Last updated on April 11th, 2024 at 01:12 am
In this blog post, we will discuss Financial statements. To be more precise, we will learn about the Tools of Financial Statement Analysis.
For every business, organization, and stakeholder, it is essential to be aware of the business’s financial position. For that, the business’s financial statement is the way to go.
A company’s financial statement reflects its financial position and its operations and management effectiveness. It helps forecast the company’s share price after evaluating its intrinsic value.
That’s where these 3 Tools of Financial Statement Analysis come in. These tools help the stakeholders to understand the financial condition of the company. But before we jump onto the Tools of Financial Statement Analysis, let’s look at financial statements and their objectives.
What Are Financial Statements?
Financial statements are a medium through which the accounting system provides summarized data about the financial position of the business. There are 3 components of financial statements – The income statement, the Balance sheet, and the cash flow statement.
The Income Statement
The income statement informs about all the revenue generated, expenses, losses, and company gains during a specific accounting period. The income statement is also called The Profit & Loss statement. It provides details about the company’s operational efficiency, the quality of management, and underperforming sectors.
The Balance Sheet
The balance sheet details the company’s shareholder’s equity, assets, and liabilities during the specific accounting period. It gives the user an idea about what the company owns and owes.
The Cash Flow Statement
The cash flow statement summarizes the movement of cash and cash equivalents. The main cash activities are from the area of operations, investments, and finance. It helps to understand how well the company manages its cash.
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What is Financial Statement Analysis?
Financial Statement Analysis is the process of analyzing a company’s financial statement. Financial Statement Analysis is performed so that the stakeholders of the company are aware of the performance of the company.
It also details how the company’s share prices are expected to fluctuate. The fluctuation of shares Depends on the intrinsic value of the company. Market forces ensure that the share price is always close to the intrinsic value. These changes occur because the intrinsic value is the company’s real value.
The shares are expected to fall if the intrinsic value is lower than the current price. If the intrinsic value is higher than the current share price, the share price is expected to go up.
In other words, if the intrinsic value is low, time to sell the shares. And if the intrinsic value is higher, it’s time to buy the shares.
Objectives of Tools of Financial Statement Analysis
- The tools of financial statement analysis help us understand the present earning capacity. It also enables us to learn about future earning and profit capability.
- These tools of financial statement analysis provide us with details about the effectiveness of company operations. It becomes the base for both company and stakeholders. It helps to analyze effective and non-effective operational departments.
- We can evaluate the long-term liquidity position of the company with the help of these tools of financial statement analysis.
- It also helps to recognize the short-term and long-term solvency of the firm. This solvency report benifits the trade creditors and debenture holders.
- The tools of financial statement analysis help assess the Financial stability of the concerned area.
- It helps in comparative studies with the help of financial statement analysis. It enables comparative study between firms or departments.
- It helps in forecasting future earnings and the financial position of the company. With the help of tools of financial statement analysis, past earning and financial positions are analyzed, which becomes the base for forecasting.
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Tools of Financial Statement Analysis
Now that we know what Financial statement analysis is let’s see the tools of financial statement analysis.
In essence, there are 3 tools of financial statement analysis that are used. The 3 tools are comparative analysis, common size statement, and ratio analysis.
Comparative Analysis
The first of the tools of financial statement analysis is comparative analysis. It is also called horizontal analysis.
In this method, two or more statements are compared side by side. It shows the growth or decline of the item presented in percentile form. Horizontal analysis is done for Intra-firms comparisons.
