Financial statement analysis involved a study of the relationship between income statement and balance sheet accounts, how these relationships change over time and how a particular firm compares with other firms in its industry (Comparative ratio analysis). Although financial analysis has limitation, when uses with care and judgment, is can provide some very useful insight into the operation of a company.
Ratio analysis is a widely used tool of financial analysis. The systematic use of ratio helps to interpret the financial statement so that the strength and weakness of a firm can be determined and assessed. The ratio describes the significance relationship that exists between figures shown in balance sheet and income statement or any part of a financial statement.
Financial ratio are customarily expressed in the form of times, proportion and percentage. They may be also be depicted in the form of graphs. Ratio makes the related information comparable. A single figure by itself has no meaning. But when expressed in terms of related figure, it yields significant inferences. Their use as tools of financial analysis involved their comparison as single ratio, like absolute figure, are not much use. Two types of comparison are generally involved.
I) Trend Analysis: The comparison of ratio for the same firm over the time is called trend analysis. It is also known as the time series analysis. A trend analysis indicated a firm’s performance over time and reveals whether its position is improving or deteriorating relative to other companies in the industry. A trend analysis requires that a number of different ratios be calculated over several years and plotted a yield a graphic representation of the company’s performance. Trend analysis can provide clues as to whether the firm’s financial situation is likely to improve or to deteriorate.
II) Cross sectional analysis: Cross sectional analysis involve the comparison of different firm’s financial ratios at same point in time. The typical business is interested in how well it has performed in relation to other firm in its industry. Often, the reported financial statement of competing firm will be available for analysis. Frequently, a firm will compare its ratio values to those of a key competitor or group of competitors that it wishes to emulate. This type of cross sectional analysis, called benchmarking, has become very popular. Benchmarking is the process of comparing the ratio of a particular company with those of a smaller group of “benchmark” companies, rather than with the entire industry. Benchmarking makes it easy for a firm to see exactly where the company stands relative to its competition. Another popular type of comparison is to industry average. Ration analysis involves comparison because a company’s ratios are compared with those of other firms in the same industry, that is, to industry average figures. Comparative ratios are available from a number of resources.
Source: Khanal's Business Finance.
