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Techniques of Financial Statement Analysis

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Techniques of Financial Statement Analysis

Techniques of Financial Statement Analysis

Financial statement analysis is interpreted mainly to determine the financial and operational performance of the business concern. A number of methods or techniques are used to analyze the financial statement of the business concern. The following are the common methods or techniques, which are widely used by the business concern.

Techniques of Financial Statement AnalysisFig. 1   Techniques of Financial Statement Analysis

IMPORTANCE OF FINANCIAL MANAGEMENT

  1. Comparative Statement Analysis
    1. Comparative Income Statement Analysis
    2. Comparative Position Statement Analysis
  2. Trend Analysis
  3. Common Size Analysis
  4. Fund Flow Statement
  5. Cash Flow Statement
  6. Ratio Analysis

Comparative Statement Analysis

Comparative statement analysis is an analysis of financial statements at different periods of time. This statement helps to understand the comparative position of financial and operational performance at different periods of time.

Comparative financial statements again classified into two major parts such as comparative balance sheet analysis and comparative profit and loss account analysis.

Comparative Balance Sheet Analysis

Comparative balance sheet analysis concentrates only on the balance sheet of the concern at different periods of time. Under this analysis, the balance sheets are compared with the previous year’s figures or one-year balance sheet figures are compared with other years. A comparative balance sheet analysis may be a horizontal or vertical basis. This type of analysis helps to understand the real financial position of the concern as well as how the assets, liabilities, and capitals are placed during a particular period.

Comparative Profit and Loss Account Analysis

Another comparative financial statement analysis is comparative profit and loss account analysis. Under this analysis, only the profit and loss account is taken to compare with the previous year’s figure or compare within the statement. This analysis helps to understand the operational performance of the business concern in a given period. It may be analyzed on a horizontal basis or vertical basis.

Trend Analysis

The financial statements may be analyzed by computing trends of series of information. It may be upward or downward directions which involve the percentage relationship of each and every item of the statement with the common value of 100%. Trend analysis helps to understand the trend relationship with various items, which appear in the financial statements. These percentages may also be taken as index numbers showing relative changes in the financial information resulting from the various period of time. In this analysis, only major items are considered for calculating the trend percentage.

Common Size Analysis

Another important financial statement analysis techniques are a common size analysis in which figures reported are converted into a percentage to some common base. In the balance sheet, the total assets figures are assumed to be 100 and all figures are expressed as a percentage of this total. It is one of the simplest methods of financial statement analysis, which reflects the relationship between each and every item with the base value of 100%.

FUNDS FLOW STATEMENT

Funds flow statement is one of the important tools, which is used in many ways. It helps to understand the changes in the financial position of a business enterprise between the beginning and ending financial statement dates. It is also called a statement of sources and uses of funds.

Institute of Cost and Works Accounts of India, funds flow statement is defined as “a statement prospective or retrospective, setting out the sources and application of the funds of an enterprise. The purpose of the statement is to indicate clearly the requirement of funds and how they are proposed to be raised and the efficient utilization and application of the same”.

CASH FLOW STATEMENT

The cash flow statement is a statement that shows the sources of cash inflow and uses of cash out-flow of the business concern during a particular period of time.  It is the statement, which involves only a short-term financial position of the business concern. The cash flow statement provides a summary of operating, investment and financing cash flows and reconciles them with changes in its cash and cash equivalents such as marketable securities.

Difference Between Funds Flow and Cash Flow Statement

Funds Flow Statement Cash Flow Statement
  1. Funds flow statement is the report on the movement of funds or working capital
  2. Funds flow statement explains how working capital is raised and used during the particular
  3. The main objective of the fund flow statement is to show how the resources have been balanced mobilized and used.
  4. Funds flow statement indicates the results of current financial management.
  5. In a fund flow statement increase or decrease in working capital is recorded.
  6. In the fund’s flow statement there is no opening and closing balances
  1. The cash flow statement is the report showing sources and uses of cash.
  2. The cash flow statement explains the inflow and outflow of cash during a particular period.
  3. The main objective of the cash flow statement is to show the causes of changes in cash between two balance sheet dates.
  4. The cash flow statement indicates the factors contributing to the reduction of cash balance in spite of the increase in profit and vice-versa.
  5. In a cash flow statement, only cash receipts and payments are recorded.
  6. The cash flow statement starts with opening cash balance and ends with closing cash balance.

 

RATIO ANALYSIS

Ratio analysis is a commonly used tool for financial statement analysis. The ratio is a mathematical relationship between one number to another number. The ratio is used as an index for evaluating the financial performance of the business concern. An accounting ratio shows the mathematical relationship between two figures, which have a meaningful relationship with each other.  The ratio can be classified into various types.  Classification from the point of view of financial management is as follows:

  • Liquidity Ratio
  • Activity Ratio
  • Solvency Ratio
  • Profitability Ratio

Liquidity Ratio

It is also called a short-term ratio.  This ratio helps to understand the liquidity in a business which is the potential ability to meet current obligations.  This ratio expresses the relationship between current assets and current assets of the business concern during a particular period.   The following are the major liquidity ratio:

S. No Ratio Formula Significant Ratio
1 Current Ratio = Current Assets
Current Liability
2: 1
2 Quick Ratio = Quick Assets
Quick / Current
    Liability
1: 1

Activity Ratio

It is also called a turnover ratio. This ratio measures the efficiency of the current assets and liabilities in the business concern during a particular period. This ratio is helpful to understand the performance of the business concern. Some of the activity ratios are given below:

S. No Ratio Formula
1 Stock Turnover Ratio      Cost of Sales
Average Inventory
2 Debtors Turnover Ratio     Credit Sales
Average Debtors
3 Creditors Turnover Ratio   Credit Purchase
average credit
4 Working Capital Turnover Ratio              Sales
Networking capital

Solvency Ratio

It is also called a leverage ratio, which measures the long-term obligation of the business concern. This ratio helps to understand, how long-term funds are used in the business concern.   Some of the solvency ratios are given below:

S. No Ratio Formula
1 Debt-Equity Ratio    External Equity
Internal Equity
2 Proprietary Ratio Shareholder / Shareholder ‘s Fund
Total Assets
3 Interest Coverage Ratio                       EBIT
Fixed Interest Charges

Profitability Ratio

The profitability ratio helps to measure the profitability position of the business concern.  Some of the major profitability ratios are given below.

S. No Ratio Formula
1 Gross Profit Ratio        Gross Profit     X 100
Net Sales
2 Net Profit Ratio              Net Profit after tax       X 100
Net sales
3 Operating Profit Ratio      Operating Net Profit  X 100
Sales
4 Return in Investment     Net Profit after tax  X 100
Shareholder Fund

 

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