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.
The top 4 Most common financial analysis tools are –
- Common Size StatementCommon 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 Statements
- 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
Top 4 Financial Analysis Tools
Let’s 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. 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 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.
For example, in the balance sheet- the base of total asset, in income statement- the base of net sales and cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities. – a base of total cash flows can be taken. 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 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 analysis. It helps in analyzing 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 component has the maximum impact.
Such comparative financial statements can be either prepared in currency amount terms or 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 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. used by various 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 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 shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.
- 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 FormulasTop 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 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 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, 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 the industry average can be compared and should try to arrive at a better position. The company named Xerox, 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. Also, 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 organization, as well as of the competitor, as it will help in maintaining the performance and help in thriving the business.
This article 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 –