## Analytical Functions & Principal Tools of Analysis

Category: Financial Control Management

The following are some additional analytical processes in widespread use:

Direct measurements (relationship between debt and equity);

Indirect evidence (financial habits of the management team revealed in the past Cash Flow Statements);

Predictive functions (assistance in the prediction of expected future conditions and results);

Comparison and Use of external data (industry composites, «benchmarking»).

In the analysis of financial statements, the analyst has available a variety of tools from which he can choose best suited to his specific purpose, such as:

Comparative financial statements; a. Year-to-year changes

Index-number trend series;

Common-size financial statements; a. Structural analysis

Ratio analysis;

Specialized analysis;

a. Cash forecasts

b. Analysis of changes in cash flows

c. Statement of variation in gross margin

d. Cost-Volume-Profit analysis (Break-even analysis)

Year-to-Year Changes. The most important factor revealed by comparative financial statements is trend that shows the direction, velocity, and the amplitude of trend. For example, a year-to-year increase in sales of 10% accompanied by an increase of accounts receivable of 25% during the same period would also warrant an investigation into the reason for the difference in the rate of increase of sales as against that of receivables.

The comparison of year-to-year changes is a simple matter. However, a few clarifying rules should be borne in mind, such as:

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;

When an item has a value in a base year and none in the following period, the decrease is 100 percent. Where there is no figure for the base year, no percentage change can be computed;

The value of comparing yearly amount with an average covering a number of years is that unusual factors in any one year are highlighted. Averages smooth out erratic or unusual fluctuations in data.

Index-Number Trend Series (horizontal analysis). When a comparison of financial statements covering more than three years is undertaken, the year-to-year method of comparison may become too cumbersome. The best way to effect such longer-term trend comparisons is by means of index numbers.

One must observe the following rules:

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 conditions sense, is as typical or normal as possible;

Only the most significant items need to be included in such a comparison.

Common-Size Financial Statements (vertical analysis). In the analysis of financial statements, it is often to find out the proportion that a single item represents of a total group or subgroup. The following bases (100%) are used:

For Balance Sheet — Total Assets

For Profit and Loss Statement — Net Sales

For Cash Flow Statement — Net Sales or Total Inflows

Common size statements are very well suited to intercompany comparison because the financial statements of a variety of companies can be recast into the uniform common size format regardless of the size of individual accounts. While common-size statements do not reflect the relative sizes of the individual companies that are compared, the problem of actual comparability between tem is a matter to be resolved by the analyst’s judgment.

Ratio Analysis. Ratios are among the best known and most widely used tools of financial analysis. At the same time, their function is often misunderstood, and consequently their significance may easily be overrated. A ratio expresses the mathematical relationship between one quantity and another. While the computation of a ratio involves a simple arithmetical operation, its interpretation is a far more complex matter. The major deficiency while using financial ratios is the proper interpretation of those that requires good knowledge of finance, accounting, economics, and statistics.

Financial ratios are tools of analysis when:

Express a relationship that has significance;

Provide the analyst with clues and symptoms of underlying conditions;

Properly interpreted, can also point the way to areas requiring further investigation and inquiry;

Show the factors that will influence particular items in the future;

In the final analysis, the usefulness of ratios is wholly dependent on their intelligent and skillful interpretation.

Whatever approach to financial statement analysis the analyst takes and whatever methods are used, the analyst will always have to examine one or more of the important aspects of an enterprise’s financial condition and results of its operations. All such aspects, with perhaps the exception of the most specialized ones, can be found in one of the following six categories:

Short-term liquidity;

Funds flow;

Capital structure and long-term solvency;

Return on investments;

Operating performance;

Assets utilization.

Each of the above categories and the tools used in measuring them will be discussed in greater depth in the following sections.