# Tools and Limitation of Financial Analysis | Ratio Analysis

The compilation of these Analysis of Financial Statements Notes makes students exam preparation simpler and organised.

## Statements and Limitations of Financial Analysis

Financial Statement Analysis aka financial analysis is a process in which we review and analyze the company’s financial statements. Financial analysis is important for making the right financial decisions, and for improving the economic health of an organization. The financial statement contains a balance sheet, income statement, cash flow statement, and statement of changes. Tools of Financial Analysis are Comparative statements, common-size statements, Trend Analysis, Ratio Analysis, Cash Flow Analysis. Learn more about Financial Analysis and the limitations of Financial Analysis.

### Tools of Financial Analysis

1. Comparative Statements
Such statements are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to get an idea about the position of the firm in two or more periods.

Firms and companies apply this with regard to only 2 financial statements viz. Balance Sheet and Income Statement. Hence, they prepare these 2 financial statements in comparative form. Noteworthy, the firms need to use the same accounting principles to get a better result.

But if it is possible to use the same principles then the firm should mention the change in the footnote. It is known as ‘Horizontal Analysis’.

Format of Comparative Statements

Steps to prepare comparative statement:
1. Firstly, put the absolute figures from the financial statement in the relevant years.

2. Then, find the absolute change by deducting the values of the 1st year from the values of the 2nd year.

3. In order to find out the % change, use the given formula:

2. Common Size Statement

These are the statements which indicate the relationship of different items of a financial statement with some common item by showing each item as a percentage of the common item.

It enables the firms to do the inter-firm as well as an intra-firm comparison which is almost impossible in the case of comparative statements. Hence, it is also known as ‘Vertical analysis‘. Its purpose is to study the key changes and trends in the financial position.

Format of Common Size Statement

Steps to prepare Common Size Statements
1. Firstly, put the absolute figures in the relevant year columns. (Col. 2 and 4)

2. Then, select a Common Base as 100. In the case of Income Statements, take Sales Revenue as 100. In the case of the Balance Sheet, take Total Assets or Liabilities as 100.

3. Find out the % value with the help of the following formula:

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, a business enterprise does trend analysis to observe the percentage changes over time for the selected data.

Trend analysis is important for the business because it points at the basic changes in the nature of the business. By looking at a trend in the particular ratio, firms may find whether the ratio is falling, rising or remaining constant. After due observation, relevant steps can be taken.

Steps to prepare trend analysis
1. Firstly, put the relevant absolute figures in the relevant columns.

2. Then, choose the base year which is mostly the first year and put it as 100 in trend. Otherwise, the question will specify.

3. Find out the trend with the given formula:

4. Ratio Analysis
Ratio analysis is a process of analyzing and reviewing the company’s financial statement and performance. It is a quantitative analysis in which many factors of company financial performance is evaluated. Like solvency ratios, debt management ratios, liquidity, market value ratio, asset management ratio, profitability, etc.

As a technique of financial analysis, accounting ratios measure the comparative importance of the individual items of the income and position statements. Hence, it helps to assess the profitability, solvency, and efficiency of an enterprise.

5. Cash Flow Analysis
It refers to the analysis of the actual movement of cash in and out of the organization. The flow of cash into the business is called cash inflow and the flow of cash out of the firm is called cash outflow or negative cash flow.

Hence, by preparing the cash flow statement, the firm is able to find out the various reason behind the inflow and outflow of the cash.

### Limitations of Financial Analysis

Although there are many advantages of financial statements, there are certain disadvantages of the same. As the analysis is done on the basis of data provided in the financial statements which can be incorrect.

Hence, it is necessary for the firms to consider in mind various limitations as well.

1. While doing the financial analysis, firms often fail to consider the price changes. When firms compare data from various time periods, they do it without providing the index to the figures. Hence, the firm does not show the inflation impact.
2. Intangible assets not recorded. Firms do not record many intangible assets. Instead, any expenditure made to create an intangible asset is immediately charged to the expense.
3. Firms consider only the monetary aspects of financial statements. They do not consider the non-monetary aspect.
4. Firms prepare the financial statements on the basis of ongoing concepts, as such, it does not reflect the current position.
5. The statements do not necessarily provide any value in predicting what will happen in the future.

Example:

Question:
Calculate the trend percentages from the following figures of sales, stock, and profit of Harshit Ltd., taking 2001 as the base year.

Solution: