Tools and techniques of Financial

Analysis
Financial Analysis is defined as being the process of identifying financial strength and
weakness of a business by establishing relationship between the elements of balance sheet and
income statement. The information pertaining to the financial statements is of great importance
through which interpretation and analysis is made.

It is through the process of financial analysis that the key performance indicators, such
as, liquidity solvency, profitability as well as the efficiency of
operations of a business entity may be ascertained, while short term and long term prospects
of a business may be evaluated.

Thus, identifying the weakness, the intent is to arrive at recommendations as well as forecasts
for the future of a business entity.

Financial analysis focuses on the financial statements, as they are a

disclosure of a financial performance of a business entity. “A Financial
Statement is an organized collection of data according to
logical and consistent accounting procedures. Its purpose is
to convey an understanding of some financial aspects of a
business firm. It may show assets position at a moment
of time as in the case of balance sheet, or may reveal a series
of activities over a given period of times, as in the case of an
income statement.”

Since there is recurring need to evaluate the past performance, present

financial position, the position of liquidity and to assist in forecasting the
future prospects of the organization, various financial statements are to be
examined in order that the forecast on the earnings may be made and the
progress of the company be ascertained.

The financial statements are: Income statement, balance sheet,

statement of earnings, statement of changes in financial position and
the cash flow statement. The income statement, having been termed
as profit and loss account is the most useful financial statement to enlighten
what has happened to the business between the specified time intervals
while showing, revenues, expenses gains and losses. Balance sheet is a
statement which shows the financial position of a business at certain point
of time. The distinction between income statement and the balance sheet is
that the former is for a period and the latter indicates the financial position
on a particular date. However, on the basis of financial statements, the
objective of financial analysis is to draw information to facilitate decision
making, to evaluate the strength and the weakness of a business, to
determine the earning capacity, to provide insights on liquidity, solvency
and profitability and to decide the future prospects of a business entity.

There are various types of Financial analysis. They are briefly mentioned
herein:

External analysis: The external analysis is done on the basis of

published financial statements by those who do not have access to
the accounting information, such as, stock holders, banks, creditors, and the
general public.

Internal Analysis: This type of analysis is done by finance and accounting

department. The objective of such analysis is to provide the information to
the top management, while assisting in the decision making process.

Short term Analysis: It is concerned with the working capital analysis.

It involves the analysis of both current assets and current liabilities, so that
the cash position (liquidity) may be determined.

Horizontal Analysis: The comparative financial statements are an

example of horizontal analysis, as it involves analysis of financial
statements for a number of years. Horizontal analysis is also regarded
as Dynamic Analysis.

Vertical Analysis: it is performed when financial ratios are to be calculated

for one year only. It is also called as static analysis.

An assortment of techniques is employed in analyzing financial statements.

They are: Comparative Financial Statements, statement of changes in
working capital, common size balance sheets and income statements,
trend analysis and ratio analysis.

Comparative Financial Statements: It is an important method of analysis

which is used to make comparison between two financial statements. Being
a technique of horizontal analysis and applicable to both financial
statements, income statement and balance sheet, it provides
meaningful information when compared to the similar data of prior periods.
The comparative statement of income statements enables to review the
operational performance and to draw conclusions, whereas the balance
sheets, presenting a change in the financial position during the period, show
the effects of operations on the assets and liabilities. Thus, the absolute
change from one period to another may be determined.

Statement of Changes in Working Capital: The objective of this analysis

is to extract the information relating to working capital. The amount of net
working capital is determined by deducting the total of current liabilities
from the total of current assets. The statement of changes in working capital
provides the information in relation to working capital between two
financial periods.

Common Size Statements: The figures of financial statements are

converted to percentages. It is performed by taking the total balance sheet
as 100. The balance sheet items are expressed as the ratio of each asset to
total assets and the ratio of each liability to total liabilities. Thus, it shows
the relation of each component to the whole - Hence, the name common
size.

Trend Analysis: It is an important tool of horizontal analysis. Under this

analysis, ratios of different items of the financial statements for various
periods are calculated and the comparison is made accordingly. The analysis
over the prior years indicates the trend or direction. Trend analysis is a
useful tool to know whether the financial health of a business entity is
improving in the course of time or it is deteriorating.

Ratio Analysis: The most popular way to analyze the financial statements
is computing ratios. It is an important and widely used tool of analysis of
financial statements. While developing a meaningful relationship between
the individual items or group of items of balance sheets and income
statements, it highlights the key performance indicators, such as, liquidity,
solvency and profitability of a business entity. The tool of ratio analysis
performs in a way that it makes the process of comprehension of financial
statements simpler, at the same time, it reveals a lot about the changes in the
financial condition of a business entity.

It must be noted that Financial analysis is a continuous process being

applicable to every business to evaluate its past performance and current
financial position. It is useful in various situations to provide managers
the information that is needed for critical decisions. The process of financial
analysis provides the information about the ability of a business entity to
earn income while sustaining both short term and long term growth.

