FINANCIAL STATEMENTS ANALYSIS
MEANING AND TYPES OF FINANCIAL STATEMENTS
A financial statement is an organized collection of data
according to logical and consistent accounting procedures. Its purpose is to
convey an understanding of some financial aspects of a business firm. It may
show a position at a moment of time as in the case of a balance sheet, or may
reveal a series of activities over a given period of time, as in the case of an
Income Statement.
Thus, the term 'financial statements' generally refers to
two basic statements: (i) the Income Statement and (ii) the Balance
Sheet. A business may also prepare (iii) a Statement of Retained Earnings, and
(iv) a Statement of Changes in Financial Position in addition to the above two
statements.
The meaning and significance of each of these statements
is being explained below:
1. Income Statement
The Income statement (also termed as Profit and Loss
Account) is generally considered to be the most useful of all financial
statements. It explains what has happened to a business as a result of
operations between two balance sheet dates. For this purpose it matches the
revenues and costs incurred in the process of earning revenues and shows the
net profit earned or less suffered during a particular period. The nature of
the 'Income' which is the focus of the Income Statement can be well understood
if a business is taken as an organization that uses 'inputs' to 'produce' output.
The outputs are the goods and services that the business provides to its customers.
The values of these outputs are the amounts paid by the customers for them.
These amounts are called 'revenues' in accounting. The inputs are the economic
resources used by the business in providing these goods and services. These are termed as 'expenses' in accounting.
2. Balance Sheet
It is a statement of financial position of a business at a
specified moment of time. It represents all assets owned by the business at a
particular moment of time and the claims of the owners at outsiders against
those assets at that time. It is in a way a snapshot of the financial condition
of the business at that time. The important distinction between an income
statement and a Balance Sheet is that the Income Statement is for a period
while Balance Sheet is on a particular date. Income Statement is, therefore, a
flow report, as contrasted with the Balance Sheet which is a static report.
However both are complementary to each other.
3. Statement of Retained Earnings
The term retained earnings means the accumulated excess of
earnings over losses and dividends. The balance shown by the Income Statement
is transferred to the Balance Sheet through this statement, after making
necessary appropriations. It is thus a connecting link between the Balance
Sheet and the Income Statement. It is fundamentally a display of things that
have caused the beginning of the period retained earnings balance to be changed
into the one shown in the end- of the period balance sheet. The statement is
also termed as Profit and Loss Appropriation Account in case of companies.
4. Statement of Changes in Financial Position (SCFP)
The Balance Sheet shows the financial condition of the
business at a particular moment of time while the Income Statement discloses
the results of operations of business over a period of time. However, for a
better understanding of the affairs of the business, it is essential to
identify the movement of working capital or cash in and out of the business.
This information is available in the statement of changes in financial position
of the business. The statement may emphasize any of the following aspects
relating to change in financial position of the business:
i. Change in working capital position. In such a
case the statement is termed as SCFP (Working Capital basis) or popularly Funds
Flow Statement.
ii. Change in cash position. In such a case the
statement is termed as SCFP (Cash basis) or popularly Cash Flow Statement.
iii. Change in overall financial position. In such
a case the statement is termed simply as Statement of Changes in Financial
Position (SCFP).
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
Financial Statements are indicators of the two significant
factors:
i. Profitability, and
ii. Financial soundness
Analysis and interpretation of financial statements, therefore,
refers to such a treatment of the information contained in the Income Statement
and the Balance Sheet so as to afford full diagnosis of the profitability and
financial soundness of the business.
A distinction here can be made between the two terms -
'Analysis' and ‘interpretation’. The term' Analysis' means methodical
classification of the data given in the financial statements. The figures given
in the financial statements will not help one unless they are put in a
simplified form. For example, all items relating to 'Current It Assets' are put
at one place while all items relating to 'Current Liabilities' are put at
another place. The term 'Interpretation' means explaining the meaning and
significance of the data so simplified. However, both' Analysis' and 'Interpretation'
are complementary to each other. Interpretation requires Analysis, while
Analysis is useless without Interpretation. Most of the authors have used the term'
Analysis' only to cover the meanings of both analysis and interpretation, since
analysis involves interpretation. According to Myres, "Financial statement
analysis is largely a study of the relationship among the various financial
factors in a business as disclosed by a single set of statements and a study of
the trend of these factors as shown in a series of statements." For the
sake of convenience, we have also used the term 'Financial Statement Analysis'
throughout the chapter to cover both analysis and interpretation. '
TYPES OF FINANCIAL
ANALYSIS
Financial Analysis can be classified into different
categories depending upon (i) the material used, and (ii) the modus
operandi of analysis.
