Types And Methods Of Financial Analysis

Before we know the types and methods or techniques of financial analysis, first we should know the meaning of financial analysis. Well financial analysis is a process of ascertaining the financial strength and weakness of the firm by properly establishing relationships between the items of balance sheet and income statement. The information provided in the financial statements are not sufficient to evaluate the profitability and financial soundness of the business firm. So it requires further analysis and interpretation to draw meaningful conclusion which helps management to take appropriate decisions.


Types of financial analysis

There are various types of users like investors, creditors, customers, financial institutions, employees, potential investors, government and general public analyze the financial reports in different angles for different purposes. However all kinds of analysis can be classified on the basis of their users and the method of operations followed in the analysis.

Here is a chart which describes it better.

External Analysis

The name itself suggests that this type of analysis is done by the outsiders who do not have access to the detailed accounting information of the business firm. For this type of analysis external users like investors, creditors, credit agencies, general public etc. mostly rely on the published financial statements.

Internal Analysis

This analysis is performed by the executives and employees of the business firm. They have full access to all internal accounting records of the business concern. They do all these analysis only for the management of the business enterprises.

On the basis of method of operations followed in the analysis we can again categorize analysis in to dynamic or horizontal analysis and static or vertical analysis.

Dynamic Analysis

In this analysis the financial data of the company is compared for several years. A base year which is normally the beginning year is chosen and the financial data of various years are compared with the standard or the base year. Dynamic analysis helps the management and other users to find out the trend of items of financial statements that have changed significantly during the period. Comparison of an item over several periods with the base year may show a trend developing. Comparative statements and trend percentages are two tools used in  dynamic analysis.

Static Analysis

Static analysis refers to study of relationships of various items in the financial statement of one financial year only. In static analysis items of financial statement of a year are compared with the base selected from the same year's statement.  Common-size financial statements and financial ratios are two tools used in static or vertical analysis. As items for one time period are taken for analysis in static analysis so it is not conducive for proper analysis of financial statements. However it may be analyzed with dynamic analysis to make it more meaningful and effective.

Number of methods or devices are used for analysis of financial statements. Here I am giving a list of it. In this post I will discuss about the first three methods and the rest methods will be discussed in the next posts

1. Comparative Statements
2. Trend Analysis
3. Common-size Statements
4. Ratio Analysis
5. Funds flow Analysis
6. Cash flow Analysis
7. Cost-volume-profit Analysis

Comparative Statements

Under comparative statement, financial statements like balance sheet and income statement are prepared in comparative form for financial analysis. The items of financial statements are shown in a comparative form to give an idea of financial position of the business at two or more periods. As the items are shown in a comparative form so the analysts are able to draw useful conclusion. out of it. For example when sales figure of current period is compared with the previous periods then the analysts will be able to study the trend of sales over different period of time.

The two comparative statements are

• Comparative balance sheet and
• Comparative income statement

In comparative balance sheet items of two or more balance sheets of the same business concern are shown on different dates. Changes in items between two or more balance sheets make analysts to draw conclusions about the progress of the concern. Comparative balance sheet helps to study the aspects such as current financial and liquidity position, long term financial position and the profitability of the concern.

Current financial position of the concern can be known from the changes in working capital of the business firm. Working capital is the excess of current assets over current liabilities. An increase in working capital shows the improvement of current financial position. But if the increase of working capital were mainly for the increase of inventory due to accumulation of  stock for want of customers, decrease in demand or inadequate sales promotion then it is not a good financial position of the business.

Liquid assets like cash, bank, bills receivables, debtors etc. show an increase in the current year than the previous years then it will improve the liquidity position of the business concern.

The long term financial position of the business can be known from the changes in fixed assets, long term liabilities and capital. A good financial policy will be to finance the fixed assets by the issue of either long term securities such as debentures, bonds,  loan from financial institutions or issue of fresh share capital. An increase in  fixed assets should be compared to the increase in long term loan and cap[ital. If increase in fixed assets is more than the increase in long term loans then part of fixed assets has been financed from working capital. On the other hand if the increase in long term loan is more than the increase in fixed assets then the fixed assets have not only been financed from the long term sources but part of working capital has also been financed from long term sources. A wise policy will be to finance fixed assets by raising long term funds.

The profitability of the business concern can be studied from the comparative balance sheet. An increase in the balance of profit and loss account and other resources created from profit will mean an increase in profitability of the concern. The decrease in such accounts represents deterioration in profitability of the concern.

Here is an example of comparative balance sheet.

In the above comparative balance sheet during the year 2010 there has been an increase in fixed assets of 75000 while long term liabilities to outsiders have increased by 117000 and share capital has increased by 150000. So here it tells that the fixed assets have been purchased from long term sources of finance thereby not affecting the working capital of the business.

