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Financial statements are the end products of financial acounting. They are
the summarised statements and reports prepared by business concerns to disclose
their accounting information and communicate them to the interested parties.
Financial statements include mainly two statements which the accountant prepares
at the end of a given period. These are Income Statement (Profit and Loss
Account) and Position Statement (Balance Sheet). These statements are
supplemented by Cash Flow Statement, Fund Flow Statement, Statement of
Retained Earnings, Schedules etc.
1. Income Statement: It is prepared to determine the operational position of
the concern. It is a statement of revenues earned and the expenses incurred
for earning that revenue. The difference is either profit or loss. The income
statement is prepared for a particular period.
2. Position Statement: It is one of the important financial statements depicting
the financial strength of the concern. It shows on the one hand the properties
that it utilises and on the other hand the sources of these properties. The
balance sheet shows all the assets owned by the concern and the liabilities
and claims it owes to owners and outsiders. It is prepared as on a particular
date.
3. Cash Flow Statement: It summarises the causes of changes in cash position
of a business enterprise between two Balance Sheet dates. It focuses
attention on cash changes only. It describes the sources of cash and its uses.
4. Fund Flow Statement: It is designed to analyse the changes in the financial
condition of a enterprise between two periods. This statement will show the
sources from which the funds are received and the uses to which these have
been put.
5. Statement of Retained Earnings: Also known as Profit and Loss
Appropraition Account. It shows the appropriaion of earnings like dividend
paid, transfer to reserve, etc. The balance in this account will show the
amount of profits retained and carried forward.
6. Schedules: A number of schedules are prepared to supplement the
information supplied in the Balance Sheet. The schedules of investments,
fixed assets, debtors, etc. are prepared to give details about these
transactions. All these schedules are used as part of financial statements.
ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS
The financial statements become meaningless unless they are analysed and
interpreted. On proper analysis and interpretation of the results, they become of
valuable and useful. Managerial decisions often depend on the results of financial
statements and their interpretations.
Analysis of finacial statement is the process of determining the significant
operating and financial characteristics of a firm from the accounting data. It is the
treatment of the information contained in the fiancial statements to afford a full
diagnosis of the profitability and financial position of the firm. It helps the
executives to evaluate past performance, present financial position, liquidating
situation, profitability of the firm, and to make forecast for the future earnings.
Interpretation of financial statement refers to drawing inferences or
conclusions on the basis of analysis conducted on the financial statements. Proper
interpretation leads to proper conclusion and judgement and taking effective
measures for improvements.
Objectives of Financial Analysis
1. Efficiency of operation: The earning capacity of a firm varies between
periods due to different factors such as pricing, competition, etc. The
analysis of financial statements helps to estimate the effieciency of
operations of the firm. The ratios such gross profit ratio, net profit ratio, etc.
are calculated and interpreted for the purpose of measuring the efficiency of
operations of the business.
2. Measure the financial position and financial performance of the firm: The
analysis of financial statement help to gauge the financial position as on any
particular date and the financial performance of the firm within the period
under review.
3. Long term liquidity of funds: Analysis of finacial statements help to
determine the long term liquidity of funds. It helps to make arrangement for
funds for the future when required.
4. Solvency of the firm: Analysis of Balance Sheet figures helps to measure the
solvency of the firm. The solvencies measures by studying the value of
assets over liabilities. It shows the debt paying capacity of the firm.
5. Future prospects of the firm: The future prospects of the firm can be
ascertained by studying the trend of activities for the last few years and the
expected changes that may take place in the near future. Trend ratios help to
measure the future prospects of the business.
6. Progress of the firm: By comparing the profit and loss account and balance
sheet figures of the current year with those of the previous year or of the
previous years helps to measure the progress of the firm. Comparative
statements are prepared for the purpose of measuring the progress of the
firm.
Features of Financial Analysis
To present a complex data contained in the financial statement in simple and
understandable form.
To classify the items contained in the financial statement in convenient and
rational groups.
To make comparison between various groups to draw various conclusions.
