In this article we will discuss about the three important tools of financial analysis.
1. Comparative Financial Statement:
The preparation of comparative financial and operating statement is an important device of horizontal financial analysis. As their very name suggests, comparative financial statements are statements of the financial position of a business so designed as to provide time perspective to the consideration of various elements of financial position embodied in such statements.
Generally, Balance Sheet and Income Statement which alone are prepared in a comparative form because they are the most important statements of financial position. In these statements figures for two or more periods are placed side by side to facilitate comparison.
These statements render comparison between two periods of time and exhibit the magnitude and direction of historical changes in the operating results and financial status of a business.
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Financial statements of two or more firms may also be compared for drawing inferences. This is known as inter-firm comparison. The statement also provides for columns to indicate the change from one year to another in absolute terms and also in percentage form.
The following illustrations make a clear understanding:
Illustration 1:
From the following Profit and Loss Account and Balance Sheet of Ramco Ltd. for the year ended 2003 and 2004, you are required to prepare a comparative income statement and a comparative Balance Sheet.
The above statement shows that though the sales have gone up in 2004, the rate of gross profit remains at 25%. The cost of goods sold and its percentage remains at 75%. Administrative expenses remain the same, but selling expenses have been increased. This is due to the increase in sales. The rate of net profit is also increased.
2. Common Size Statement:
Financial statements when read with absolute figures are not easily understandable. They are even misleading. Each item of assets is converted into percentage to Total Assets and each item of Capital and Liabilities is expressed to Total Liabilities and Capital Fund. Thus the whole Balance Sheet is converted into percentage form. Such converted Balance Sheet is known as Common-Size Balance Sheet.
When Balance Sheets of the same concern for several years or when Balance Sheets of two or more than two concerns for the same year are converted into percentage form and presented as such, they are known as Comparative Common-Size Balance Sheets.
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Again, in Profit and Loss Account Sales figure is assumed to be equal to 100 and all other figures are expressed as percentage to sales. Similarly, in Balance Sheet the total of assets or liabilities is taken as 100 and all the figures are expressed as percentage of the total.
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Illustration 2:
From the following Balance Sheet, prepare a Common-size statement:
Illustration 3:
The summary of Balance Sheet data in respect of A Ltd. and B Ltd. is as under:
3. Trend Analysis:
The Comparative and Common-size statements suffer from a major limitation i.e., absence of a basic standard to indicate whether the proportion of an item is normal or abnormal. Trend analysis overcomes this limitation. This method is also an important and useful technique of financial statement analysis.
The calculation of trend ratio involves the ascertainment of arithmetical relationship which each item of several years to the same item of base year. Thus, one particular year out of many years is taken as base. The value of one particular item out of several items shown in the financial statements are converted into ratio or percentage taking that item in base year as equal to 100.
Illustration 4:
From the following data relating to the purchases of a firm, prepare Trend Percentages and Trend Ratios.
