Tools of Financial Analysis:
Financial analysis transforms raw information of financial statements in helpful financial information. Only subsequent to financial analysis, we can employ financial statements for decision making. This financial information is helpful for planning. For illustration, we can predict our future ability of earning on advertising when we did financial analysis of our advertising expenditures with direct return on investment in advertising. Similar to this, we can do financial analysis of all items of gain and loss account, cash flow statement and balance sheet.
For doing financial analysis, we utilize following tools.
A. Financial Statement Analysis:
The financial statement analysis is that tool of financial analysis in which we make and highlight the important relationships of various items of financial statement. We too interpret that relationship in easy words. For illustration, an investor might be interested to know past earning data with its connection with company's investments. Two kind of financial statement analysis are very significant. One is horizontal analysis and the second is vertical analysis. In horizontal analysis, we compare each and every item of balance sheet and profit-loss account with previous year’s balance sheet and profit and loss account's items. In vertical analysis, we transform each element of the information into a percentage of the net amount of statement so as to set up relationship with other components of similar statement.
B. Ratio Analysis:
In actuality, it is also financial statement analysis although for detail study we can build separate topic of study. We compute different ratios such as balance sheet ratios, revenue ratios and mixed ratios. Ratio analysis is mainly based on the fact, if we make relationship among two accounting figures, we can obtain helpful information associating to performance, strengths and weakness. For illustration, we know that according to the rule of thumb, debt equity ratio must not more than 2:1 since it is risky. As an investor, we compute debt -equity ratio prior to invest our money in the form of debt. Here are two company and we have compute its debt equity ratio.
Debt - Equity ratio = Total debt/ Total shareholder fund
Debt Equity ratio of X co. = 690/1000 = 0.69 Debt Equity ratio of Y co. = 1060/500 = 2.12
We see the debt equity ratio of Y Co. is more than our rule of thumb. Therefore, we should invest in company X's debentures.
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