Explanations of the Tools of Financial Analysis

Financial analysis tools can elaborately stand defined as an assessment of, how effective the investments or funds engage by the organization or business.

In this article, we will discuss the six important tools of financial analysis. Explanations of the Tools of Financial Analysis.

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 Analysts can use a variety of tools for the analysis and interpretation of financial statements particularly to suit the requirements of the specific enterprise. The principal tools are as under:

1. Comparative Financial Statements
2. Common-size Statements
3. Trend Analysis
4. Cash Flow Statement
5. Ratio Analysis
6. Funds Flow statements

Comparative Financial Statements:

Comparative financial statements are those statements that have stood designed in a way 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 exist placed side by side to facilitate comparison. Both the Income Statement and Balance Sheet can prepare in the form of Comparative Financial Statements.

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 the Comparative Income Statement would be as follows:

• The changes in sales should compare 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 a decrease in sales would imply a decrease in operating profit. And a decrease in operating expenses or increase in sales would imply an 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 is as follows:

• The increase in working capital would imply an increase in the liquidity position of the firm over the period. And the decrease in working capital would imply a deterioration in the liquidity position of the firm.
• An assessment of the long-term financial position can stand 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 the capital and long-term liabilities has stood 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 toward an increasing degree of risk to which the long-term solvency of the concern would expose to.
• The changes in retained earnings, reserves, and surpluses will indicate the trend in the 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 the profitability of the concern.

Common-size Financial Statements:

Common-size Financial Statements are those in which figures reported stand converted into percentages to some common base. In the Income Statement, the sale figure assumes to be 100 and all figures stand expressed as a percentage of sales. Similarly, in the Balance sheet, the total of assets or liabilities stands taken as 100 and all the figures stand expressed as a percentage of this total.

Common Size Income Statement

In the case of the Income Statement, the sales figure assume to be equal to 100. And all other statistics stand expressed as the percentage of sales. The relationship between items on the Income Statement and the volume of sales is quite significant. Since it would help evaluate the 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 a decline in sales, selling expenses should decrease.

Common Size Balance Sheet

For a common-size Balance Sheet, the total of assets or liabilities takes 100. And all the figures are expressed as a percentage of the total. In other words, each asset stands expressed as the percentage of total assets/liabilities. And each liability exists expressed as the percentage of 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.

Trend Analysis

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 calculate for each item of the financial statement taking the figure of the base year as 100. The starting year stands 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 present in the form of index numbers showing the relative changes 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 compare with industry ratios to know the strong or weak points of concern. These stand calculated only for major items instead of calculating for all items in the financial statements.

While calculating trend percentages, the following precautions may be taken:

• The accounting principles and practices must follow constantly over the period for which the analysis make. This is necessary to maintain consistency and comparability.
• The base year selected should be a normal and representative year.
• Trend percentages should calculate only for those items which have a 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 adjust in light of price level changes as compared to the 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 brings about changes in the cash balance between two balance sheet dates. All the items whether current or non-current that 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 do not shown in a fund flow statement 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 dividends 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 that would be useful in making rational decisions.

The basic objective is to enable the users of the information to predict cash flows in an organization. Since the ultimate success or failure of the business depends upon the amount of cash generated. This objective stands sought to be met by preparing a cash flow statement.

Ratio Analysis

A ratio is a simple arithmetical expression of the relationship of one number to another. According to the Accountant’s Handbook by Wixon, Kelland bedboard, “a ratio” is an expression of the quantitative relationship between two numbers”. In simple language, the ratio of one number is expressed in terms of the other and can work out by dividing one number by the other. This relationship can express 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 throws no light on its adequacy or otherwise. The figure for net profit has to consider other variables. How does it stand for sales? What does it represent by way of return on total assets used or total capital employed?

In case net profits

They show in terms of their relationship with items such as sales, assets, capital employed, and equity capital. And so on, meaningful conclusions can draw 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 analyze and interpret.

The following are the four steps involved in the ratio analysis:

• The selection of relevant data from the financial statements depends 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, 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 the transfer of economic values from one asset or equity to another. The flow of funds stands said to have taken place when any transaction makes changes in the number of funds available before happy the transaction happens the effect of the transaction results in the increase of funds. It calls a source of funds and if it results in the decrease of funds, it knows as an application of funds.

Further, in case the transaction does not change funds, it stands 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 increases working capital. It stands said to be a source of inflow of funds and if it results in a decrease of working capital. It stands said to be an application or outflow of funds.