Discuss the three commonly used tools of Financial Statement Analysis
Financial statement analysis uses different analytical tools to evaluate a company’s financial performance and position. The three most commonly used tools are discussed below:
Horizontal Analysis (Trend Analysis)
Horizontal analysis evaluates financial data over a period of time. It measures the increase or decrease in each financial statement item compared with a base year. The change may be expressed as an amount or a percentage.
This analysis helps identify growth patterns and trends. It is mainly used for intra-company comparison.
Formula: Percentage Change = (Current Year Amount − Base Year Amount) ÷ Base Year Amount × 100
Vertical Analysis (Common Size Analysis)
Vertical analysis expresses each item in a financial statement as a percentage of a base amount. In the Balance Sheet, total assets serve as the base. In the Income Statement, net sales serve as the base.
This method removes the effect of company size. It makes comparison easier between companies of different sizes. It is useful for both intra-company and inter-company comparison.
Ratio Analysis
Ratio analysis is the most widely used tool of financial statement analysis. It expresses the relationship between two financial figures.
The analysis helps evaluate a company’s operating efficiency, profitability, liquidity, solvency, and financial performance.
The major types of financial ratios include:
- Growth Ratios
- Profitability Ratios
- Coverage Ratios
- Activity Ratios
- Liquidity Ratios
- Leverage Ratios
Financial ratios can be compared over different years within the same company. They can also be compared with industry peers, industry averages, or standard benchmarks to assess overall performance.
Credit Operations & Management, Module: B, 5th Exam Q2(b)
