Analysis of Financial Statements

Analysis of Financial Statements:
Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. Financial Statement Analysis help business owners and other interested people to analyze the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.

Tools and Techniques of Analysis of Financial Statements:
The commonly used tools used for financial statement analysis are:
1. Financial ratio analysis
2. Comparative financial statement analysis

1. Financial Ratio analysis: Financial ratio analysis involves calculating and analyzing ratios that use data from one, two or more financial statements. Ratio analysis also expresses relationships between different financial statements. Financial Ratios can be classified into 4 main categories:

• Profitability ratios: Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm.
• Liquidity or Short-Term Solvency ratios: These are the ratios which measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm’s ability to meet its current obligations.
• Asset Management or Activity Ratios: Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales.
• Long Term Solvency or Leverage Ratios: Long term solvency or leverage ratios convey a firm’s ability to meet the interest costs and payment schedules of its long term obligations.

2. Comparative financial statement analysis: In comparative financial statement analysis, two or more balance sheet and/or the income statement of a firm are presented simultaneously in columnar form. The comparative financial statement analysis is prepared to show:

• The absolute amount of different items in monetary terms
• The percentage of periodic changes to reveal the proportionate changes
• The amount of periodic changes in monetary terms.

a) Horizontal Analysis or Trend Analysis: Comparison of two or more year’s financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form.
Horizontal analysis of  financial statements can also be carried out by computing trend percentages. Trend percentage states several years’ financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base.

b) Vertical analysis: It is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements.