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.
There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.
Tools and Techniques of Financial Statement Analysis:
Following are the most important tools and techniques of financial statement analysis:
Horizontal and Vertical Analysis
Ratios Analysis
1. Horizontal and Vertical Analysis:
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.
Trend Percentage:
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
Vertical Analysis:
Vertical analysis 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.
2. Ratios Analysis:
Accounting Ratios Definition, Advantages, Classification and Limitations:
The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another.
Profitability Ratios:
Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under:
Gross profit ratio
Net profit ratio
Operating ratio
Expense ratio
Return on shareholders investment or net worth
Return on equity capital
Return on capital employed (ROCE) Ratio
Dividend yield ratio
Dividend payout ratio
Earnings Per Share (EPS) Ratio
Price earning ratio
Liquidity Ratios:
Liquidity ratios 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. Following are the most important liquidity ratios.
Current ratio
Liquid / Acid test / Quick ratio
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. Following are the most important activity ratios:
Inventory / Stock turnover ratio
Debtors / Receivables turnover ratio
Average collection period
Creditors / Payable turnover ratio
Working capital turnover ratio
Fixed assets turnover ratio
Over and under trading
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. Following are some of the most important long term solvency or leverage ratios.
Debt-to-equity ratio
Proprietary or Equity ratio
Ratio of fixed assets to shareholders funds
Ratio of current assets to shareholders funds
Interest coverage ratio
Capital gearing ratio
Over and under capitalization
Financial-Accounting- Ratios Formulas:
A collection of financial ratios formulas which can help you calculate financial ratios in a given problem
Limitations of Financial Statement Analysis:
Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.
Advantages of Financial Statement Analysis:
There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.
There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.
Tools and Techniques of Financial Statement Analysis:
Following are the most important tools and techniques of financial statement analysis:
Horizontal and Vertical Analysis
Ratios Analysis
1. Horizontal and Vertical Analysis:
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.
Trend Percentage:
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
Vertical Analysis:
Vertical analysis 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.
2. Ratios Analysis:
Accounting Ratios Definition, Advantages, Classification and Limitations:
The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another.
Profitability Ratios:
Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under:
Gross profit ratio
Net profit ratio
Operating ratio
Expense ratio
Return on shareholders investment or net worth
Return on equity capital
Return on capital employed (ROCE) Ratio
Dividend yield ratio
Dividend payout ratio
Earnings Per Share (EPS) Ratio
Price earning ratio
Liquidity Ratios:
Liquidity ratios 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. Following are the most important liquidity ratios.
Current ratio
Liquid / Acid test / Quick ratio
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. Following are the most important activity ratios:
Inventory / Stock turnover ratio
Debtors / Receivables turnover ratio
Average collection period
Creditors / Payable turnover ratio
Working capital turnover ratio
Fixed assets turnover ratio
Over and under trading
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. Following are some of the most important long term solvency or leverage ratios.
Debt-to-equity ratio
Proprietary or Equity ratio
Ratio of fixed assets to shareholders funds
Ratio of current assets to shareholders funds
Interest coverage ratio
Capital gearing ratio
Over and under capitalization
Financial-Accounting- Ratios Formulas:
A collection of financial ratios formulas which can help you calculate financial ratios in a given problem
Limitations of Financial Statement Analysis:
Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.
Advantages of Financial Statement Analysis:
There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.
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