Financial analysis is the process of identifying a company’s strengths and weaknesses by analyzing the relationships between the various components of its financial statements (income statement, balance sheet, and cash flow statement).
Principal Tools of Financial Analysis
1. Comparative Financial Statement
2. Common Size Financial Statement
3. Ratio Analysis
4. Analysis of Cash Flow
5. Break-Even Analysis
1. Comparative Financial Analysis
Generally, comparative financial statement analysis is a technique used to compare a firm’s financial statements for a particular year with the previous year and identify changes in various accounts. After identifying the changes, the causes of those changes are traced and remedal actions are taken. The two most important comparative statements of a business:
a) Comparative Income Statement
b) Comparative Statement of Financial Position
Example: One year ago, XYZ LLC had fixed assets of $1,000,000. This year fixed assets value $1,500,000. In this case the year to year change is $500,000.
2. Common Size Financial Statement
Common Size Financial Statement is a technique of financial statement analysis in which each item of the financial statement is converted from monetary figures to percentages.
Like, each expense item is shown as a percentage of net sales, with sales considered to be 100%. This method is used to compare two similar organizations.
3. Ratio Analysis
Ratio analysis is the process of reviewing and analyzing financial statements with the help of ratios and determining the level of actual financial success of the organization.
Example: XYZ LLC’s current assets and current liabilities for the last year were $50,000 and $100,000, respectively. Current ratio is obtained by dividing current assets by current liabilities. XYZ LLC’s current ratio value is (50,000 รท 100,000) = 0.5. For every $1 of current liabilities there are $0.5 of current assets. From the value of current ratio it can be said that XYZ LLC has liquidity problem. Because the company does not have enough current assets to meet its current liabilities.
4. Analysis of Cash Flow
Cash flow analysis refers to the comparison of cash inflows and outflows of different sections of the cash flow statement and the determination of the relationship between the cash flow statement and the balance sheet and the income statement. A cash flow analysis measures an organization’s ability to generate cash flow, repay debt, earn profit, and so on.
5. Break-Even Analysis
Break-even analysis is the process of examining the relationship between the cost of goods sold, the amount of sales revenue and the profit earned from the sale of the product. A firm can use break-even analysis to evaluate how much production or sales it must produce to cover all operating costs and the profitability associated with different sales volumes.
More Resources
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