Ratios are used as tools in financial analysis

Financial analysis tools are different ways to evaluate and interpret a company’s financial statements for various purposes like planning, investment, and performance. Some of the most used financial tools based on their usage and requirements are common size statements (vertical analysis), comparative financial statements (comparison of financial statements), ratio analysis (quantitative analysis), cash flow analysis, and trend analysis.

When an analyst, business executive, or a student is dealing with a financial issue or wishes to understand the financial implications and economic trade-offs involved in decisions about business investment, operations, or financing; a wide variety of analytical techniques and infrequent rules of thumb is available to generate quantitative answers. Therefore, choosing the appropriate tools from the available alternatives is an important aspect of the analytical task.

The top four most common financial analysis tools are: –

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Source: Financial Analysis Tools (wallstreetmojo.com)

Let us discuss each tool one by one in detail

Let us evaluate different tools used for analysis: –

#1 – Common Size Statements

It is the first financial analysis tool. In the market, companies of various sizes and structures are available. To compare them, one must prepare their financial statement in absolute formats bringing all the particulars. The globally acceptable form to disclose the financials for comparison is to bring in data in a percentage format. The organization will prepare main financial statements like financial statementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more like Common size Balance sheetThe term "common size balance sheet" refers to a percentage analysis of balance sheet items based on a common figure, with each item presented as an easy-to-compare percentage. For example, each asset is expressed as a percentage of total assets, and each liability is expressed as a percentage of total liabilities.read more, Common size Income statementCommon Size Income Statement is a Company’s financial statement that presents every listed line item as a percentage of total revenue or sales. Moreover, it helps analyze the contribution of every item towards the profitability of the Company. read more, and common-size cash flow statement.

It will adequately disclose all the items for internal or external analysis with the peer group in percentage form. For example, the balance sheet can consider the base of total assetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more. The income statementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more may contemplate the base level of net sales, and the cash flow statementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more can depend on the base level of total cash flows.

#2 – Comparative Financial Statement

Comparative financial statements are used in horizontal analysisHorizontal analysis interprets the change in financial statements over two or more accounting periods based on the historical data. It denotes the percentage change in the same line item of the next accounting period compared to the value of the baseline accounting period.read more or trend analysisTrend analysis is an analysis of the company's trend by comparing its financial statements to analyze the market trend or analysis of the future based on past performance results, and it is an attempt to make the best decisions based on the results of the analysis done.read more. It helps analyze the periodic change in various components of the financial statementsThe components of financial statements are the income statement, balance sheet, cash flow statement, and shareholders equity statement, which are the building blocks that together form the statements and help in understanding the financial health of the business.read more and displays which element has the maximum impact.

One can prepare such financial statements in currency amount terms or percentage terms.

Thus, one can easily compare the periodic data numerically or in percentage terms from the above.

The comparative financial statement has advantages like easy comparability, observing the trend, periodic performance evaluation, etc. However, it has disadvantages like ignoring inflationary impact, high dependability on financial information that can be manipulated, use of a different method of accountingAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more by various entities, etc.

#3 – Ratio Analysis

Ratio analysis is the most commonly used financial analysis tool by analysts, experts, internal financial planners, the analysis department, and other stakeholders. It has various kinds of ratios, which can help in commenting on.

Moreover, an entity based on their requirement can prepare the ratios for their analysis and manage the operations.

However, below are the odd side of ratio analysis:

Learn more from these Top 28 Financial Ratios with FormulasFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more

#4 – Benchmarking

Benchmarking is the process of comparing the actuals with the targets set by the top management. It also refers to the comparison made with the best practices and strives to achieve the same.

In this procedure, the below steps are to be performed: –

For benchmarking, ratios, operating margin matrix, etc., can be used. The operating margin of the industry average can be compared and should try to arrive at a better position. For example, the company known as Xerox initiated benchmarking to sustain itself in the photocopy business. They have currently optimized more than 100 functions compared to industry standards. Benchmarking can be considered a tool for improvement with customer-oriented activities driven by customer and internal organization needs. Eventually, it is the practice of being humble enough to accept that someone else is better at something and wise enough to learn how to match and surpass them.

Conclusion

In today’s competitive world, it is of utmost importance to follow the organization’s performance and the competitor, as it will help maintain and thrive the performance of the business. There are numerous tools available in the market to carry out the financial analysisFinancial analysis is an analysis of finance-related projects/activities, company's financial statements (balance sheet, income statement, and notes to accounts) or financial ratios to evaluate the company's results, performance, and trends, which is useful for making significant decisions such as investment, project planning and financing activities.read more based on the various needs. Furthermore, based on their conditions, organizations also build various in-house tools which help them track their requirements.