1. Preparation of Comparative Financial Statements:

Comparative Financial Statements refer to the statements of
financial position of a business, which are prepared in such a way as
to provide a time perspective to the various elements embodied in
the financial statements.

These statements include two types of analytical statements. They

are Comparative Balance Sheets and Comparative Income
Statement. In these statements figures are placed side by side for
two or more periods in order to facilitate comparison.

They also facilitate comparison among two or more firms that

belong to the same industry. Comparison may be regarding to
profitability and financial soundness.

Preparation of Comparative Financial Statements:

Comparative statements mainly show the following
information for analytical purposes:
(a) Actual data in absolute money values, as given in the financial
statements for the periods under consideration.

(b) Increases or decreases in various items in money values, and

(c) Increases or decreases in various items in terms of percentages

The following examples would illustrate the method of

preparation of a Comparative Balance Sheet and a
Comparative Income Statement with imaginary figures:
Tentative Conclusions:
Total fixed assets have been added during the year 2002 by Rs.55
lakhs [i.e., about 5%] compared to 2001, for which long-term
investments worth Rs.50 lakhs have been realized. The level of
current assets worth Rs.42 lakhs has been reduced.

Despite the increase in fixed assets, the total assets have been
decreased by Rs.37 lakhs. It implies that the addition to fixed assets
has been partly financed by the sale or reduction of other assets.

Increase in fixed assets and decrease in current assets reflect a poor

financial policy. The relationship between the total current assets
and total current liabilities is not satisfactory.
Increase in the preference share capital of Rs.100 lakhs might have
been due to the fresh issue of shares for the redemption of
debentures. Also, the increase in reserves may represent the
redemption of debentures out of profits.

Comparative Income Statement:

Similar to the Comparative Balance Sheet, the Comparative Income
Statement contains the same columns and supplies the same type of
information.

The Comparative Income Statement explains the relationship

between sales and cost of goods sold and its effect on gross profit.
Increase in selling expenses and office and administration expenses
relating to the increase in sale should not be proportional.

This will indicate clearly the efficiency of operations by showing

changes in absolute figures and also in terms of percentage of the
operating profits from one period to another.

The Companies Act of India insists that companies should give

figures for different items for the previous year together with the
current year’s figures in the Profit and Loss account and Balance
Sheet.
Inferences:
While net sales have increased by 33.33%, the cost of goods sold has
increased by 25%. The percentage of profits has increased by 50%.
The increase in total operating expenses is 25% only, which has
increased the net operating profits by 56.25%. The overall
performance in 2002 is satisfactory compared to 2001.

The main limitation of Comparative Financial Statements is that

they fail to show the changes that have taken place from year to year
in relation to total assets, total liabilities and capital or total net
sales. Common-size Analysis eliminates this limitation.

2. Preparation Common-Size Statements:

Common-size Financial Statements are those statements in which
items reported in the financial statements are converted into
percentages taking some common base. In the Common-size
Income Statement, the net sales are assumed to be 100% and other
items are expressed as a percentage of sales.

Similarly in the Common-size Balance Sheet the total assets or total

liabilities are assumed to be 100% and other items of assets and
liabilities are expressed as a percentage of this total [i.e., 100%].

Common- size statements are also called as “Component

Statements” or “100 per cent Statement” because each statement is
reduced to the total of 100 and each individual item is expressed as
a percentage of this total.

Example:
The preparation of Common-size statement is illustrated
below based on the imaginary figures used in the
examples of Comparative Financial Statements:
Interpretation:
The percentage of fixed assets to total assets increased from 58.83%
in 2001 to 63% in 2002. At the same time the percentage of current
assets decreased from 30.47% to 28.31%. This indicates a poor
current assets management policy.

The value of investments has also decreased from 10.70% to 8.19%,

which may be in order to finance the increase in fixed assets. The
preference share capital has increased from 10.70% to 16.37% and
reserves from 10.69% to 13.64% but at the same time, the long-term
as well as the current liabilities to total liabilities has come down
from 51.87% to 42.72%.

Compared to total current liabilities the total current assets are

inadequate. Hence, the working capital position is not satisfactory.
In general the financial policy of the concern is highly
unsatisfactory.

Interpretation:
The gross profit percentage has increased from 33.33 to 37.50. This
increase is more than proportionate compared to sales. This is
because the increase in cost of goods sold is less than proportional.
Similarly the net profit percentage has also increased from 26.67 to
31.25. In general, the overall operating efficiency of the business is
highly satisfactory.

3. Trend Percentages or Ratios:

Trend Analysis refers to the comparison of past data over a period
of time with that of a base year. Under this method, percentage
relationship that each statement item bears to the same item in the
base year is calculated.

Any year i.e., the earliest year involved in comparison, or the latest
year, or any intervening year, may be taken as the base year. As the
purpose of this analysis is to highlight some important changes, the
trend percentages are calculated only for some important items that
can be connected with each other.