The current assets have increased by 142000 and cash and bank have increased by 50000. On the other hand the stock has increased by 60000 and the current liabilities have increased only by 42000. This position says that the long term finances have been utilized by the firm to improve its liquidity position.

reserves and surpluses have decreased by 50000 which depicts that the business concern has used its reserves and surpluses for the payment of dividends to shareholders.

So from the above interpretation it can be called that the overall financial position of the company is good.

The income statement is prepared to ascertain the operational result of the business concern. Comparative income statement is prepared to analyze the profitability of the business. It shows the progress of the business concern over a period of time.

The profitability and progress of the business concern can be determined from the study of following aspects of the comparative income statement

An increase in sales increases the profit of the business but it is not always true. If the cost of goods sold increases more than the increase in sales then it will not improve the profitability of the business. So the increase or decrease of sales should be compared to the increase or decrease of cost of goods sold to determine the actual profitability of the business concern.

Increase in sales and control of operating expenses will increase the operating profit of the business concern. Operating profit is the gross profit less operating expenses like administrative and selling and distribution expenses. Change in a particular expense may be due to lack of managerial efficiency or due to expansion of the business.

An increase or decrease in the net profit shows the overall profitability of the business concern. Net profit is the operational profit less all non operating expenses like interest paid, loss from sale of old assets, deferred expenses written off etc. There may be some non operating incomes which will increase the net profit of the business concern.

Here is an example of the comparative income statement

In the above comparative income statement the sales has increased by 13.41% where as cost of goods sold has increased by 10.42% resulting in increase in gross profit by 17.65%. Total operating expenses has increased by 7.53% but the increase of gross profit is sufficient to compensate the increase of operating expenses so there has been an increase in operational profit of Rs. 46000. There is an increase in net profit by Rs.36000. So it may be stated that the overall profitability of the business is good. There has been a progress in the business.

Trend Analysis

From the name of the analysis it is clear that here financial statements are analyzed on the basis of trends of figures in the statements. In trend analysis percentage of each item of statement is calculated in relation to the same item in the base year. Here the information for number of years is taken and generally the beginning year is taken as the base year. The base year should be a normal year. The figure of the base year is taken as 100 and trend percentages for other years are calculated on the basis of base year. Down or upward trends of figures of items are seen in this analysis. For example if current assets figure for the year 2005 to 2010 to be studied then current assets of 2005 is taken as 100 and percentage of current assets for other years will be calculated in relation to the base year.

The interpretation of trend analysis should be done properly. The mere increase or decrease in trend percentages may provides misleading information if studied in isolation. An increase of current assets by 25% may be good for the concern but if at the same time current liabilities also increases by 25% then this increase will not be favorable. Similarly the increase of sales may not improve the profitability if the cost of production also increases equivalently.

Trend Percentages

(Base Year 2005 = 100)

From the above trend percentages sales have continuously increased in all the years up to 2009
.The sales percentage has increased to 200% in year 2009 as compared to 100% in 2005. So during the five years sales have been doubled. So the increase in sales is quite satisfactory.

The percentage of cost of goods sold have also increased from 100% in year 2005 to 150% in year 2009. But as compared to increase in sales percentage it is quite less. So cost control has been done efficiently resulting in improvement of profitability of the business.

The net profit percentage has increased to 233.33% in year 2009. In five years the increase in profit percentage is more than the increase of sales percentage. It suggests a good control of operating and non  operating expenses.

Common-size Statement

In common-size statements, balance sheet and income statement the figures are shown in percentages. The figures of these statements are expressed as percentages of total assets, total liabilities and total sales. Total assets are taken as 100 and different assets are shown as percentage of total assets. Similarly total liabilities are taken as 100 and different liabilities are expressed as a percentage of of total liabilities. Here every item of the statements is expressed as a percentage of the total 100.

Common-size Balance Sheet

In common-size balance sheet the total assets and liabilities are taken as 100 and each asset and liability is expressed as a percentage of the total 100. Common-size balance sheet can be used to compare companies of different sizes.

Here is an example of a common-size balance sheet to compare the financial position of two companies.

Common-size Balance Sheet

Year ending 31st march, 2010

If we analyze the financing of two companies, then we can say that xyz ltd. has been financed more out of its own fund in caparison to abc ltd. In case of xyz ltd. out of total investments 64.03% is the proprietor's fund where as it is 60.68% for abc ltd. 

If we analyze the working capitals of two companies, then we can say that abc ltd. is in much better position then the xyz ltd. In case of xyz ltd. the percentage of its current liabilities 17.38 % is more than its current assets 13.57%. So this company is suffering from shortage of working capital. In case of abc ltd. its percentage of current assets 14.72% is more than its current liabilities 13.11%. So this company's working capital position is better than the xyz ltd. 

