DEMYSTIFYING FINANCIAL ANALYSIS: TOOLS FOR ANALYZING FINANCIAL STATEMENTS (PART 1)

Introduction

Financial accounting is principally about collecting, summarizing, and reporting information concerning the impact various business events have on a company’s financial status and financial performance.  Measuring performance is significant to the effective management of a company.

Types of Financial Analysis Tools

There are several financial analysis techniques or tools used to interpret and evaluate financial information. They are as follows;

1. Common-Size Analysis: The common-size analysis tool converts financial statement data into percentages, which enables comparisons between companies of different sizes or within the same company over time. This tool helps identify trends, patterns, and relative proportions of the various components within the financial statements. For instance, in a common-size balance sheet, each asset and liability account is expressed as a percentage of total assets which provides insights into the composition and relative significance of each component.
2. Regression Analysis: This is a statistical technique used to determine the relationship between two or more variables. In accounting, especially financial analysis, regression analysis can be used to analyze the relationship between a dependent variable (for example, sales or profit) and one or more independent variables (such as advertising expenditure or economic indicators). This tool helps identify and quantify the impact of these variables on the financial performance of a company. For example, regression analysis can be used to determine how changes in the advertising expenditure of a company may affect a company’s sales revenue. When historical data is analyzed regression techniques are applied, analysts can estimate the impact of advertising on sales and then make informed decisions regarding marketing strategies.
3. Graphical Analysis: With this tool, analysts can visually represent financial data through charts, graphs, or diagrams. The graphics analysis tool provides a visual representation of financial trends, patterns, and relationships, this makes it easier to interpret and understand complex financial information. This tool can be used to plot trends in financial ratios, revenue growth, stock prices, or other relevant variables. For instance, a line chart can be used to display the trend in a company’s revenue over a specific period, allowing analysts to identify growth or decline patterns. In the same vein, a scatter plot can visually express the relationship between two variables, such as the correlation between advertising expenditure and sales.
4. Financial Ratio Analysis: This tool requires calculating and analyzing various ratios derived from financial statement data. Financial ratios provide insights into different aspects of a company’s financial performance, profitability, liquidity, efficiency, and leverage. The financial ratio analysis tools help in comparing a company’s performance to industry benchmarks, historical trends, or competitors. Some common financial ratios include profitability ratios (e.g., gross profit margin, net profit margin), efficiency ratios (e.g., inventory turnover, asset turnover), solvency ratios (e.g., debt-to-equity ratio, interest coverage ratio), and liquidity ratios (e.g., current ratio, quick ratio). Analysts can evaluate a company’s financial health, identify areas of strength or weakness, and make informed decisions regarding investment, credit, or operational improvements by examining these financial ratios.

In conclusion, the above-mentioned financial analysis tools play a significant role in understanding and interpreting financial information, which in turn, enables stakeholders to assess the performance, financial position, and prospects of a company. In addition, they provide valuable insights for decision-making and assist in evaluating the effectiveness of financial strategies and operational efficiency.