1. On the Basis of Material Used
According to this basis, financial analysis can be of two
types:
(i) External Analysis. This analysis is done by
those who are outsiders for the business. The term outsiders include investors,
credit agencies, government agencies and other creditors who have no access to
the internal records of the company. These persons mainly depend upon the
published financial statements. Their analysis serves only a limited purpose.
The position of, these analysts has improved in recent times on account of
increased governmental control over companies and governmental regulations
requiring more detailed disclosure of information by the companies in their
financial statements.
(ii) Internal Analysis. This analysis is done by
persons who have access to the books of account and other information related
to the business. Such an analysis can, therefore, be done by executives and
employees of the organization or by officers appointed for this purpose by the
Government or the Court under powers vested in them. The analysis is done
depending upon the objective to be achieved through this analysis.
2. On the basis of modus operandi
According to this, financial analysis can also be of two
types:
(i) Horizontal Analysis. In case of this type of
analysis, financial statements for a number of years are reviewed and analyzed.
The current year's figures are compared with the standard or base year. The
analysis statement usually contains figures for two or more years and the
changes are shown regarding each item from the base year usually in the fom1 of
percentage. Such an analysis gives the management considerable insight into
levels and areas of strength and weakness. Since this type of analysis is based
on the data from year to year rather than on one date, it is also
tern as 'Dynamic Analysis'.
(ii) Vertical Analysis. In case of this type of
analysis a study is made of the quantitative relationship of the various items
in the financial Statements on a particular date. For example, the ratios of
different items of costs for a particular period may be calculated with the
sales for that period. Such an analysis is useful in comparing the performance
of several companies in the same group', or divisions or department in the same company. Since this analysis depends
on the data for one period, this is not very
conducive to a proper analysis of the company's financial position. It is also called 'Static Analysis' as it is
frequently used for referring to ratios
developed on one date or for one accounting period. It is to be noted that both analyses-vertical and
horizontal-can be done simultaneously also.
For example, the Income Statement of a company for several years may be given. Horizontally it may show the change in
different elements of cost and sales over a
number of years. On the other hand, vertically it may show the percentage of each element of cost to sales.
STEPS
INVOLVED IN FINANCIAL STATEMENTS ANALYSIS
The analysis of the financial
statements requires:
(i). Selection of data sources
and techniques
(ii). Methodical classification
of the data given in the financial statements.
(iii) Comparison of the various
inter-connected figures with each other by different 'Tools of Financial Analysis'.
(iv). Interpreting the result of
the analysis.
Each of the above steps has been
explained in the following pages.
Methodical
Classification
In order to have a meaningful
analysis it is necessary that figures should be arranged properly. Usually
instead the two-column (T form) statements, as ordinarily prepared the
statements are prepared in single (vertical) column form "which should
throw up significant figures by adding or subtracting". This also facilitates
showing the figure of a number of firms or number of years side by side for
comparison purposes.
METHOD or TECHNIQUES
OF FINANCIAL ANALYSIS
A financial analyst can adopt
one or more of the following techniques/tools of financial analysis:
1. Comparative Financial Statements
Comparative financial statements are those statements
which have been designed in a way so as to provide time perspective to the
consideration of various elements of financial position embodied in such
statements. In these statements figures for two or more periods are placed side
by side to facilitate comparison. Both the Income Statement and Balance Sheet
can be prepared in the form of Comparative Financial Statements.
(i) Comparative Income Statement. The Income Statement
discloses Net Profit or Net Loss on account of operations. A Comparative Income
Statement will show the absolute figures for two or more periods, the absolute
change from one period to another and, if desired, the change in terms of
percentages. Since the figures for two or more periods are shown side by side,
the reader can quickly ascertain whether sales have increased or decreased,
whether cost of sales has increased or decreased, etc. Thus, only a reading of
data included in Comparative Income Statements will be helpful in deriving
meaningful conclusions.
(ii) Comparative Balance Sheet. Comparative Balance
Sheet as on two or more different dates can be used for comparing assets and
liabilities and finding out any increase or decrease in those items. Thus;
while in a single Balance Sheet the emphasis is on present position, it is on
change in the comparative Balance Sheet. Such a Balance Sheet is very useful in
studying the trends in an enterprise.
2. Common-size Financial Statements
Common-size Financial Statements are those in which
figures reported are converted into percentages to some common base. In the
Income Statement the sale figure is assumed to be 100 and all figures are
expressed as a percentage of this total.
