Tools of Financial Analysis
Financial analysis tools are different ways to evaluate and interpret a company’s financial statements for various purposes like planning, investment, and performance. Some of the most used financial tools based on their usage and requirements are common size statements (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 a 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 infrequent rules of thumb is available to generate quantitative answers. Therefore, choosing the appropriate tools from the available alternatives is an important aspect of the analytical task.
The top four most common financial analysis tools are: –
- Common size statementsCommon Size StatementIn a common size financial statement, each element of financial statements are shown as a percentage of another item. For instance, in case of the Balance Sheet assets, liabilities, and share capital are represented as a percentage of total assets. In the case of Income Statement, each element of income and expenditure is defined as a percentage of the total sales.
- Comparative financial statement
- Ratio analysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.
- Benchmarking analysis
Let us discuss each tool one by one in detail.
Table of contents
- Financial analysis tools are the finance tools that help to maintain the company/organization’s financial position through planning, controlling, and analyzing financial business transactions.
- The top four financial analysis tools are common size statements, comparative financial statements, ratio analysis, and benchmarking analysis.
- In today’s competitive world, it is of utmost importance to follow the organization’s performance and the competitor, as it will help maintain and thrive the performance of the business.
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Top 4 Financial Analysis Tools
Let us evaluate different tools used for analysis: –
#1 – Common Size Statements
It is the first financial analysis tool. In the market, companies of various sizes and structures are available. To compare them, one must prepare their financial statement in absolute formats bringing all the particulars. The globally acceptable form to disclose the financials for comparison is to bring data in a percentage format. The organization will prepare main financial statements like financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. like common size balance sheetCommon Size Balance SheetThe term "common size balance sheet" refers to a percentage analysis of balance sheet items based on a common figure, with each item presented as an easy-to-compare percentage. For example, each asset is expressed as a percentage of total assets, and each liability is expressed as a percentage of total liabilities., common size income statementCommon Size Income StatementCommon Size Income Statement is a Company’s financial statement that presents every listed line item as a percentage of total revenue or sales. Moreover, it helps analyze the contribution of every item towards the profitability of the Company. , and common-size cash flow statement.
It will adequately disclose all the items for internal or external analysis with the peer group in percentage form. For example, the balance sheet can consider the base of total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity. The income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. may contemplate the base level of net sales, and the cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business. can depend on the base level of total cash flows.
#2 – Comparative Financial Statement
Comparative financial statements are used in horizontal analysisHorizontal AnalysisHorizontal analysis interprets the change in financial statements over two or more accounting periods based on the historical data. It denotes the percentage change in the same line item of the next accounting period compared to the value of the baseline accounting period. or trend analysisTrend AnalysisTrend analysis is an analysis of the company's trend by comparing its financial statements to analyze the market trend or analysis of the future based on past performance results, and it is an attempt to make the best decisions based on the results of the analysis done.. It helps analyze the periodic change in various components of the financial statementsComponents Of The Financial StatementsThe components of financial statements are the income statement, balance sheet, cash flow statement, and shareholders equity statement, which are the building blocks that together form the statements and help in understanding the financial health of the business. and displays which element has the maximum impact.
One can prepare such financial statements in currency amount terms or percentage terms.
Thus, one can easily compare the periodic data numerically or in percentage terms from the above.
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 that can be manipulated, use of a different method of accountingMethod Of AccountingAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods. by various entities, etc.
#3 – Ratio Analysis
Ratio analysis is the most commonly used financial analysis tool by analysts, experts, internal financial planners, the analysis department, and other stakeholders. It has various kinds of ratios, which can help in commenting on.
- Profitability ratio formulaProfitability Ratio FormulaProfitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.
- Rate of return analysis
- Solvency ratiosSolvency RatiosSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business.
- LiquidityLiquidityLiquidity is the ease of converting assets or securities into cash.
- 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 manage the operations.
However, below are the odd side of ratio analysis:
- Highly relying on past information.
- Ignorance of inflation impact.
- Chances of manipulation/window dressingWindow DressingWindow dressing in accounting refers to the intentional manipulation of financial statements by company management in order to present a more favourable picture of the company to users of the financial statement before it is released to the public. of financials may enhance ratios fairness.
- Ignorance of seasonal changes is based on the nature of the business, as they cannot be directly adjusted in financials.
Learn more from these Top 28 Financial Ratios with Formulas.Top 28 Financial Ratios With FormulasFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.
#4 – Benchmarking
Benchmarking is the process of comparing the actuals with the targets set by the top management. It also refers to the comparison made with the best practices and strives to achieve the same.
In this procedure, the below steps are to be performed: –
- Step 1: Select the area which needs to be optimized.
- Step 2: Identify the trigger points to compare them.
- Step 3: Try to set up a better standard 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; if not, do variance analysisVariance AnalysisVariance analysis is the process of identifying and analyzing the difference between the standard numbers that a company expects to accomplish and the actual numbers that they achieve, in order to help the firm analyze positive or negative consequences..
- Step 6: If achieved, strive to set up a better benchmark.
For benchmarking, ratios, operating margin matrix, etc., can be used. The operating margin of the industry average can be compared and should try to arrive at a better position. For example, the company known as Xerox initiated benchmarking to sustain itself in the photocopy business. They have currently optimized more than 100 functions compared to industry standards. Benchmarking can be considered a tool for improvement with customer-oriented activities driven by customer and internal organization needs. Eventually, it is the practice of being humble enough to accept that someone else is better at something and wise enough to learn how to match and surpass them.
In today’s competitive world, it is of utmost importance to follow the organization’s performance and the competitor, as it will help maintain and thrive the performance of the business. There are numerous tools available in the market to carry out the financial analysisFinancial AnalysisFinancial analysis is an analysis of finance-related projects/activities, company's financial statements (balance sheet, income statement, and notes to accounts) or financial ratios to evaluate the company's results, performance, and trends, which is useful for making significant decisions such as investment, project planning and financing activities. based on the various needs. Furthermore, based on their conditions, organizations also build various in-house tools which help them track their requirements.
Frequently Asked Questions (FAQs)
The most commonly used financial analysis tools are comparative statements, common size statements, trend analysis, ratio analysis, funds flow analysis and cash flow analysis.
The financial analysis tools for project evaluation are horizontal analysis, vertical analysis, and ratio analysis.
The three most common financial analysis tools are horizontal analysis, vertical analysis, and ratio analysis.
The best financial analysis tool is ratio analysis. It calculates ratios from the income statement and balance sheet. Also, it is the most common method of financial analysis.
This article has been a guide to Financial Analysis Tools. Here, we discuss the top four financial analysis tools, including common size, comparative statements, ratio analysis, benchmarking, and examples. You may learn more about financial statement analysis from the following articles: –