Accountancy · Ch 8 — Analysis of Financial Statements
Tools of Analysis of Financial Statements
Tools of Analysis of Financial Statements
The purpose of financial statement analysis is to turn raw accounting data into meaningful insights. To do this, analysts use a set of standard tools. Each tool looks at the data from a different angle — some compare across time, some compare across companies, and some focus on relationships within a single period.
The textbook lists five main tools. The first three are covered in this chapter; the last two are dealt with in separate chapters.
1. Comparative Statements
A comparative statement places the financial data of two or more periods side by side. This lets you see the absolute change (in rupees) and the percentage change from one period to the next. The idea is to spot trends — is profit growing? Are debts rising faster than assets?
These statements are prepared for the two main financial statements:
- Comparative Balance Sheet
- Comparative Statement of Profit and Loss
For the comparison to be valid, the same accounting principles must be used in all periods being compared. If there has been a change in accounting policy, that deviation must be clearly disclosed as a footnote. Without this, the comparison is misleading.
Because this technique looks across time horizontally (from one year to the next), it is also called horizontal analysis.
2. Common Size Statements
A common size statement converts each item in a financial statement into a percentage of a common base figure. This removes the effect of size, making it possible to compare:
- A company's performance across different years (intra-firm comparison)
- Two companies of very different sizes in the same industry (inter-firm comparison)
The common base is:
- For the Statement of Profit and Loss: Revenue from Operations is taken as 100%. Every other item (cost of materials, employee benefit expense, other expenses, etc.) is expressed as a percentage of revenue.
- For the Balance Sheet: Total Assets (or Total Equity and Liabilities) is taken as 100%. Every asset and every liability item is expressed as a percentage of this total.
Because this technique looks at the relationship of items within a single period (vertically down the statement), it is also called vertical analysis.
3. Trend Analysis
Trend analysis studies data over a series of years — often five or more — to observe the direction and rate of change. It answers the question: is a particular figure rising, falling, or staying constant over the long run?
The method is to pick a base year (usually the earliest year in the series). The value of each item in the base year is set at 100. For every subsequent year, the value of that same item is expressed as a percentage of the base year value.
Trend Percentage = (Current Year Value / Base Year Value) × 100
A trend percentage of 150 means the figure has grown by 50% since the base year. A trend percentage of 80 means it has fallen by 20%.
The value of trend analysis is its long-run view. A single year's dip in profit might be a temporary blip, but a steady five-year decline in the gross profit ratio points to a fundamental problem — perhaps rising input costs or falling selling prices. It helps detect basic changes in the nature of the business and signals whether management is performing well or poorly.
4. Ratio Analysis
Ratio analysis describes the significant relationship between two items (or groups of items) from the balance sheet and/or the statement of profit and loss. It measures the comparative significance of individual items. Through ratios, an analyst can assess:
- Profitability (e.g., net profit ratio, return on capital employed)
- Solvency (e.g., debt-equity ratio, interest coverage ratio)
- Efficiency (e.g., inventory turnover ratio, trade receivables turnover ratio)
This technique is covered in detail in Chapter 5.