Example: Following is the information for XYZ LTD. for 2022 and 2023. Prepare a comparative income statement.
| Particular | 2022 | 2023 |
| Net sales | 3,00,000 | 3,50,000 |
| Cost of goods sold | 2,50,000 | 2,80,000 |
| Administrative expenses | 30,000 | 40,000 |
| Other income | 15,000 | 22,000 |
| Interest | 10,000 | 13,000 |
| Taxes | 17,000 | 18,000 |
Answer :
Particular | 2022 | 2023 | Change | Change in Percentage |
| Net Sales | 3,00,000 | 3,50,000 | 50,000 | 16.66% |
| Less : Cost of goods sold | 2,50,000 | 2,80,000 | 30,000 | 12% |
Gross profit | 50,000 | 70,000 | 20,000 | 40% |
| Less : Admin expenses | 30,000 | 40,000 | 10,000 | 33.33% |
Net operating profit | 20,000 | 30,000 | 10,000 | 50% |
| Add : Other income | 15,000 | 22,000 | 7,000 | 46.66% |
Earning before interest and taxes | 35,000 | 52,000 | 17,000 | 48.57% |
| Less : Interest | 10,000 | 13,000 | 3,000 | 30% |
Earning before Taxes | 25,000 | 39,000 | 14,000 | 56% |
| Less : taxes | 17,000 | 18,000 | 1,000 | 5.88% |
Net profit | 8,000 | 21,000 | 13,000 | 162.5% |
Common Size Statement
The second tool of the 3 tools of financial statement analysis is the common size statement. It is also called vertical analysis.
This method compares the firm’s financial items as a percentile of the base figure. The base is considered 100%, so every item collectively makes up 100%. Vertical analysis is done for both – Intra and Inter-firm comparison.
Example : Prepare a Common size statement for ABC LTD.
| Particulars | Amount |
| Income | |
| Revenue from operations | 2538000 |
| Other Income | 38000 |
| Total Revenue | 2578000 |
| Expenses | |
| Cost of Material Consumed | 1400000 |
| Other Expenses | 500000 |
| Total Expenses | 1900000 |
| Tax | 338000 |
Answer :
Particulars | Absolute Change | % of Revenue from Operations |
| Revenue from operations | 2538000 | 100% |
| Add: Other Income | 38000 | 1.5% |
| Total Revenue | 2576000 | 101.5% |
| Less: Expenses | ||
| Cost of Materials Consumed | 1400000 | 55.16% |
| Other Expenses | 500000 | 19.70% |
| Total Expenses | 1900000 | 74.86% |
Earning before taxes | 676000 | 26.64% |
| Less; Tax | 338000 | 13.32% |
Net Profit | 338000 | 13.32% |
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Ratio Analysis
The last tool from the 3 tools of financial statement analysis is The ratio analysis tool.
Ratio analysis provides a ratio for comparison. This ratio is for selected items from the statement. This ratio is for the two or more financial statements of the firms.
There are a total of 9 types of Ratio analysis methods. These methods are given below :
Limitations of Financial Statement Analysis
Cost Changes
The tools of financial statement analysis do not analyze and consider the cost changes.
Off Record Transactions
The Financial Statement analysis method studies the reports of the company. The transactions happening off the record are not included.
Changes in Accounting Principles
If the company’s accounting techniques changes, Tools of Financial Statement Analysis become obsolete.
Intangible Assets
If the company’s accounting techniques changes, Tools of Financial Statement Analysis become obsolete.
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FAQs
What are the 3 basic tools for financial statement analysis?
The 3 Main Tools of Financial Statement Analysis are Comparative analysis, Common size statement, and Ratio analysis. These are also called as Horizontal analysis, Vertical analysis, and Ratio analysis.
What is basic financial analysis?
Financial Statement Analysis is the process of analyzing a company’s financial statement. Financial Statement Analysis is performed so that the stakeholders of the company are aware of the performance of the company.
Closing Statement
Financial Statement Analysis is an important and useful method for the company and its stakeholders. It helps to forecast the future value of the company share. It also helps the company to evaluate its performance.
Financial Statement Analysis is a method performed by the accounting system. This method is used for Equity research purposes as well.
I hope this blog post about the Tools of Financial Statement Analysis is informative. If you have any questions or suggestions, use the tool below – Comment box, and let me know about it.
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