The analysis of financial
statements involves gaining an understanding of the financial situation of an
organization by reviewing the organization’s financial statements. You can use
three key financial statements – Income statement, Balance sheet and statement
of cash flows. Analysis of these financial statements is often reported to the
board of directors and senior management. They use this information as input in
their decision-making process. External parties such as regulatory bodies and
investors also use this analysis for gaining insight into the organization.
Comparative Statements
Also known as ‘horizontal analysis, are financial
statements showing financial position & profitability at different
periods of time. These statements give an idea of the enterprise financial
position of two or more periods. Comparison of financial statements is possible
only when same accounting principles are used in preparing these statements.
Comparative Balance Sheet
The progress of the company can
be seen by observing the different assets and liabilities of
the firm on different dates to make the comparison of balances from one date to
another. To understand the comparative balance sheets. A third column is used to show increases/decrease in
figures. The fourth column gives percentages of increases or decreases.
By comparing the
balance sheets of different dates, one can observe the following aspects
·
Current financial position and Liquidity position
·
Long-term financial position
·
Profitability of the concern
It is broken into three parts to include a company’s assets, liabilities, and shareholders' equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency. Liabilities include its expense arrangements and the debt capital it is paying off. Shareholder’s equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance with assets minus liabilities equaling shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value. This value is an important performance metric that increases or decreases with the financial activities of a company.
Comparative Income Statement
Traditionally
known as trading and profit and loss A/c. Net sales, cost of goods sold,
selling expenses, office expenses etc are important components of an income
statement. To compare the profitability, particulars of profit
& loss are compared with the corresponding figures of previous
years individually. To analyze the profitability of the business, the
changes in money value and percentage is determined. The income statement is broken into three parts which help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit which subtracts indirect expenses such as marketing costs, general costs, and depreciation. Finally it ends with net profit which deducts interest and taxes. By comparing the profits
of different dates, one can observe the following aspects:
·
The increase/decrease in gross profit.
·
The study of operational profits.
·
The increase or decrease in net profit
·
Study of the overall profitability of the business.
Common Size Statements
Common size
statements are also known as ‘Vertical analysis’. Financial
statements, when read with absolute figures, can be misleading. Therefore, a
vertical analysis of financial information is done by considering the
percentage form. The balance sheet items are compared:
to the total
assets in terms of percentage by taking the total assets as 100.
·
to the total liabilities in terms of percentage by
taking the total liabilities as 100.
Therefore the
whole Balance Sheet is converted into percentage form. And such converted
Balance Sheet is known as Common-Size Balance Sheet. Similarly
profit
& loss items are compared:
·
to the total incomes in terms of percentage by taking
the total incomes as 100.
·
to the total expenses in terms of percentage by taking
the total expenses as 100.
Therefore the
whole Profit & loss account is converted into percentage form. And such
converted profit & loss account is known as Common-Size Profit & Loss
account. As the numbers are brought to a common base, the percentage
can be easily compared with the results of corresponding percentages of the
previous year or of some other firms.
Trend Analysis
Also known as the
Pyramid Method. Studying the operational results and financial position
over a series of years is trend analysis. Calculations of
ratios of different items for various periods is done & then compared under
this analysis. Whether the enterprise is trending upward or backward, the
analysis of the ratios over a period of years is done. By observing this
analysis, the sign of good or poor management is detected.
Ratio
Analysis
Quantitative
analysis of information contained in a company’s financial statements is ratio
analysis. It describes the significant relationship which exists between
various items of a balance sheet and a statement of profit and loss of a firm. To
assess the profitability, solvency, and efficiency of a business, management
can go through the technique of ratio analysis. It is an attempt at developing
a meaningful relationship between individual items (or group of items) in the balance sheet or profit
and loss account.
Below is a breakdown of some of the most common ratio metrics:
Balance sheet: asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity
Income statement: gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage
Cash Flow: Cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per share basis.
Cash Flow Analysis
The actual
movement of cash into and out of a business is cash flow analysis. The
flow of cash into the business is called the cash inflow. Similarly, the flow
of cash out of the firm is called cash outflow. The difference between
the inflow and outflow of cash is the net cash flow. Cash flow
statement is prepared to project the manner in which the cash has been received
and has been utilized during an accounting year. It is an important analytical
tool. Analysis of cash flow explains the reason for a change in cash. It helps
in assessing the liquidity of the enterprise and in evaluating the operating,
investment & financing decisions.
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