Tools of Financial Analysis
Financial analysis tools are different ways or methods of evaluating and interpreting company’s financial statements for different purposes like planning, investment and performance where some of the most used financial tools based on their usage and requirement are common size statement (vertical analysis), comparative financial statements (comparison of financial statements), ratio analysis (quantitative analysis), cash flow analysis and trend analysis.
When an analyst, business executive, or student is dealing with a financial issue or wishes to understand the financial implications and economic trade-offs involved in decisions about business investment, operations, or financing, a wide variety of analytical techniques—and sometimes rules of thumb—is available to generate quantitative answers. To choose the appropriate tools from the available alternatives is clearly an important aspect of the analytical task.
Top 4 Most common financial analysis tools are –
Let us discuss each tool one by one in detail
Top 4 Financial Analysis Tools
Let’s evaluate different tools used for analysis:
#1 – Common Size Statements
This is the first financial analysis tool. In the market, companies of different sizes and structures are available. In order to make them comparable, their financial statement must be prepared in absolute format, which brings all the particulars at one level. The globally acceptable format to disclose the financials for comparison is to bring in data in a percentage format. The organization will prepare main financial statements like Common size Balance sheet, Common size Income statement, and Common Size Cash flow statement.
For example, in the balance sheet- the base of total asset, in income statement- the base of net sales and in cash flow statement – a base of total cash flows can be taken and all the line items will be disclosed in percentage form, which can be adequately used for doing internal analysis or for doing external analysis with peers group.
#2 – Comparative Financial Statement
Comparative financial statements are used in horizontal analysis or trend analysis. It helps in analyzing the periodic change in various components of the financial statements and displays which component has the maximum impact.
Such comparative financial statements can be either prepared in currency amount terms or in percentage terms.
Thus from the above one can easily compare the periodic data either in numeric format or in percentage terms.
The comparative financial statement has advantages like easy comparability, observing the trend, periodic performance evaluation, etc. However, it has disadvantages like ignoring inflationary impact, high dependability on financial information, which can be manipulated, a different method of accounting used by different entities, etc.
#3 – Ratio Analysis
Ratio Analysis is the most commonly used financial analysis tool used in the market by an analyst, experts, internal Financial Planning & Analysis department, and other stakeholders. Ratio Analysis has various kinds of ratios, which can help in commenting on
- Profitability Ratio Formula
- Rate of Return Analysis
- Solvency Ratios
- Coverage of Interest or any cost
- Comparing any component with turnover
Moreover, an entity based on their requirement can prepare the ratios for their analysis and try to manage the operations.
However, below are the odd side of ratio analysis:
- Highly relying on past information
- Inflation impact is ignored
- Chances of manipulation/window dressing of financials, which can enhance the fairness of ratios
- Any seasonal changes, based on the nature of business will be ignored, as it cannot be directly adjusted in financials
Learn more from these Top 28 Financial Ratios with Formulas
#4 – Benchmarking
Benchmarking is the process of comparing the actuals with the targets set out by the top management. Benchmarking also refers to the comparison made with the best practices and strives to achieve the same keeping the same as the target. In benchmarking below steps are to be performed:
- Step 1: Select the area which is needed to be optimized.
- Step 2: Identify the trigger points with which it can be compared.
- Step 3: Try to set up the better standard for the same or take industrial standards as the benchmark.
- Step 4: Evaluate the periodic performance and measure the trigger points.
- Step 5: Check whether the same is achieved or not, if not do variance analysis.
- Step 6: If achieved, then strive to set up the better benchmark.
For doing the above benchmarking, ratios, operating margin matrix, etc can be used. The operating margin of industry average can be compared and should try to arrive at a better position. The company named Xerox, in order to sustain itself in the photocopy business, initiated Benchmarking. Presently, they have optimized more than 100 functions in comparison to industrial standards. Benchmarking can be observed as a tool for improvement with the aim of customer-focused improvement activities and should be driven by customer and internal organization needs. Benchmarking is the practice of being humble enough to admit that someone else is better at something and wise enough to learn how to match and even surpass them.
There are numerous tools available in the market to carry out the financial analysis based on the various needs. In addition, organizations based on their need, also build up various in-house tools, which help them to track their requirements. In today’s competitive world, it is of utmost importance to track the performance of its own organization, as well as of the competitor as it will help in maintaining the performance and help in thriving the business.
This has been a guide to Financial Analysis Tools. Here we discuss the top 4 financial analysis tools including common size, comparative statements, ratio analysis, and benchmarking along with examples. You may learn more about Financial Statement Analysis from the following articles –