Goals
Financial analysts often assess the firm’s:
1. Profitability - The firm’s ability to earn income and sustain growth in both
short-term and long-term. A company’s degree of profitability is usually
based on the income statement, which reports on the company’s results of
operations.
2. Solvency - The firm’s ability to pay its obligation to creditors and other third
parties in the long-term.
3. Liquidity - The firm’s ability to maintain positive cash flow, while satisfying
immediate obligations.
4. Stability – The firm’s ability to remain in business in the long run, without
having to sustain significant losses in the conduct of its business. Assessing
a company’s stability requires the use of the income statement and the
balance sheet, as well as other financial and non-financial indicators.
Purpose of Analysis of Financial Statements
To know the earning capacity or profitability.
To know the solvency.
To know the financial strengths.
To know the capability of payment of interest and dividends.
To make comparative study with other firms.
To know the trend of business.
To know the efficiency of management.
To provide useful information to management.
Procedure of Financial Statement Analysis
The following procedure is adopted for the analysis and interpretation of
financial statements:
1. The analyst should acquaint himself with principles of accounting. He
should know the plans and policies of the management so that he may be
able to find out whether these plans are properly executed or not.
2. The extent of analysis should be determined so that the sphere of work may
be decided. If the aim is to find out the earning capacity of the enterprise,
then, analysis of income statement will be undertaken. On the other hand, if
financial position is to be studied, then, balance sheet will be necessary.
3. The financial data given in the statement should be recognized and
rearranged. It involves grouping of similar data under same heads, breaking
down of individual components of statement according to its nature and
reducing the data to a standard form.
4. A relationship is established among financial statements with the help of
tools and techniques of financial analysis such as ratios, trends, common
size statements, fund flow statements, etc.
5. The information is interpreted in a simple and understandable way. The
significance and utility of financial data is explained for help in decision
making.
6. The conclusions drawn from interpretation are presented to the management
in the form of reports.
Functions of Finance Department
The functions of finance department include the following areas:
1) Effective management of financial resources of the company.
2) Coordinates & Monitors the functions of accounts activities in the
units/marketing offers.
3) Establish and maintain systems of financial control, internal check and
render advice on financial & accounting matters including examination of
feasibility report and detailed project reports.
4) Establish and maintain proper system of budgetary control, cost control and
management reporting.
5) Maintain financial accounts and compile annual periodical accounts in
accordance with the companies Act, 1956, ensuring the audit of accounts as
per law/Govt. directions.
6) Looks after overall funds management and arranges funds required for the
capital schemes and working capital form govt., banks and financial
institutions etc.
7) Timely payment of all taxes, levies & duties under the Law, Maintenance of
records and filing returns statements connected with such taxes, levies and
duties with the appropriate authorities, as per law.
All the power involving financial implications are to be exercised in prior
consultation with head of concerned finance department. In the event of any
difference of opinion between the General Manger and the Head of Finance Dept.,
the matter shall be referred to Managing Director who after consulting Director
(Finance) shall issue appropriate instruction after following the prescribed
procedures.
Types of Financial Analysis
Distinction between the different types of finacial analysis can be made
either on the basis of material used for the same or according to the modus
operandi of the analysis or the object of the analysis. The following chart will give
a snap-shot view of it.
1. External Analysis: It is made by those who do not have access to the
deatailed accounting records of the company, i.e., banks, creditors and
general public. These people depend almost entirely on published financial
statements. The main objective of such analysis varies from party to party.
2. Internal Analysis: Such analysis is made by the finance and accounting
department to help the top management. These people have direct approach
to the relevant financial records. So they can peep behind the two basic
Types of financial analysis
According to materials used
External Analysis
Internal Analysis
According to modus operandi
Horizontal Analysis
Vertical Analysis
According to objectives of analysis
Long term Analysis
Short term Analysis
financial statements and narrate the inside story. Such analysis emphasises
on the performance appraisal and assessing the profitability of different
activities.
3. Horizontal Analysis: When the financial statements for a number of years
are reviewed and analysed, the analysis is called ‘horizontal analysis’. The
preparation of comparative statements is an example of horizontal analysis.
