Methods and Approaches for Financial Statement Analysis
Financial statement analysis involves the examination and interpretation of various components of an enterprise's financial statements, such as assets, liabilities, equity, revenues, expenses, profits, and cash flows. While these statements may not be easily understood by external users at first glance, their true value and meaning come to light when analyzed in conjunction with other financial statements from the same enterprise for previous periods, or when compared to similar enterprises within the industry. Several tools and techniques are commonly employed for conducting financial statement analysis:
1. Comparative Statements:
Comparative Statements, also known as Comparative Financial Statements or Horizontal Analysis, involve the side-by-side comparison of individual items or components of financial statements, such as the Balance Sheet and Statement of Profit and Loss, for two or more years within the same enterprise. This analysis presents the absolute and percentage changes in amounts, facilitating a meaningful comparison. It can be used for both intra-firm analysis (comparing actual values of one period with those of another for the same firm) and inter-firm analysis (comparing actual values with those of similar enterprises).
Read more: MEANING OF FINANCIAL STATEMENTS
2. Common-size Statements:
Common-size Statements, or Vertical Analysis, entail presenting individual items of financial statements from multiple years side by side and converting them into percentages using a common base. For example, the Total Assets or Total Equity and Liabilities are taken as 100 for Common-size Balance Sheets, while Revenue from Operations (Net Sales) is taken as 100 for Common-size Statements of Profit and Loss. This technique helps in identifying trends and proportionate changes in financial items over time.
3. Ratio Analysis:
Ratio Analysis involves the calculation of various accounting ratios, which are arithmetical expressions of the relationship between two related or interdependent components of financial statements within a specific accounting period. These ratios aid in evaluating the profitability, solvency, liquidity, and efficiency of an enterprise. Ratio Analysis is an essential tool for interpreting financial statements and gaining insights into a company's financial health.
4. Cash Flow Statement:
The Cash Flow Statement is a crucial financial statement that illustrates the flow of Cash and Cash Equivalents during an accounting period, categorized under Operating Activities, Investing Activities, and Financing Activities. This statement reveals the sources from which cash is generated and the purposes for which it is used. Additionally, it shows changes in the cash position from one period to another, providing valuable insights into an enterprise's cash flow management.
By using these tools and techniques of financial statement analysis, analysts and stakeholders can gain a comprehensive understanding of a company's financial performance, stability, and overall health.