Common-size Income Statement

In common-size income statement the items in the income statement are shown in relation to sales. Each item in the statement is expressed as a percentage of sales. An increase or decrease in sales will directly affect the selling expenses not the administrative and financial expenses. But if the sales volume increases considerably then it may increase the administrative and financial expenses to certain extent. So a relationship is set between sales and other items to evaluate the operational activities of the business concern.

 Here is an example of a common-size income statement

Common-size Income Statement

year ending 31st March 2010

In the above common-size income statement sales and gross profit have increased in absolute figures in year 2010 but the percentage of gross profit to sales has decreased in 2010. The cost of sales as a percentage of sales has decreased the profitability from 43.33% to 36.00%.

Both operating and non operating expenses has slightly decreased in 2010.

Net profits have gone down both in absolute figures and percentage in 2010 as compared to 2009.

The overall profitability has decreased in 2010 due to rise in cost of sales. The management should take immediate actions to control the cost of sales.

This is all about in this post. In next posts I will discuss about the Ratio Analysis.

Financial Reports

Now I am going to explain the financial reports of a business concern. Well it is the end products of business transactions. It primarily comprises the position statement or balance sheet and income statement or profit and loss account.. These statements or reports are the result of a business concern at the end of the period normally the financial year.These reports are the sources of information on the basis of which conclusions are drawn about the profitability and the financial position of the business concern. Management and the outsiders like investors, creditors, customers, suppliers, financial institutions, employees, potential investors, government and general public who have interests in the affairs of the business take decisions on the basis of these reports.

Objectives of financial reports :

As you know the financial reports show the profitability and the financial position of a business concern, so the primary objective of financial reports is to assist in decision making.

It provides reliable information about the assets and liabilities of a business firm.

It provides other useful information about changes in assets and liabilities.

It provides information that helps in earning potential of the business.

Let's discuss about the anatomy of financial reports

I have said before that financial reports comprises two basic statements i)  Balance Sheet or the position statement  and ii) Profit and Loss account. However it may also include two other statements  iii) A report of changes in owners' account  or Retained Earnings and iv) A report of changes in financial position.

 Look at the chart below to have a better understanding

 Let me briefly discuss the meaning and significance of each of these statements

Balance Sheet : This report shows the resources (assets) the business has and the sources of these resources (liabilities). Liabilities are the investments by owners and outsiders. The Balance Sheet depicts the financial position of the concern. It is prepared in a particular date.  However there is not a particular sequence of showing various assets and liabilities.

Profit and Loss Account or Income Statement : This report is prepared to ascertain the  profit or loss made by a business firm at the end of the period. This report shows the revenues earned and the expenses incurred for earning that revenues. Excess of revenues over expenses is the profit and the reverse is the loss of the business concern.

Income statement may be prepared in the form of a Manufacturing Account to find out the cost of production, in form of Trading Account to ascertain the gross profit or loss , in the form of a Profit & Loss Account to determine the net profit or loss.

Retained Earnings or changes in owners' equity : Owners' equity has two elements i) paid-up share capital or the initial amount invested by the share holders and ii) retained earnings/reserves and surplus representing undistributed profits. The report of changes in owners' equity shows the beginning balance of owners' equity account, the reason of increase or decrease and its ending balance. The report of changes in owners' equity is the report of retained earning. This report is also called as profit and loss appropriation account.

Report of changes in financial position : The balance sheet gives a static view of assets and liabilities of a business concern at a certain point of time. So another report called report of changes in financial position is prepared to show the changes in assets and liabilities from end of one period to end of another point of time. This report shows the movement of funds or working capital during a particular period. The report of changes in financial position takes any of the two forms:

• Funds Flow Statement

The word 'fund' means the working capital of the business concern. Funds flow report is prepared to analyze the changes in the financial condition of a business firm between two periods. This report helps the management to know the sources of funds and their applications. It provides information to the management in policy formulation and performance appraisal.

• Cash Flow Statement

This statement shows the financial position of a business concern on cash basis. It says the causes of changes in cash position of a business concern between dates of two balance sheets. This statement focuses on changes of cash only. In brief you can say that cash flow report describes the sources of cash and its uses. I will discuss these two reports in detail in my next posts.

 Here I am going to discuss more about the Balance Sheet. Well I have said before that Balance Sheet shows the details of assets and liabilities of a business concern. This report can be prepared in horizontal and vertical form. Normally it is prepared in horizontal form. Assets are shown in the right side and liabilities in the left side. This may be shown in reverse order in some regions of the globe.

The assets and liabilities are shown either on liquidity basis or on permanency basis. If it is shown on liquidity basis then more liquid assets like cash and bank etc are shown first and least liquid assets will be shown at last. In liabilities side liabilities to be redeemed in short period are shown first and the long term liabilities are shown last.

