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Principal Tools Used For The Analysis Of Financial Statements

This article deals with the following principal tools that we can used to analyze the financial statement: 

  1. Comparative Financial Statements – Year to year changes
  2. Index Number Trend Series
  3. Specialized Analysis
  4. Common - Size Financial Statements
  5. Ratio Analysis

1. Comparative financial statements -Year to year changes This analysis is very commonly used however there are certain basic rules we  need to understand/avoid: Rule No.1:-

  • when a negative amount appears in the base year and a positive amount in the following year or vice versa no percentage change can be meaningfully computed.

Rule No.2:-

  • When an item has a value in a base year and none in the following period, the decrease is 100 percent.

Rule No. 3:-

  • Where there is no figure for the base year, no percentage change can be computed.

 Simple Illustration:                                  Year 1      Year 2        $            % Net income/(loss)    (4,500)      1,500      6,000         -          Tax expense              2,000      (1,000)   (3,000)        -Notes payable              -            8,000      8,000         -Notes receivable      10,000          -        (10,000)    (100)
 Next, we move to the second method which is the
Index-Number Trend SeriesWhen a comparison of financial statements covers more than 3 years method no 1- Year to year method of comparison may become too cumbersome. The best way to effect such longer-term trend comparison is by means of index numbers. The computation of a series of index numbers requires the choice of a base year that will, for all items, have an index amount of 100. since such a base year represents a frame of reference for all comparisons, it is best to choose a year that, in a business condition sense, is as typical or normal as possible. If the earliest year in the series compared cannot fulfils this function , another year is chosen. As is the case with the computation of year-to-year percentages changes, certain changes, such as those from negative to positive amounts, cannot be expressed by means of index numbers. All index numbers are computed by reference to the base year.
In planning an index-number trend comparison, only include the most significant item. Care should be exercised in the use of index-number trend comparisons because such comparisons have weaknesses as well as strength. For the specialized analysis method, this includes like:- 

  • Cash forecasts
  • Analysis of changes in financial position
  • Statement of variation in gross margin
  • Breakeven analysis

The next article is on Common-Size Financial Statements which will enable readers to properly analysis and interpret financial statements.

This entry was posted on Sunday, October 14th, 2007 at 3:31 am and is filed under d. Interpretation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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