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Financial ratio analysis is a statistical tool that measures the relationship between two financial figures. It involves determining, interpreting and presenting numerical relationships between the various items in the financial statements.
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Investors, lenders, management, customers, government, financial analysts, researchers are a few parties interested in ratio analysis, which speaks about the financial soundness of the firm.
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Financial ratios are not free from limitations. Management adheres to window-dressing to change the character of financial ratios. Differences in accounting policies, interpretation of financial terms and accounting periods make the comparison of ratios between two firms non-comparable.
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The cross-sectional analysis technique is used to study the relationship within a set of financial statements at a point of time. It involves making a comparative study of data of similar companies.
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Two popularly used techniques of cross sectional analysis are - common size statements and ratio analysis.
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The data for cross-sectional analysis must be made comparable by removing any variations arising due to variation in accounting period or variation in accounting policies or methods adopted.
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The profit and loss account can be taken as the basis for constructing a common-size income statement. Each element of the income statement is converted and expressed as a percentage of the total income.
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The total assets and liabilities is taken as a base and all other figures are expressed as a percentage to this total in case of construction of a common-size balance sheet.
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Trend Analysis is a comparative analysis of a company's financial position over time. Trend analysis is important because it may point to basic changes in the nature of a business and also helps in drawing meaningful conclusions regarding the operating performance and financial position of the enterprise.
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The three techniques of time series analysis are - year-to-year comparison Trend Analysis, and Financial ratios. Year-to-year analysis compares financial statement over two time periods using amounts and percentages for meaningful interpretation. GAAP requires the presentation of comparative financial statements that give financial information for the current year and the previous year.