Tools of Financial Analysis: Comparative financial Statements
Also known as ‘horizontal analysis, are financial statements showing financial position & profitability at different periods of time. These statements give an idea of the enterprise financial position of two or more periods. Comparison of financial statements is possible only when same accounting principles are used in preparing these statements.
Comparative Balance Sheet
The progress of the company can be seen by observing the different assets and liabilities of the firm on different dates to make the comparison of balances from one date to another. To understand the comparative balance sheet, it must have two columns for the data of original balance sheets. A third column is used to show increases/decrease in figures. The fourth column gives percentages of increases or decreases.
By comparing the balance sheets of different dates, one can observe the following aspects
- Current financial position and Liquidity position
- Long-term financial position
- Profitability of the concern
Comparative Income Statement
Traditionally known as trading and profit and loss A/c. Net sales, cost of goods sold, selling expenses, office expenses etc are important components of an income statement. To compare the profitability, particulars of profit & loss are compared with the corresponding figures of previous years individually. To analyze the profitability of the business, the changes in money value and percentage is determined.
By comparing the profits of different dates, one can observe the following aspects:
- The increase/decrease in gross profit.
- The study of operational profits.
- The increase or decrease in net profit
- Study of the overall profitability of the business.
Advantages of Comparative Financial Statement:
The comparative statements show the figures of various firms or number of years side by side i.e. both for inter-firm comparison and intra-firm comparison.
(b) Horizontal Analysis:
The variables are arranged horizontally for the purpose of analysis and interpretations of data taken from financial statements for assessing profitability, overall efficiency and financial position of a firm.
(c) Trend Analysis:
The comparative financial statement helps to ascertain the ‘trend’ relating to sales, cost of goods sold, operating expenses etc. so that a proper comparison can easily be made which helps the analyst to understand the overall performance of a firm.
(d) Trend and Directions:
The comparative financial statement provides necessary information for comparison of trends in related items e.g. the analyst can compare the trend of sales with the trend of accounts receivable which gives very useful information. A 20% increase in accounts receivable and an increase of sales by only 10% warrants investigation into the reasons for this difference in the rate of increase.
(e) Evaluation of:
The comparative financial statement helps the analyst to compare Performance the performance of one firm with that of other similar firm in the industry and also compare the performance of the competitors in the line. This comparison helps to find out the weakness or strength of a firm and to take adequate steps.
(f) Measuring Financial:
Comparative financial statements help to measure important Distress financial ratios which are used for predicting financial distress and predicting corporate failure with the help of Multivariate Model.
Disadvantages of Comparative Financial Statement:
(a) Inter-firm Comparison:
Inter firm comparison will only be effective if both the firms follow the same accounting principles, method of valuations of stocks, assets etc. i.e. all the accounting concepts and conventions, which in real world situation, are not identically followed by both the firms e.g. Firm A follows the FIFO method of valuing stock whereas Firm B follows LIFO method for the same.
(b) Inflationary Effect:
Comparative financial statements do not recognise the change in prices level and, as such, it will be of no use.
(c) Ascertaining Correct Trend:
It is very difficult to ascertain the correct trend if there is a structural changes in a firm which are frequently happened.
(d) Supply Misleading Information:
Sometimes a comparative financial statement provides meaningless information, e.g. if a negative amount comes in base year, and a positive amount in the next year, it is not possible to find out the change in percentage.
(e) Uniformity in Principle:
There must be a consistency while following accounting principles, concepts and convention. But in practice, this is not done and as such, multi-year analysis becomes useless.
Comparative Income Statement:
We know that an Income Statement presents the results of the operation i.e. net profit or net loss. A Comparative Income Statement shows the absolute figures of incomes and expenses of two or more years and also the absolute change of those figures, together with the percentage change of those figures which, in other words, help the analyst to understand the change both in terms of absolute figures, as well as in terms of percentage.
The analyst can draw a meaningful conclusion after analysing and scrutinizing the figures presented in absolute and percentage form, i.e. to record the change between the two figures at a glance. For example, as the figures are presented or shown side by side, the analyst can easily determine whether a particular item is increased or decreased, e.g. percentage of gross profit on sales.
Comparative Expenses Statement:
When we want to prepare a comparative income statement we consider also the amount of various expenses. Without considering the amount of expenses income can never be ascertained. We will explain here the various components of expenses both in absolute figure as well as in percentage figure.
Comparative Expenses statement helps to ascertain the changes of various component of expenses which will help the management to take decision in future. For expense, if it is found that percentage of direct expenses are comparatively high in succeeding years or previous year, the reason for such increase must be ascertained.
So comparative expenses statement will highlight the changes in various components of expenses which provide very useful information to the management and accordingly the management can look into the matter and will take necessary steps.
Comparative Balance Sheet:
A single Balance Sheet exhibits the final position at a particular date i.e. the position of assets and liabilities. Comparison from a single Balance Sheet is not possible, the same can be compared with the Balance Sheets of the previous years.
In other words, if we take two or more Balance Sheets and compare them with their respective figures of assets and liabilities, a meaningful conclusion can be drawn after analysing and scrutinizing their changed figures and the reason for such changes which is very helpful on the part of the management to take financial decisions and future courses of action.
A single Balance Sheet presents only the current information of the firm. That is why a meaningful or significant conclusion about the financial status can be drawn only when we take the Balance Sheets for at least 3 years to 5 years after ascertaining the changes of both assets and liabilities position in terms of absolute figures as well as in terms of percentage.
Analysis of Comparative Balance Sheet:
(a) Ascertaining short-term Solvency position/Liquidity position/Working Capital Position:
A comparative Balance Sheet presents the position of current assets and current liabilities of the two consecutive years for the purpose of ascertaining the Gross Working Capital (i.e. the sum total of current assets), Net Working Capital (i.e. Current Assets – Current liabilities) i.e. it helps to know the short-term liquidity position.
If it is found that the net working capital employed with the firm is found to be less in comparison with the previous year, causes of such reduction must be found out, or, if it is found that the period of realisation of accounts receivables is more in comparison with the previous year, reasons for the same must be enquired for. Thus, a comparative Balance Sheet highlights us to know the working capital positions (both gross and net) and the liquidity positions as well.
(b) Ascertaing Long-Term Solvency position:
A comparative Balance Sheet helps to ascertain the long-term solvency position of a firm with the comparative study of Debt-Equity Ratio, Capital Gearing Ratio and various other ratios. In other words, the analyst must consider the changes made in long-term liabilities, fixed assets or change in proprietor’s fund.
Thus, these three items have a special bearing on the long-term solvency position of a firm. For example if the amount of long-term liabilities increase there will be a higher capital Gearing ratio/Debt Equity Ratio which is not desirable from the standpoint of long-term solvency position of a firm.
It is interesting to note that if the amount of long-term liabilities increase with a corresponding increase in fixed assets that will not be a problem but problem will arise only when a part of long-term liabilities is used by way of working capital.
(c) Increase in Net Worth:
An analyst must see that the net worth must be increased which indicates the rate of growth. If net worth/proprietors’ fund increases due to increase in net profit, in indicates a healthy sign and vice-versa is the opposite case.
An analyst with the help of analysis of comparative Balance Sheets must interpret or comment on the financial positions as a whole i.e., not in an isolated manner. He must analyse the liquidity and solvency position, profitability position, Capital structure position, as well as on management efficiency position.
If he only analyses the liquidity position alone the real picture of the financial position cannot be known. Thus, in order to arrive at a proper conclusion he must examine the various financial ratios that are frequently used in this regard.