As it is based on data from year to year, rather than on one date or period or
time as a whole, this is also known as ‘Dynamic Analysis’.
4. Vertical Analysis: It is also known as ‘Static Analysis’. When ratios are
calculated from the Balance Sheet of one year, it is called vertical analysis. It
is not very useful for long term planning as it does not include the trend
study for future.
5. Long term Analysis: In the long run, the company must earn a minimum
amount sufficient to maintain a suitable rate of returm on the investment to
provide for the necessary growth and development of the company and to
meet the cost of capital. Thus, in the long run analysis the stress is on the
stability and earning potentiality of the concern. In long term analysis, the
fixed assets, long term debt structure and the ownership interst is analysed.
6. Short term Analysis: It is mainly concerned with the working capital
analysis. In the short run, a company must have ample funds readily
available to meet its current needs and sufficient borrowing capacity to meet
the contingencies. Hence, in short term analysis, the current assets and
current liabilities are analysed and cash position of the concern is
determined. For short term analysis the ratio analysis is very useful.
Tools and Techniques of Financial Analysis (Methods)
The analysis of financial statements consists of a study of relationships and
trends to determine whether or not the financial position of the concern and its
operating efficiency have been satisfactory. In the process of this analysis, various
tools or methods are used by the financial analyst. The analytical tools generally
available to an analyst for this purpose are as follows:
1. Comparative financial and operating statements
2. Common-size statements
3. Trend ratios(trend percentages)
4. Average analysis
5. Statement of changes in working capital
6. Funds flow and cash flow analysis
7. Ratio analysis
1. Comparative Financial and Operating Statements
The preparation of comparative financial and operating statements is
an important device of horizontal financial analysis. Financial data becomes
more meaningful when compared with similar data for a previous period or a
number of prior periods. Statements prepared in a form that reflects financial
data of two or more periods are known as comparative statements. Such
statements are very helpful in measuring the effects of the conduct of a
business during the period under consideration. Comparative satatement
may show :
i. Absolute figures
ii. Change in the absolute figures (increase or decrease)
iii. Absolute data in terms of percentages
iv. Increase or decrease in terms of percentages
Comparative statements can be of 2 types:
i. Comparative Balance Sheet: The comparative balance sheet
analysis is the study of the trend of the same items or group of
items of two or more balance sheets of the same business
enterprise on different dates. The changes in periodic balance
sheet items reflect the conduct of the business. It has 2 columns
for the data for original balance sheet. A third column is used to
show increase in figures, the fourth column may be added for
giving percentage of increase or decreases.
ii. Comparative Income Statement: The comparative income
statement is a statement prepared to get an idea of the progress
of a business over a period of time. The changes in absolute
data in money values and percentages help to analyse the
profitability of a business. It has 4 columns. First two columns
give figures of various items for two years. Third and fourth
columns are used to show increase or decrease in figures, in
absolute amounts and percentages respectively.
2. Common Size Statements
These are the statements prepared to show the relationship of different
individual items with some common items. These are the comparative
statements that give only the vertical percentage ratio for financial data
without giving rupee values. They are also known as 100% statements. It
shows the relation of each component to the whole. It is useful in vertical
financial analysis and comparison of two business enterprises at a certain
date. Common size statements include:
i. Common Size Balance Sheet: A statement in which balance
sheet items are expressed as percentage of each asset to total of
assets and percentage of each liability to total of liabilities is
called Common Size Balance Sheet. This statement establishes
the relationship between each asset to total value of assets and
each liability to total of liabilities.
ii. Common Size Income Statement: A common size income
statement is a statement in which each item of expense is shown
as a percentage of net sales. A significant relationship can be
established between items of income statement and volume of
sales. Increase in sales will certainly increase the selling
expense and not the administration and financial expenses
which are mostly fixed in nature. In case the volume of sales
increases to a considerable extent, administration and financial
expenses may also go up.