When Balance Sheet is prepared on permanency basis, in assets side fixed assets are shown first and liquid assets are shown last. On the liabilities side the long term liabilities are shown first and the short term in last.

Look at the specimen of a Balance Sheet below. Here assets and liabilities haven been shown on permanency basis

Horizontal form of Balance Sheet

Liabilities	Amount	Assets	Amount
Share Capital Equity Share Capital Preference Share Capital Reserves And Surplus Capital Reserve Share Premium Other Reserves Profit And Loss Account Secured Loans Debentures Long term loan from Banks Unsecured Loans Current Liabilities Advance From Customers Unpaid Dividends Sundry Creditors Outstanding Expenses Provisions Provision for doubtful debts Provision for insurances, pension and other benefits		Fixed Assets Land Building Plant & Machinery Furniture & Fittings Vehicles Goodwill Patents Copy Right Investments Government Securities Shares, Debentures and Bonds Current Assets Closing Stocks Loans and Advances Sundry Debtors Bills Receivables Preliminary Expenses Cash Bank

 

Vertical Form Of Balance Sheet

	Amount
Sources Of Funds Capital Reserves and Surplus Loans Secured Loans Unsecured Loans Total : Application Of Funds Fixed Assets Investments Net Current Assets Profit and Loss Account (debit)

 In the next post I will discuss about the types and different methods of financial analysis.

Management Accounting

Hello friend,thank you for visiting my blog. I have written this blog on Management Accounting. Hope this blog will be helpful to you.. This blog  will  be  helpful to students, academicians, professionals and all other persons who are in the field of Management Accounting. 

Well if you ask me the age of accounting I will tell you that it is as old as money itself. It is the language of business. The role of accounting has been changing with economic and social developments. Over the years new dimensions have been added to the discipline of accounting.

Here I would like to tell you that accounting has several branches which are as follows:

• Financial Accounting
• Cost Accounting and
• Management Accounting

In this blog I will only discuss about the management accounting. Management accounting provides information to the management for the internal management of the business concern.

Today's complexities of business environments have necessitated the use of management accounting for planning, coordinating  and controlling the functions of management.

Management accounting has two words 'management' and 'accounting'. So these two words says that it is the study of managerial aspects of accounting. The study of management accounting is to redesign accounting in such way that it is helpful to the management in formation of policy and carrying out the function of business more efficiently.

Now you must have understood the meaning of management accounting. Now I will discuss some characteristics of management accounting.

- Management accounting is based on accounting information. These information are presented in such a way that it suits the managerial needs. Management accounting is a service function and it provides useful information to the different level of management.

- Cause and effect relationship is studied in management accounting. If there is a loss in the business then the reason for this is probed and if there is profit the factors influencing the profitability is also discussed. Profits are compared to sales, different expenditures, current assets, share capital etc.

- In management accounting different techniques are used to help in taking decisions by the management. There are some techniques like financial planning and analysis, standard costing, budgetary control, marginal costing , project appraisal, control accounting etc. are used to manage the business effectively.

Now I will discuss about some functions of management accounting

• Planning and forecasting

Planning and forecasting is quite essential for the effective management of the business. Various techniques such as budgeting, standard costing, funds flow statement, probability and trend, ratios are used for fixing the targets. These techniques are also used for planning  of various activities.  I will discuss these techniques elaborately in my next blogs.

• Modification of data

Here management accountants classifies and modifies the accounting data according to the requirements of the management.

• Financial analysis and interpretation

I would like to tell you that this function is very important for the management accountants. Here management accountants analyzes and interprets the financial data in a simple way and presents it in a non technical language so that it can be easily understandable by the managerial executives who have no technical knowledge.

• Facilitates managerial control

Management accountants setup the standards of departments and individuals. Actual performances of the departments and individuals are recorded and deviations are calculated. This function enables the management to assess the performance of everyone in the business organization. Techniques of standard costing and budgetary control can be used for  performance evaluation.

• Communication

Management accountants prepare different financial reports for the uses of different levels of management and employees. These reports communicate within the organization and with the outsiders like bankers, investors, creditors, government agencies etc.

• Qualitative information

Management accountants do not concentrate on financial data only, they also collects and uses qualitative information.  Here I am giving you an example a management accountant while preparing production budget rely on the assessment of persons dealing with production, productivity, reports, consumer surveys etc.

• coordinating

As you know coordination between different departments is very essential for the smooth running of the business . Management accountants act as a coordinator among different financial departments through budgeting and financial reports.

• Helpful in taking strategic decisions

Management accounting is very helpful for decisions for seasonal or temporary stoppage of production, replacement decisions, expansion or diversification of works etc.

Let me to wind up this post. In the next post I will discuss about financial reports of  business concerns.