ANALYSIS OF FINANCIAL STATEMENTS-SELECTIVE TOOLS

Any successful business owner is constantly evaluating the performance of his or her company, comparing it with the company’s historical figures, with its industry competitors, and even with successful businesses from other industries. To complete a thorough examination of your company’s effectiveness, however, you need to look at more than just easily attainable numbers like sales, profits, and total assets. You must be able to read between the lines of your financial statements and make the seemingly inconsequential numbers accessible and comprehensible.

     This massive data overload could seem staggering. Luckily, there are many well-tested ratios out there that make the task a bit less daunting. Comparative ratio analysis helps you identify and quantify your company’s strengths and weaknesses, evaluate its financial position, and understand the risks you may be taking.

     As with any other form of analysis, comparative ratio techniques aren’t definitive and their results shouldn’t be viewed as gospel. Many off-the-balance-sheet factors can play a role in the success or failure of a company. But, when used in concert with various other business evaluation processes, comparative ratios are invaluable.

When performing a ratio analysis of financial statements, it is often helpful to adjust the figures to common-size numbers. To do this, change each line item on a statement to a percentage of the total. For example, on a balance sheet, each figure is shown as a percentage of total assets, and on an income statement, each item is expressed as a percentage of sales.

    This technique is quite useful when you are comparing your business to other businesses or to averages from an entire industry, because differences in size are neutralized by reducing all figures to common-size ratios. Industry statistics are frequently published in common-size form.

     When comparing your company with industry figures, make sure that the financial data for each company reflect comparable price levels, and that it was developed using comparable accounting methods, classification procedures, and valuation bases.

     Such comparisons should be limited to companies engaged in similar business activities. When the financial policies of two companies differ, these differences should be recognized in the evaluation of comparative reports. For example, one company leases its properties while the other purchases such items; one company finances its operations using long-term borrowing while the other relies primarily on funds supplied by stockholders and by earnings. Financial statements for two companies under these circumstances are not wholly comparable.

A financial analyst can adopt the following tools for analysis of the financial statements.  These are also termed as methods of financial analysis.

1.      Comparative Financial Statements:-

 Comparative Financial statements are those statements which have been designed in a way so as to provide time perspective to the consideration of various elements of financial position embodied in such statements. In these statements figures for two or more periods are placed side by side to facilitate comparison.  Both the Income statements and Balance Sheet can be prepared in the form of Comparative Financial Statements.

 Comparative Income Statements:-

The Income statement discloses net profit or net loss on  account of operations.  A comparative income statements will show the absolute figures for two or more periods, the absolute change from one period to another and if desired the change in terms of percentages.  Since, the figures for two or more periods are shown side by side; the reader can quickly ascertain whether sales have increased or decreased, whether cost of sales has increased or decreased etc. thus, only a reading of data included in comparative income statements will be helpful in deriving meaningful conclusions.

Comparative Balance Sheet:-

  Comparative Balance Sheet as on two or more different dates can be used for comparing assets and liabilities and finding out any increase or decrease in those items.  Thus, while in a single balance sheet the emphasis is on present position, it is on change in the comparative balance sheet.  Such a balance sheet is very useful in sty dying the trends in an enterprise.

 2.Common-size Financial Statements:-Common-size Financial Statements are those in which figures reported are converted into percentages to some common base.  In the income statements the sale figure is assumed to be 100 and all figures are expressed as a percentage of sales.  Similarly in the balance sheet the total of assets or liabilities is taken us 100 and all the figures are expressed as a percentage of this total.

3.Trend Percentages:-

  Trend Percentage is immensely helpful in making a comparative study of the financial statements for several years.  The methods of calculating trend percentages involve the calculation of percentage relationship that each item bears to the same item in the base year.  Any year may be taken as the base year.  It is usually the earliest year.  Any intervening year may also be taken as the base year.  Each item of base year is taken as 100 and on the basic the percentages for each of the items of     each of the years are calculated.  These percentages can also be taken as index numbers showing relative changes in the financial data resulting with the passage of time.

 4. Ratio Analysis:- This is the most important tool available to financial analysts for their work.  An accounting ratio shows the relationship in mathematical terms between two interrelated accounting figures.  These figures have to be interrelated because no useful purpose will be served if ratios are calculated between two figures which are not at all related to each other.

The above mentioned are selective financial tools which can be employed by the analyst to do homework for the financial statement review and hence appraise the strength of the company.