3. Trend Ratios (Trend Percentages)
Trend signifies tendency. Therefore, review and appraisal of tendency
in accounting variables is simply called as trend analysis. Trend ratios are
also an important tool of horizontal financial analysis. Under this technique
of financial analysis, the ratios of different items for various periods are
calculated and then a comparison is made. An analysis of the ratios over the
past few years may well suggest the trend or direction in which the concern
is going upward or downward.
Uses or advantages of trend analysis:
i. It helps in easily knowing the direction of movement of the
activity of the business, i.e., whether upward or downward.
ii. Trend analysis is helpful in forecasting and budgeting.
iii. It helps in comparing one period with another period.
iv. It makes data brief and easily understandable.
Procedure for calculation of trends:
i. One year is taken as the base year. Usually, the first year is
taken as the base year.
ii. The figures of base year are taken as 100.
iii. Trend percentages are calculated in relation to the base year.
If a figure in a year is less than the base year figure, the rend
percentage will be less than 100 and if the figure is more than
the base year figure the trend percentage will be more than 100.
Trend percentage = Current year amount * 100
Base year amoun
4. Average Analysis
It is an improvement over trend analysis method. When trend ratios
have been determined for the concern, these figures are compared with
average trend of the industry. Both these trends can be presented on the
graph paper also in the shape of curves. This presentation of facts in the
shape of pictures makes the analysis and comparison more comprehensive
and impressive.
5. Statement of Changes in Working Capital
To discuss the increase or decrease in working capital over a period of
time, the preparation of a statement of changes in working capital is also
very useful. The main objective of this statement preparation is to derive a
fairly accurate summary of the events that affected the amount of working
capital. The amount of net working capital is determined by deducting the
total of current liabilities from the total of current assets. Hence, it is a rough
statement which may be prepared by using balance sheet date only. But it
does not explain the detailed reasons for the changes in working capital and
methods of financing additional requirements of working capital. Hence, the
preparation of funds flow statement becomes necessary.
6. Ratio Analysis
It is an important and widely used tool of analysis of financial
statements. It is essentially an attempt to develop meaningful relationship
between individual items or group of items in the balance sheet or profit and
loss account. The object and utility of ratio analysis as a technique of
financial analysis is confined not only to the internal parties but to the trade
creditors, banks and lending institutions also. It functions as a sort of health
test. In the nut-shell, ratio analysis gives the answer to the problems such as:
i. Whether the enterprise’s financial position is basically sound,
ii. Whether the capital structure is in proper order,
iii. Whether the profitability is satisfactory,
iv. Whether the credit policy in relation to sales and purchase is
sound,
v. Whether the company is credit worthy.
Thus, ratio analysis highlights the liquidity, solvency,
profitability, capital gearing etc.
Limitations of Financial Statement Analysis
The analysis of financial statement has certain limitations
also. Hence, any person using this technique must keep in mind those
limitations. Main limitations are as follows:
i. The analysis of financial statements is only a means to reach
conclusions and not conclusion in itself. So, it cannot work as
a substitute for sound judgement. The judgement, ultimately,
will depend upon the intelligence and skill of the analyst.
ii. The figures drawn from statement of just one year have
limited use and value. So, it will be dangerous to depend on
them only.
iii. The basic nature of financial statement is historic. Past can
never be hundred per cent representative of the future. Hence,
future course of business events should be forecasted and
interpreted in the context.
iv. The results of the analysis of financial statements should not
be taken as an indication of good or bad management. The
ratios or other figures explain only probable state of events.
v. Any change in the method o r procedure of accounting marks
the utility of such analysis. The figures of different financial
statements lose the characteristic of comparability.
vi. An analyst should also be cautious from window dressing in
the accounts.
vii. The rapid changes in the value of money also reduce the
validity of such analysis and no useful conclusions can be
drawn from a comparative study of the financial statements
of different years.
viii. It does not disclose reasons for changes.
i.
RATIO ANALYSIS
Ratio analysis is one of the most powerful tools of analysis of
financial statements. It aims at making use of quantitative information
for decision making. These are widely used as they are simple to
calculate and easy to understand.
