In the financial ratio, comparative analysis involves two types of comparison.
On this post I will explain comparative analysis definition, and what is a comparative market analysis with examples. These are very essential for this very topic.
First, the analyst can compare a present ratio with past and expected future ratios for the same company.
For example, in comparative analysis, the current ratio (the ratio of current assets to current liabilities) for the previous year end could be compared with the current ratio for the previous year end.
In a comparative analysis, when the financial ratios are arrayed on a spread sheet over a period of years, the analyst can study the composition of change and determine whether there has been an improvement or a deterioration in the financial condition and performance of the firm over time.
What is comparative analysis
In comparative analysis, financial ratios can be computed for projected, or pro forma, statements and compared with present and past ratios.
The second method of comparison in a comparative analysis involves comparing the ratios of one firm with those of similar firms or with industry averages at the same point in time.
Such a comparison gives an insight into the relative financial condition and performance of the firm.
Example of comparative analysis
Below is a good example of comparative analysis or I will say comparative profit and loss statement for ABC Ltd for two years ended 31st December 2003 and 2004.
|Other incomes||29, 576||11,902|
|Cost of goods sold||71.85||69.45|
|Selling and general expenses||3.86||3.66|
|Provision for tax||8.86||9.95|
In the comparative analysis variation in the above profit and loss statement call for critical analysis determine why they occurred.
As it can be seen, some of the items increases while others reduced or decreased. A financial ananlyst cannot ignore these changes.
The key question to ask in a comparative analysis includes the followings;
1. Why did the cost of goods reduced? Although it is good yet further analysis to determine whether the products are no longer in high demand leading to the reduction in price need to be carried out.
2. The increase in administrative expenses, was it a sign of wastages or extravagance on the part of the management or as a result of increased administrative services.
If so, this must translate into increase in sale and profit in a comparative analysis.
3. The reduction in selling and general expenses will lead to increase in profit but if such reduction means unattractive sells commission, it would rate impact negatively on the profit.
4. The increase in interest rate payable and provision for tax must be investigated as well to know whether they are justifiable.
5. The reduction in net profit is the consequences of the changes in the other components. It must as well be investigated to ascertain why it occurred.
The financial statement analysis comprises of the comparative analysis, the funds flow analysis and lastly the ratio analysis.
The financial statement is analyzed by using various tools which helps to interpret the statements to enable a lender draw up a meaningful conclusion.
The tools used in the financial statement analysis are the comparative analysis, the funds flow analysis and lastly the ratio analysis. They are considered most popular and helpful for appraising loan application from customers of varying degrees.
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Funds Flow Analysis
Aside from comparative analysis, we have the funds flow analysis in the financial statement analysis.
What is fund flow analysis?
The fund flow analysis statement enables the user to consider how the funds were sourced and how they were used.
The usefulness of the funds flow approach cannot be over emphasized. It assists the lender to determine whether or not a wise policy has been formulated and followed to the letter in raising and utilizing funds.
This works similar to the comparative analysis though it is all about comparison.
The funds flow analysis shows at a glance, the efficiency of the firm’s management since the broad policy regarding procurement and employment of funds is laid down by the the management.
The funds flow analysis will take the lender to a more simplified picture of the balance sheet called sources and uses of funds which is shown as follows;
SOURCES OF FUNDS
- Increase in liabilities
- Increase in assets
USES OF FUNDS
- Decrease in liability
- Decrease in assets
Again funds flow analysis works similar to the comparative analysis especially as it is useful for a short run planning.
A firm needs sufficient cash to pay debts maturing in the near future, to pay interest and other expenses and to pay dividends to shareholders.
A firm can make projections of cash inflows and outflows for the near future to determine the availability of cash.
This cash balance can be matched with the firm’s need for cash during that period, and accordingly, arrangements can be made to meet the deficit or invest the surplus cash temporarily.
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A historical comparative analysis cash flow provides insight to prepare reliable cash flow projection for the immediate future.
The followings are sources and uses of cash;
SOURCES OF CASH
- The profitable operations of the firm
- Decrease in any asset (except cash)
- Increase in any liability
- Sale proceeds from ordinary or preference share issue
USES OF CASH
- The loss from the operations
- Increase in any asset (excpet cash)
- Decrease in any liability
- Redemption of redeemable preference shares
- Cash dividends
This can be seen on the example of comparative analysis using the tables above.
The changes in current assets (except marketable securities) and current liabilities (except items such as tax liability, dividend payable, etc) are not usually shown separately as sources or uses of cash.
Rather, they are adjusted in net profit to determine the net cash flow operations.
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Facts on comparative analysis and fund flow analysis
The followings facts should be borne in mind relation to the comparative analysis, and more especially to the funds flow analysis;
- A firm can make losses in the short run and yet survive if it remains solvent. That ie to say if such a firm has a good healthy working capital and liquidity.
- A firm that is adjustable profitable can be brought to a halt by lack of liquid funds to pay wages and creditors in immediate future.
- It is imprudent to use short term funds to acquire fixed assets unless long-term funds will be raised to cover the position quickly.
- In comparative analysis and funds flow analysis, the statement is also called a movement of funds statement or a source and application of funds statement.
- When funds flow analysis is projected forward from a recent balance sheet like on the example of comparative analysis to the budgeted position, it is sometimes called a long-term cash budget.
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The comparative analysis method and the importance of funds flow analysis or source and application of funds statement in the balance sheet appraisal therefore cannot be over emphasized.