FINANCIAL STATEMENT ANALYSIS
Lesson 2
TECHNIQUES AND TOOLS OF FINANCIAL STATEMENT ANALYSIS
Learning objectives
At the end of the lesson participants should be able to;
Identify the components and contents of financial statements
Explain the applicability of various tools used in analyzing financial statements
Explain the importance of comparative financial statements
Lecture outline
Introduction financial statements analysis
Different techniques of analyzing financial statements
Comparative financial statements
Horizontal or trend analysis
Common size financial statements
2.1 Introduction
Financial statements give complete information about assets, liabilities, equity, reserves, expenses
and profit and loss of an enterprise. They are not readily understandable to interested parties like
creditors, shareholders, investors etc. Thus, various techniques are employed for analyzing and
interpreting the financial statements. Techniques of analysis of financial statements are mainly
classified into three categories:
(i) Cross-sectional analysis
It is also known as inter firm comparison. This analysis helps in analyzing financial characteristics
of an enterprise with financial characteristics of another similar enterprise in that accounting
period. For example, if company A has earned 15% profit on capital invested. This does not say
whether it is adequate or not. If we analyze further and find that a similar company has earned
16% during the same period, then only we can make a conclusion that company B is better. Thus,
it turns into a meaningful analysis.
(ii) Time series analysis
It is also called as intra-firm comparison. According to this method, the relationship between
different items of financial statement is established, comparisons are made and results obtained.
The basis of comparison may be:
– Comparison of the financial statements of different years of the same business unit.
– Comparison of financial statement of a particular year of different business units.
12
, FINANCIAL STATEMENT ANALYSIS
(iii) Cross-sectional cum time series analysis
This analysis is intended to compare the financial characteristics of two or more enterprises for a
defined accounting period. It is possible to extend such a comparison over the year. This approach
is most effective in analyzing of financial statements. The analysis and interpretation of financial
statements is used to determine the financial position. A number of tools or methods or devices
are used to study the relationship between financial statements. However, the following are the
important tools which are commonly used for analyzing and interpreting financial statements:
Comparative financial statements
Trend analysis
Common size statements
Ratio analysis
2.2 Comparative Financial Statements
In brief, comparative study of financial statements is the comparison of the financial statements
of the business with the previous year’s financial statements. It enables identification of weak
points and applying corrective measures. Practically, two financial statements (balance sheet and
income statement) are prepared in comparative form for analysis purposes.
1. Comparative Balance Sheet
The comparative balance sheet shows the different assets and liabilities of the firm on different
dates to make comparison of balances from one date to another. The comparative balance sheet
has two columns for the data of original balance sheets. A third column is used to show change
(increase/decrease) in figures. The fourth column may be added for giving percentages of
increase or decrease. While interpreting comparative Balance sheet the interpreter is expected to
study the following aspects:
i. Current financial position and Liquidity position- For studying current financial
position or liquidity position of a concern one should examine the working capital in
both the years. Working capital is the excess of current assets over current liabilities.
ii. Long-term financial position- For studying the long-term financial position of the
concern, one should examine the changes in fixed assets, long-term liabilities and
capital.
iii. Profitability of the concern- The next aspect to be studied in a comparative balance
sheet is the profitability of the concern. The study of increase or decrease in profit will
help the interpreter to observe whether the profitability has improved or not.
After studying various assets and liabilities, an opinion should be formed about the financial
position of the concern.
13
Lesson 2
TECHNIQUES AND TOOLS OF FINANCIAL STATEMENT ANALYSIS
Learning objectives
At the end of the lesson participants should be able to;
Identify the components and contents of financial statements
Explain the applicability of various tools used in analyzing financial statements
Explain the importance of comparative financial statements
Lecture outline
Introduction financial statements analysis
Different techniques of analyzing financial statements
Comparative financial statements
Horizontal or trend analysis
Common size financial statements
2.1 Introduction
Financial statements give complete information about assets, liabilities, equity, reserves, expenses
and profit and loss of an enterprise. They are not readily understandable to interested parties like
creditors, shareholders, investors etc. Thus, various techniques are employed for analyzing and
interpreting the financial statements. Techniques of analysis of financial statements are mainly
classified into three categories:
(i) Cross-sectional analysis
It is also known as inter firm comparison. This analysis helps in analyzing financial characteristics
of an enterprise with financial characteristics of another similar enterprise in that accounting
period. For example, if company A has earned 15% profit on capital invested. This does not say
whether it is adequate or not. If we analyze further and find that a similar company has earned
16% during the same period, then only we can make a conclusion that company B is better. Thus,
it turns into a meaningful analysis.
(ii) Time series analysis
It is also called as intra-firm comparison. According to this method, the relationship between
different items of financial statement is established, comparisons are made and results obtained.
The basis of comparison may be:
– Comparison of the financial statements of different years of the same business unit.
– Comparison of financial statement of a particular year of different business units.
12
, FINANCIAL STATEMENT ANALYSIS
(iii) Cross-sectional cum time series analysis
This analysis is intended to compare the financial characteristics of two or more enterprises for a
defined accounting period. It is possible to extend such a comparison over the year. This approach
is most effective in analyzing of financial statements. The analysis and interpretation of financial
statements is used to determine the financial position. A number of tools or methods or devices
are used to study the relationship between financial statements. However, the following are the
important tools which are commonly used for analyzing and interpreting financial statements:
Comparative financial statements
Trend analysis
Common size statements
Ratio analysis
2.2 Comparative Financial Statements
In brief, comparative study of financial statements is the comparison of the financial statements
of the business with the previous year’s financial statements. It enables identification of weak
points and applying corrective measures. Practically, two financial statements (balance sheet and
income statement) are prepared in comparative form for analysis purposes.
1. Comparative Balance Sheet
The comparative balance sheet shows the different assets and liabilities of the firm on different
dates to make comparison of balances from one date to another. The comparative balance sheet
has two columns for the data of original balance sheets. A third column is used to show change
(increase/decrease) in figures. The fourth column may be added for giving percentages of
increase or decrease. While interpreting comparative Balance sheet the interpreter is expected to
study the following aspects:
i. Current financial position and Liquidity position- For studying current financial
position or liquidity position of a concern one should examine the working capital in
both the years. Working capital is the excess of current assets over current liabilities.
ii. Long-term financial position- For studying the long-term financial position of the
concern, one should examine the changes in fixed assets, long-term liabilities and
capital.
iii. Profitability of the concern- The next aspect to be studied in a comparative balance
sheet is the profitability of the concern. The study of increase or decrease in profit will
help the interpreter to observe whether the profitability has improved or not.
After studying various assets and liabilities, an opinion should be formed about the financial
position of the concern.
13