A ratio is an expression of relationship between two figures or two
amounts. It is a yardstick which measures relationship between two
variables. Ratios are simply a means of highlighting in arithmetical
terms the relationship between the figures drawn from various financial
statements. Robert Anthony defines a ratio as “simply one number
expressed in terms of another.” A large number of ratios can be
compared from the basic financial statements – Balance Sheet and Profit
& Loss Account.
Meaning and Definition
Ratio analysis is the analysis of financial statements with the help of ratios.
It includes comparison and interpretation of these ratios and their use for future
projection. Ratio analysis does not provide and end in itself, but only a means to
understand the financial position and performance of business concerned.
Ratio analysis may be defined as “the process pf computing, determining
and presenting the relationship of items and groups of items of financial statements
with the help of ratios and interpreting the results there from”.
A ratio may be expressed in any of the following terms:
a. Quotient or Pure Ratio (which is arrived at by the simple division of one
number by another: Eg, current asset to current liability ratio is 3 : 1).
b. Percentage (which is a special type of ratio expressing the relationship in
hundred. It is arrived at by multiplying the quotient by 100. Eg, gross profit
is 40% of sales).
c. Rates (which is the ratio between the two numerical facts over a period of
time. Eg, stock turnover is five times a year).
Objectives of Ratio Analysis
It is an important tool for checking the efficiency of a firm. It helps the
financial management in evaluating the financial position and performance of the
firm. It functions as a sort of health test of the firm. The main objective of ratio
analysis is to help the management of a firm, especially in areas of sales and costs.
But at present they are used in many ways as follows:
a. Aid in comparison: The techniques of inter-firm comparison and intra firm
comparison can be carried out successfully with the help of ratio analysis.
b. Financial forecasting: With the help of ratios of various preceding years,
projections can be made for the future.
c. Cost controlling: Different expenses ratios help to reduce and control cost
elements.
d. Trend analysis: The trend of the movement of items can be studied with the
help of ratios.
e. To test profitability: The profitability of the concern can be measured with
the help of ratios such as gross profit ratio, operating profit ratio, net profit
ratio, etc.
f. To test solvency position: the solvency of a concern can be measured with
the help different ratio computed from Balance Sheet items
g. As an instrument of management: Ratio can be used as instrument of control
regarding sales, cost and profit.
h. Taking investment decisions: Ratios are helpful in computing return on
investment. It helps management in exercising effective decisions regarding
profitable avenues of investment.
i. Measuring efficiency: Ratios help to know operational efficiency by
comparison of present ratios with those of the past working and also with
those of other firms in the industry.
Importance and uses(Advantages) of Ratio Analysis
Ratio analysis is an important and useful technique to check the efficiency
with which working capital is being used in the enterprise. Some ratios indicate the
trend or progress or downfall of the firm. It helps the financial management in
evaluating the financial position and performance of the firm. The trade creditor,
bank, lending institutions and experienced investor all use ratio analysis as their
initial tool in evaluating the firm as a desirable borrower or as potential investment
outlet. It functions as a sort of health test. The following are the important
advantages of ratio analysis:
a. It makes it easy to grasp the relationship between various items and helps in
understanding the financial statements.
b. Ratios indicate trends in important items and thus helps in forecasting.
c. Inter-firm comparison can be made with the help of ratios, which may help
management in evolving future ‘market strategies’.
d. Standard ratios can be computed. Comparison of actual ratios with standard
will help in control.
e. Ratios can effectively communicate what has happened between two
accounting dates.
f. It helps in a simple assessment of liquidity, profitability, solvency and
efficiency of the firm.
g. Ratios may be used as measures of efficiency.
h. Ratios are very useful for measuring the performance and very useful in
cost control.
i. The ratio analysis proves to be a significant value to the management in the
process of the discharge of its elementary functions such as planning, co-
ordination, communication and control.
j. It throws light on the degree of efficiency of the management and utilization
of the assets and that is why it is called surveyor of efficiency. They help
management in decision making.
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