3. Trend Percentages
Trend percentages are immensely helpful in making a
comparative study of the financial statements for several years. The method of
calculating trend percentages involves the calculation of percentage
relationship that each item bears to the same item in the base year. Any year
may be taken as the base year. It is usually the earliest year. Any intervening
year may also be taken as the base year. Each item of base year taken as 100
and on that basis the percentages for each of the items of each of the fears
is calculated. These percentages can also be taken as Index Numbers showing
relative changes in the financial data resulting with the passage of time.
The method of trend percentages is a useful analytical
device for the management since by substituting percentages for large amounts;
the brevity and readability are achieved. However, trend percentages are not
calculated for all of the items in the financial statements. They are usually
calculated only for major items since the purpose is to highlight important
changes.
4. Funds Flow Analysis
Funds flow analysis has become an important tool in the
analytical kit of financial analysts, credit granting institutions and
financial managers. This is because the Balance Sheet of a business reveals its
financial status at a particular point of time. It does not sharply focus those
major financial transactions which have been behind the Balance Sheet changes.
For example, if a loan of Rs.2, 00,000 was raised and paid during the
accounting year, the balance sheet will not depict this transaction.
However, a financial analyst must know the purpose for
which the loan was utilized and the source from which it was obtained. This
will help him in making a better estimate about the company's financial
position and policies. Funds flow analysis reveals the changes in working
capital position. It tells about the sources from which the working capital was
obtained and the purposes for which is used. It brings out in open the changes
which have taken place behind the Ice Sheet. Working capital being the
life-blood of the business, such an analysis is extremely useful. The technique
and the procedure involved in funds flow analysis has been discussed in detail
later in the book.
5. Cost-Volume-Profit Analysis
Cost-Volume-Profit Analysis is an important tool of profit
planning. It studies the relationship between cost, volume of production, sales
and profit. Of course, it is not strictly a technique used for analysis of
financial statements. However, it is an important tool for the management for
decision-making since the data is provided by both cost and financial records.
It tells the volume of sales at which firm will break-even, the effect on
profit on 'account of variation in output, selling price and cost, and finally,
the quantity to be produced and sold to reach the, target profit level.
6. Ratio Analysis
This is the most important tool available to financial
analysts for their work. An accounting ratio shows the relationship in
mathematical terms between two interrelated accounting figures. The figures
have to be interrelated (e.g., Gross Profit and Sales, Current Assets
and Current Liabilities), because no useful purpose will be served if ratios
are calculated between two figures which are not at all related to each other, e.g.,
sales and discount on issue of debentures.
LIMITATIONS OF FINANCIAL ANALYSIS
1. Financial Analysis is only a Means
Financial analysis is a means to an end and not the end
itself. The analysis should be used as a starting point and the conclusion
should be drawn not in isolation, but keeping view the overall picture and the
prevailing economic and political situation.
2. Ignores Price Level Changes
Financial statements are normally prepared on the concept
of historical costs. They do not reflect values in terms of current costs.
Thus, the financial analysis based on such financial statements or accounting
figures would not portray the effects of price level changes over the period.
3. Financial Statements are Essentially Interim Reports
The profit shown by Profit and Loss Account and the
financial position as depicted by the Balance Sheet is not exact. The exact
position can be known only when the business is closed down. Again, the
existence of contingent liabilities and deferred revenue expenditure make them
more imprecise.
4. Accounting Concepts and Conventions
Financial statements are prepared on the basis of certain
accounting concept and conventions. On account of this reason the financial
position as disclosed by statements may not be realistic. For' example, fixed
assets in the balance sheet, shown on the basis of going concern concept. This
means that value placed on& assets may not be the same which may be
realized on their sale. On account convention of conservatism the income
statement may not disclose true income of the business since probable losses
are considered while probable incomes are ignored.
5. Influence of Personal Judgment
Many items are left to the personal judgment of the
accountant. For example, the method of depreciation, mode of amortization of
fixed assets, treatment of deferred revenue expenditure - all depend on the
personal judgment of the accountant. The soundness of such judgment will
necessarily depend upon his competence and integrity. However convention of
consistency acts as a controlling factor on making indiscreet personal
judgments.
6. Disclose only Monetary Facts
Financial statements do not depict those facts which
cannot be expressed in terms of money. For example, development of a team of
loyal and efficient workers, enlightened management, the reputation and
prestige of management with the public are matters which are of considerable
importance for the business, but they are nowhere depicted by financial
statements.
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