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Following different techniques are used for financial analysis:
1. Cash Flow Analysis: This analysis focuses on the inflow and outflow of cash and cash equivalents from the various activities of a business namely, investing, operating and financing activities during an accounting period. This helps in analysing cash payments and reason of receipt and the respective changes in cash balances during the accounting year.
2. Ratio Analysis: This method highlights the relationship between items of Balance Sheet and Income Statements. It is helpful in determining efficiency, profitability and solvency of a firm. This analysis expresses the financial items as fraction, percentage or proportion. Also, it determines the qualitative relationship among different financial variables. It also serves as a source of information regarding the performance, viability and financial position of a firm.
3. Trend Analysis: This technique studies the trends in operating performance and financial position of the business over a period of many years in succession. In such study, any particular year is considered as base year and the rest years are expressed as percentage of the base year’s figures. It helps in identifying problems and inefficiency along with detecting operating efficiency and financial position of the firm.
4. Comparative Statements: These statements use figures from two accounting periods that helps determine financial position and profitability. It also enables to do intra and inter firm comparison and therefore determine the efficiency of firm in relative terms. It uses both percentage as well as absolute terms. This analysis is known as Horizontal analysis.
5. Common size Statements: Common Size Statements are those statements where the items are displayed as percentages of a common base figure instead of absolute figures. It is helpful for proper analysis between companies (inter-firm comparison) or between time periods of the same company (intra-firm comparison). In these statements the relationship between items present in financial statements and common items like balance sheet total and net sales are highlighted in percentage. The analysis based on these statements is called as Vertical Analysis.
It has following limitations:
1. It fails to depict changes in accounting policy and procedures
2. These statements provide the interim report and hence have incomplete information.
3. These statements lack the qualitative aspect like growth prospects, managerial efficiency and express only in monetary terms
4. Financial analysis is based on accounting concepts and conventions and hence are not reliable as it does not take the current market value of items.
5. It involves personal biasness and judgements of the accountant for example in case of depreciation different methods can be charged for same item.
6. It does not take into account the change in price level. Only nominal values are considered.