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Tools of Analysis of Financial Statements

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Tools of Analysis of Financial Statements–
The most commonly used techniques of financial analysis are as follows: –
1. Comparative Statements: These are the statements showing the profitability and financial
position of a firm for different periods of time in a comparative form to give an idea about the position
of two or more periods. It usually applies to the two important financial statements, namely, balance
sheet and statement of profit and loss prepared in a comparative form. The financial data will be
comparative only when same accounting principles are used in preparing these statements. If this is
not the case, the deviation in the use of accounting principles should be mentioned as a footnote.
Comparative figures indicate the trend and direction of financial position and operating results. This

analysis is also known as ‘horizontal analysis’. The two comparative statements are Comparative
income statement and Comparative balance sheet.
2. Common Size Statements: These are the statements which indicate the relationship of different
items of a financial statement with a common item by expressing each item as a percentage of that
common item. The percentage thus calculated can be easily compared with the results of
corresponding percentages of the previous year or of some other firms, as the numbers are brought to
common base. Such statements also allow an analyst to compare the operating and financing
characteristics of two companies of different sizes in the same industry. Thus, common size

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statements are useful, both, in intra-firm comparisons over different years and also in making inter-
firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical

analysis’.
3. Trend Analysis: It is a technique of studying the operational results and financial position over a
series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to
observe the percentage changes over time in the selected data. The trend percentage is the percentage
relationship, in which each item of different years bear to the same item in the base year. Trend
analysis is important because, with its long run view, it may point to basic changes in the nature of the
business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or
remaining relatively constant. From this observation, a problem is detected or the sign of good or
poor management is detected.
4. Ratio Analysis: It describes the significant relationship which exists between various items of a
balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis,
accounting ratios measure the comparative significance of the individual items of the income and
position statements. It is possible to assess the profitability, solvency and efficiency of an enterprise
through the technique of ratio analysis.
5. Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an
organisation. The flow of cash into the business is called as cash inflow or positive cash flow and the
flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between
the inflow and outflow of cash is the net cash flow. Cash flow statement is prepared to project the
manner in which the cash has been received and has been utilised during an accounting year as it
shows the sources of cash receipts and also the purposes for which payments are made. Thus, it
summarises the causes for the changes in cash position of a business enterprise between dates of two
balance sheets.


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