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Financial analysis is useful in the assessment of a company’s financial performance over time and identification of the trends in that performance. It can also be used in the valuation of a company’s equity securities, assessment of its financial risk exposures, and performance of necessary due diligence ahead of a prospective merger or acquisition. There are several tools and techniques which may be used when evaluating a company’s financial status. These tools and techniques can especially be useful when reviewing a company’s financial data over time (time-series analysis) vis-a-vis the performance of other companies (cross-sectional analysis). These tools and techniques include financial ratios, common-sizing financial statements, currency translations, and chart analysis. Uses and Limitations of the Tools and Techniques Used in Financial AnalysisRatio AnalysisRatio analysis enables the evaluation of a company’s past performances and assessment of its current financial position. Besides, it provides insights that can be used to project a company’s future results. Limitations to ratio analysis include:
Common-size AnalysisThe common-size analysis involves the creation of a ratio between each financial statement item and a base item. This, typically, translates to total assets (when common-sizing the balance sheet) or total revenue (when common-sizing the income statement). The vertical common-size analysis highlights the composition of the balance sheet and helps to answer questions such as what mix of assets the company is using, how it is financing itself, and how its balance sheet composition compares with that of its peers. Finally, the vertical common-size analysis offers reasons behind the differences that may exist among companies in the same industry and environment. Horizontal common-size analysis can highlight structural changes that have occurred in a company over time. An analysis of past trends (historical analysis) can help to develop future expectations by evaluating whether trends are likely to remain constant or change. Trend analysis provides useful information on a company’s historical performance and growth. It can be used as a planning and forecasting tool for management and analysts. Cross-sectional analysis or relative analysis compares metrics for one company with the same metrics for another company. This allows comparisons to be made irrespective of whether or not the companies are of significantly different sizes and/or report financial data in different currencies. Whenever companies whose financial performance is being compared differ significantly in regard to size and/or the currency in which their financial data is reported, a comparison of their net income as reported will not be useful. Financial ratios and common-size financial statements can remove size as a factor and enable a more feasible comparison. Additionally, in addressing the challenge of data being reported in different currencies:
The reported nominal currency revenue or net income amounts for a company may not highlight significant changes in its performance over time. However, using ratio analysis, charts, or stating financial statement quantities relative to a selected base year value, can make these changes more visible and apparent. Differences in fiscal year ends can pose a challenge to comparability. This can be overcome by using the trailing twelve months of data. Differences in accounting standards can also limit comparability. A financial analyst should, however, seek to identify where these differences lie and the impact they may have on comparability. As best as possible, this impact should be minimized by making adjustments where feasible. GraphsGraphs can be used to facilitate a comparison of the performance and financial structure of a company over time. They can highlight the necessary changes in significant aspects of a company’s operations. Moreover, graphs can provide a visual overview of trends in risks. Regression AnalysisRegression analysis helps to identify relationships between variables which can lead to forecast estimates. It can also facilitate the identification of items or ratios that are moving contrary to their historical statistical relationships.
What are the tools for comparison of financial statements?The three major tools for financial statement analyses are horizontal analysis, vertical analysis, and ratios analysis.
What are the most commonly used tools of analysis of financial statements?Commonly used tools of financial analysis are: Comparative statements, Common size statements, trend analysis, ratio analysis, funds flow analysis, and cash flow analysis.
What are the 3 tools of financial analysis?Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques are horizontal analysis, vertical analysis, and ratio analysis.
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