Question

What are the three tools of financial analysis? Explain what they are and how to use them.

Answer 1

Answer

The following three important tools of financial analysis:

1.Comparative Financial Statements,

2.Common Size Statements

3.Trend Ratios or Percentages.

1.Preparation of Comparative Financial Statements:

Comparative Financial Statements refer to the statements of financial position of a business, which are prepared in such a way as to provide a time perspective to the various elements embodied in the financial statements.

These statements include two types of analytical statements. They are Comparative Balance Sheets and Comparative Income Statement. In these statements figures are placed side by side for two or more periods in order to facilitate comparison.

2.Preparation Common-Size Statements:

Common-size Financial Statements are those statements in which items reported in the financial statements are converted into percentages taking some common base. In the Common-size Income Statement, the net sales are assumed to be 100% and other items are expressed as a percentage of sales.

Similarly in the Common-size Balance Sheet the total assets or total liabilities are assumed to be 100% and other items of assets and liabilities are expressed as a percentage of this total [i.e., 100%].

3. Trend Percentages or Ratios:

Trend Analysis refers to the comparison of past data over a period of time with that of a base year. Under this method, percentage relationship that each statement item bears to the same item in the base year is calculated.

Any year i.e., the earliest year involved in comparison, or the latest year, or any intervening year, may be taken as the base year. As the purpose of this analysis is to highlight some important changes, the trend percentages are calculated only for some important items that can be connected with each other.