Wednesday, January 26, 2011

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
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.

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.

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.