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Analysis of Financial Statements 4 - Prashanth · PDF fileou have learnt about the financial statements (Income Statement and ... of ratio analysis. 5. Cash Flow ... Cash flow statement

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  • You have learnt about the financial statements(Income Statement and Balance Sheet) ofcompanies. Basically, these are summarisedfinancial reports which provide the operating resultsand financial position of companies, and the detailedinformation contained therein is useful for assessingthe operational efficiency and financial soundnessof a company. This requires proper analysis andinterpretation of such information for which anumber of techniques (tools) have been developedby financial experts. In this chapter we will have anoverview of these techniques.

    4.1 Meaning of Analysis of Financial Statements

    The process of critical evaluation of the financialinformation contained in the financial statements inorder to understand and make decisions regardingthe operations of the firm is called FinancialStatement Analysis. It is basically a study ofrelationship among various financial facts andfigures as given in a set of financial statements, andthe interpretation thereof to gain an insight into theprofitability and operational efficiency of the firm toassess its financial health and future prospects.

    The term financial analysis includes bothanalysis and interpretation. The term analysismeans simplification of financial data by methodicalclassification given in the financial statements.Interpretation means explaining the meaning andsignificance of the data. These two arecomplimentary to each other. Analysis is useless

    LEARNING OBJECTIVES

    After studying this chapter,you will be able to :

    explain the nature andsignificance of financialanalysis;

    identify the objectives offinancial analysis;

    describe the various toolsof financial analysis;

    state the limitations offinancial analysis;

    prepare comparative andcommonsize statementsand interpret the datagiven therein; and

    calculate the trendpercentages and interpretthem.

    Analysis of Financial Statements 4

  • without interpretation, and interpretation without analysis is difficult or evenimpossible.

    BoxFinancial statement analysis is very aptly defined by Bernstein as, a judgementalprocess which aims to estimate current and past financial positions and theresults of the operation of an enterprise, with primary objective of determiningthe best possible estimates and predictions about the future conditions. Itessentially involves regrouping and analysis of information provided by financialstatements to establish relationships and throw light on the points of strengthsand weaknesses of a business enterprise, which can be useful in decision-makinginvolving comparison with other firms (cross sectional analysis) and with firmsown performance, over a time period (time series analysis).

    4.2 Significance of Financial Analysis

    Financial analysis is the process of identifying the financial strengths andweaknesses of the firm by properly establishing relationships between the variousitems of the balance sheet and the profit and loss account. Financial analysiscan be undertaken by management of the firm, or by parties outside the firm,viz. owners, trade creditors, lenders, investors, labour unions, analysts andothers. The nature of analysis will differ depending on the purpose of the analyst.A technique frequently used by an analyst need not necessarily serve the purposeof other analysts because of the difference in the interests of the analysts.Financial analysis is useful and significant to different users in the followingways:

    (a) Finance manager: Financial analysis focusses on the facts andrelationships related to managerial performance, corporate efficiency,financial strengths and weaknesses and creditworthiness of the company.A finance manager must be well-equipped with the different tools ofanalysis to make rational decisions for the firm. The tools for analysishelp in studying accounting data so as to determine the continuity of theoperating policies, investment value of the business, credit ratings andtesting the efficiency of operations. The techniques are equally importantin the area of financial control, enabling the finance manager to makeconstant reviews of the actual financial operations of the firm to analysethe causes of major deviations, which may help in corrective actionwherever indicated.

    (b) Top management: The importance of financial analysis is not limited tothe finance manager alone. Its scope of importance is quite broad whichincludes top management in general and the other functional managers.

    201Analysis of Financial Statements

  • 202 Accountancy : Company Accounts and Analysis of Financial Statements

    Management of the firm would be interested in every aspect of the financialanalysis. It is their overall responsibility to see that the resources of thefirm are used most efficiently, and that the firms financial condition issound. Financial analysis helps the management in measuring thesuccess or otherwise of the companys operations, appraising theindividuals performance and evaluating the system of internal control.

    (c) Trade creditors: A trade creditor, through an analysis of financialstatements, appraises not only the urgent ability of the company to meetits obligations, but also judges the probability of its continued ability tomeet all its financial obligations in future. Trade creditors are particularlyinterested in the firms ability to meet their claims over a very short periodof time. Their analysis will, therefore, confine to the evaluation of thefirms liquidity position.

    (d) Lenders: Suppliers of long-term debt are concerned with the firms long-term solvency and survival. They analyse the firms profitability overtime,its ability to generate cash to be able to pay interest and repay the principaland the relationship between various sources of funds (capital structurerelationships). Long-term tenders do analyse the historical financialstatements. But they place more emphasis on the firms projected financialstatements to make analysis about its future solvency and profitability.

    (e) Investors: Investors, who have invested their money in the firms shares,are interested about the firms earnings. As such, they concentrate onthe analysis of the firms present and future profitability. They are alsointerested in the firms capital structure to ascertain its influences onfirms earning and risk. They also evaluate the efficiency of themanagement and determine whether a change is needed or not. However,in some large companies, the shareholders interest is limited to decidewhether to buy, sell or hold the shares.

    (f) Labour unions: Labour unions analyse the financial statements to assesswhether it can presently afford a wage increase and whether it can absorba wage increase through increased productivity or by raising the prices.

    (g) Others: The economists, researchers, etc. analyse the financial statementsto study the present business and economic conditions. The governmentagencies need it for price regulations, taxation and other similar purposes.

    4.3 Objectives of Financial Analysis

    Analysis of financial statements reveals important facts concerning managerialperformance and the efficiency of the firm. Broadly speaking, the objectives ofthe analysis are to apprehend the information contained in financial statements

  • 203Analysis of Financial Statements

    with a view to know the weaknesses and strengths of the firm and to make aforecast about the future prospects of the firm thereby, enabling the analysts totake decisions regarding the operation of, and further investment in, the firm.To be more specific, the analysis is undertaken to serve the following purposes(objectives):

    to assess the current profitability and operational efficiency of the firmas a whole as well as its different departments so as to judge the financialhealth of the firm.

    to ascertain the relative importance of different components of thefinancial position of the firm.

    to identify the reasons for change in the profitability/financial positionof the firm.

    to judge the ability of the firm to repay its debt and assessing theshort-term as well as the long-term liquidity position of the firm.

    Through the analysis of financial statements of various firms, an economist canjudge the extent of concentration of economic power and pitfalls in the financialpolicies pursued. The analysis also provides the basis for many governmentalactions relating to licensing, controls, fixing of prices, ceiling on profits, dividendfreeze, tax subsidy and other concessions to the corporate sector.

    It also helps the management in self-appraisal and the shareholders (owners)and others to judge the performance of the management.

    4.4 Tools of Financial Analysis

    The most commonly used techniques of financial analysis are as follows:1. Comparative Statements: These are the statements showing the

    profitability and financial position of a firm for different periods of time ina comparative form to give an idea about the position of two or more periods.It usually applies to the two important financial statements, namely,Balance Sheet and Income Statement prepared in a comparative form.The financial data will be comparative only when same accounting principlesare used in preparing these statements. If this is not the case, the deviationin the use of accounting principles should be mentioned as a footnote.Comparative figures indicate the trend and direction of financial positionand operating results. This analysis is also known as horizontal analysis.

    2. Common Size Statements: These are the statements which indicate therelationship of different items of a financial statement with some commonitem by expressing each item as a percentage of the common item. Thepercentage thus calculated can be easily compared with the resultscorresponding percentages of the previo