The concerned item in the base year is taken to be equal to as 100

and then based on this, trend percentages for the corresponding
items in other years are calculated.

This method is a horizontal type of analysis of financial statements.

The trend percentages are shown in comparative financial
statements. Trend analysis is a useful tool for the management since
it reduces large amount of absolute data into a simple and easily
readable form. By looking at the trend in a particular ratio one can
see whether the ratio is increasing or decreasing or remaining
constant. From this a problem is unearthed and good management
is observed.

Precautions to be taken:
1. The base year selected should be normal and be truly
representative of all years involved in the analysis.

2. The financial statements used for the analysis must have been
prepared applying consistent accounting principles and practices.

3. The figures of the various accounting statements considered for

the analysis should be adjusted for any price level changes, as
compared to base year, before computing trend percentages.

4. Trend percentages should be studied along with the absolute

figures on which they are based. This will enable us to know
whether the change is significant or not.

For example, one item may increase from Rs.100 to Rs.200 [i.e.,
100% increases] and the other item may change from Rs. 10,000 to
Rs. 14,000 [i.e., 40% increase]. Of these two, the change in the first
item is not significant compared to the second item.

The trend ratios for the assets of a balance sheet are

illustrated below with imaginary figures:

Note:
A separate column for the base year [1999] need not be provided in
the comparative balance sheet.
Interpretation:
From the above statement it is clear that both the fixed assets and
current assets have registered an increasing trend. This is an
indication of the company’s growth over the period.

Similar to this analysis, trend percentages can be computed for the

important items of the liabilities side of the balance sheet and of the
Income Statement.

Illustration 1:

Comment upon the significant changes that have taken place during
the year 2002.
Solution:
Comments:
Individual as well as total current assets have decreased in 2002
when compared to 2001. The total current assets have decreased by
34%. Investments have also decreased by 37%.

Amounts realized from the assets have been mainly used to repay
current liabilities [decrease by 52%] and the balance used for the
purchase of fixed assets. Fixed assets, particularly buildings have
increased significantly by 146% and other assets by 32%.

It is heartening to note that these assets have been funded through

the issue of debentures by 63% and equity and surplus by 65%.
Generally, there is an overall increase in total assets in 2002 over
2001 only by 20%.

Illustration 2:
From the following Income Statements of ABC Ltd.,
prepare a Comparative Income Statement:
Income Statements for the year ending 31st December 2001 and
2002

Solution:
Illustration 3:
Convert the following Income Statement into Common
Size Statement and interpret the changes in 2002 in the
light of conditions in 2001:

Solution:
The analysis of the above income statement enables to
draw the following conclusions:
(a) During the year 2002 the cost of goods sold has declined by
4.5% i.e., from 60.7% to 56.2%. This decline may be due to the
decrease in cost of raw materials. Owing to this decline, the gross
profit ratio has increased from 39.3% to 43.8%.

(b) The operating expenses have declined by 2.3%, which indicates

high operating efficiency and economy in expenditure; both
administrative and selling expenses have declined less than
proportionately despite the increase in these items in absolute
amounts.

(c) The combined effect of decrease in cost of goods sold and

operating expenses has caused for an increase in net operating
income by 6.8% i.e., from 9.3% in 2001 to 16.1% in 2002.

(d) The increase in non-operating income is a welcome feature

while the corresponding increase in non-operating expenses
proportionately is not desirable.
As final conclusion, it may be said that the company has been
operating more efficiently in 2002 as compared to 2001.

Illustration 4:
From the following information, interpret the results of
operations of a manufacturing concern using trend ratios:

Solution:

Conclusions:
From the above statement, it is seen that the sales, cost of goods
sold and operating expenses have declined in 2000 when compared
to base year 1999. But one important point that the decline in sales
is comparatively less than the cost and operating expenses.

On the other hand, the sales, cost and operating expenses have all
increased in 2001 and 2002 as compared tol999. But the increase in
cost and operating expenses is lesser than the increase in sales.

As a conclusion we may infer from these trend ratios that a larger

portion of cost of goods and operating expenses is fixed and they are
not affected by change in sales volume. Because of this, we find that
the net operating profit is more in 2001 and 2002 as compared to
1999.

Illustration 5:
Develop pro-forma income statement for the months of
April, May and June for a company from the following
particulars:
(a) Sales are projected at Rs. 4, 50,000, Rs. 4, 80,000 and Rs. 5,
00,000 for April, May and June respectively.

(b) Cost of goods sold is Rs. 1, 00,000 plus 30% of selling price per
month.

(c) Rent is Rs. 15,000 per month. Administration expenses for April
are expected to be Rs. 1, 20,000 but expected to rise 1% per month
over the previous month’s expenses.

(d) The company has Rs. 6, 00,000 of 8% loan, interest payable

monthly.

(e) Corporate tax rate is 50%.

Solution: