financial statement to enlighten what has happened to the business between the specified time intervals while showing, revenues, expenses gains and losses.

Balance sheet is a statement which shows the financial position of a business at certain point of time. The distinction between income statement and the balance sheet is that the former is for a period and the latter indicates the financial position on a particular date.

The various tools and techniques available for financial statement are mentioned below –

  1. Comparative Financial Statement Analysis (Horizontal Analysis):-

As the name suggests, comparative analysis provides a year-on-year review of the various financial statements. For example, in the Income Statement, the Sales figure may be compared over a period of consecutive years to understand how the sales figures have grown (or declined) over the year. It should be noted that horizontal analysis compares the internal performance of the company.

Horizontal analysis is also regarded as Dynamic Analysis.

  1. Common-size Financial Statement Analysis (Vertical Analysis):-

Vertical analysis is applicable for internal performance review as well as for comparison to peers and bench-marking. In vertical analysis all the items in a particular statement are represented as a Percentage of a particular item.

It is also called as static analysis.

  1. Ratio Analysis: Ratio analysis is the most widely used tool of financial statement analysis. A ratio gives relationship between two numbers, in this case items in the financial statements. Ratios are popular because they readily allow internal evaluation as well as comparison across firms. The ratios are categorized according to activities or functions they perform or the information they provide. For example, profitability ratios measure the profit making capability of the company.
  2. Graphical Analysis: Graphs provide visual representation of the performance that can be easily compared over time. The graphs may be line graphs, column graphs or Pie charts.
  3. Trend Analysis: Trend analysis is used to reveal the trend of items with the passage of time and is generally used as a statistical tool. Trend analysis is used in Conjunction with ratio analysis, horizontal and vertical analysis to spot a particular trend, explore the causes of the same and if required prepare future projections.
  4. Regression Analysis: Regression analysis is a statistical tool used to establish and estimate relationship among variables.

 

Generally, the dependent variable is related to one or more independent variables. In case of financial statement analysis, the dependent variable may be, say, sales, and it is required to estimate its relationship with the independent variable, say, a macroeconomic factor like Gross Domestic Product.

The various tools and techniques are there to enable the DECISION MAKING. Different companies may have different accounting methods and hence, comparison with peers has to be done carefully. Moreover, a holistic use of various techniques should be done to arrive at any conclusion.,

Financial statement analysis is the process of evaluating a company’s financial statements to understand its financial Health and performance. This analysis can be used to make Investment decisions, assess credit risk, or simply understand how a company is doing financially.

There are a number of different techniques that can be used to analyze financial statements. Some of the most common techniques include:

  • Horizontal analysis: This involves comparing the financial statements of a company over time to see how its performance has changed.
  • Vertical analysis: This involves comparing the different line items on a company’s financial statements to each other to see how they contribute to the overall financial picture.
  • Common-size analysis: This involves converting the financial statements of a company into common-size statements, which express all of the line items as a percentage of sales. This makes it easier to compare the financial statements of different companies.
  • Trend analysis: This involves tracking the financial performance of a company over time to see how it has changed. This can be done by using horizontal or vertical analysis.
  • Ratio analysis: This involves calculating ratios of different line items on a company’s financial statements to get a better understanding of its financial health. There are many different ratios that can be calculated, and each one provides a different piece of information about the company.
  • DuPont analysis: This is a type of ratio analysis that breaks down a company’s return on Equity (ROE) into three components: return on assets (ROA), asset turnover, and financial leverage.
  • Cash flow analysis: This involves analyzing a company’s cash flow statements to see how it is generating and using cash. This can be used to assess a company’s liquidity and solvency.
  • Solvency analysis: This involves assessing a company’s ability to pay its debts. This can be done by looking at a company’s debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio.
  • Profitability analysis: This involves assessing a company’s ability to generate profits. This can be done by looking at a company’s net profit margin, gross profit margin, and operating profit margin.
  • Efficiency analysis: This involves assessing a company’s efficiency in using its Resources. This can be done by looking at a company’s asset turnover ratio, inventory turnover ratio, and days sales outstanding ratio.
  • Market analysis: This involves assessing a company’s performance in the market. This can be done by looking at a company’s market share, price-to-earnings ratio, and price-to-book ratio.

Each of these techniques can provide valuable information about a company’s financial health and performance. However, it is important to note that no single technique is perfect, and each technique has its own limitations. It is therefore important to use a combination of techniques to get a complete picture of a company’s financial situation.

In addition to the techniques listed above, there are a number of other factors that can be considered when analyzing financial statements. These include the company’s Industry, its business model, its management team, and its competitive landscape. By taking all of these factors into account, investors and analysts can get a more complete understanding of a company’s financial health and prospects.

