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. '