What are the techniques of analysis of financial statements?

There are many different techniques that can be used to analyze financial statements. Some of the most common techniques include:

  • Horizontal analysis: This involves comparing the financial statements of a company over time to see how its performance has changed.
  • Vertical analysis: This involves comparing the different items on a company’s financial statements to each other to see how they relate to each other.
  • Ratio analysis: This involves calculating ratios of different items on a company’s financial statements to get a better understanding of its financial health.
  • Trend analysis: This involves plotting the values of different items on a company’s financial statements over time to see how they have changed over time.
  • Common-size analysis: This involves converting the values of different items on a company’s financial statements to a common scale, such as a percentage of sales, to make them easier to compare.

What are the benefits of analyzing financial statements?

There are many benefits to analyzing financial statements. Some of the most important benefits include:

  • Identifying trends: By analyzing financial statements over time, you can identify trends in a company’s performance. This can help you to understand how the company is doing and to make predictions about its future performance.
  • Comparing companies: By comparing the financial statements of different companies, you can see how they compare to each other. This can help you to identify the best companies to invest in or to do business with.
  • Valuing companies: By analyzing financial statements, you can get a better understanding of the value of a company. This can help you to make informed investment decisions.
  • Identifying risks: By analyzing financial statements, you can identify the risks that a company faces. This can help you to avoid investing in companies that are too risky.

What are the limitations of analyzing financial statements?

There are some limitations to analyzing financial statements. Some of the most important limitations include:

  • Accuracy: Financial statements are only as accurate as the information that is used to prepare them. If the information is inaccurate, the financial statements will also be inaccurate.
  • Timeliness: Financial statements are typically prepared after the end of a reporting period. This means that they may not be up-to-date on the latest information about a company’s performance.
  • Complexity: Financial statements can be complex and difficult to understand. This can make it difficult for investors and other users to understand the information that is presented in the financial statements.
  • Omission of information: Financial statements only include information that is required by accounting standards. This means that they may not include all of the information that would be useful to investors and other users.

What are some tips for analyzing financial statements?

Here are some tips for analyzing financial statements:

  • Start with the basics: Before you start analyzing financial statements, it is important to understand the basics of accounting. This will help you to understand the information that is presented in the financial statements.
  • Use multiple techniques: There are many different techniques that can be used to analyze financial statements. It is important to use multiple techniques to get a complete picture of a company’s financial health.
  • Compare companies: It is helpful to compare the financial statements of different companies to see how they compare to each other. This can help you to identify the best companies to invest in or to do business with.
  • Be aware of the limitations: It is important to be aware of the limitations of financial statements. This will help you to avoid making incorrect conclusions about a company’s financial health.
  • Seek professional help: If you are not comfortable analyzing financial statements, it is a good idea to seek professional help. A financial advisor can help you to understand the information that is presented in the financial statements and to make informed investment decisions.

Question 1

Which of the following is not a technique of analysis of financial statements?

(A) Horizontal analysis
(B) Vertical analysis
(C) Ratio analysis
(D) Trend analysis

Answer
(D) Trend analysis is a technique of analysis of financial statements that compares financial statements over time. The other three techniques are used to analyze financial statements at a single point in time.

Question 2

Which of the following is not a limitation of ratio analysis?

(A) Ratios can be manipulated by management.
(B) Ratios can be affected by differences in accounting methods.
(C) Ratios can be affected by the industry in which a company operates.
(D) Ratios can be affected by the size of a company.

Answer
(D) Ratios are not affected by the size of a company. The other three limitations are all common limitations of ratio analysis.

Question 3

Which of the following is a liquidity ratio?

(A) Current ratio
(B) Quick ratio
(C) Debt-to-equity ratio
(D) Return on assets

Answer
(A) The current ratio is a liquidity ratio. It measures a company’s ability to pay its short-term debts. The quick ratio is another liquidity ratio. It measures a company’s ability to pay its short-term debts without having to sell its inventory. The debt-to-equity ratio is a solvency ratio. It measures a company’s ability to pay its long-term debts. The return on assets is a profitability ratio. It measures a company’s ability to generate profits from its assets.

Question 4

Which of the following is a profitability ratio?

(A) Return on assets
(B) Return on equity
(C) Gross profit margin
(D) All of the above

Answer
(D) All of the above are profitability ratios. They measure a company’s ability to generate profits.

Question 5

Which of the following is a solvency ratio?

(A) Debt-to-equity ratio
(B) Debt-to-assets ratio
(C) Times interest earned ratio
(D) All of the above

Answer
(D) All of the above are solvency ratios. They measure a company’s ability to pay its debts.

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