FINANCIAL STATEMENTS ANALYSIS CHAPTER OBJECTIVES

DEFINITIONS “Analysing financial statements,” according to Metcalf and Titard, “is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance.”

In the words of Myers, “Financial statement analysis is largely a study of 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.”<br>

OBJECTIVES AND IMPORTANCE OF FINANCIAL STATEMENT ANALYSIS To assess the earning capacity or profitability of the firm.
To assess the operational efficiency and managerial effectiveness.
To assess the short term as well as long term solvency position of the firm.
To identify the reasons for change in profitability and financial position of the firm.
To make inter-firm comparison.
To make forecasts about future prospects of the firm.
To assess the progress of the firm over a period of time.
To help in decision making and control.
To guide or determine the dividend action.
To provide important information for granting credit.<br>

TYPES OF FINANCIAL ANALYSIS<br>

PROCEDURE OF FINANCIAL STATEMENTS ANALYSIS The analyst should acquaint himself with the principles and postulates of accounting.
The extent of analysis should be determined so that the sphere of work may be decided.
The financial data given in the statements should be re–organised and re–arranged.
A relationship is established among financial statements with the help of tools and techniques of analysis such as ratios, trends, common size, funds flow etc.
The information is interpreted in a simple and understandable way. The significance and utility of financial data is explained for helping decision–taking.
The conclusions drawn from interpretation are presented to the management in the form of reports.<br>

TOOLS/METHODS OR TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS<br>

COMPARATIVE STATEMENTS The comparative financial statements are statements of the financial position at different periods; of time. The elements of financial position are shown in a comparative form so as to give an idea of financial position at two or more periods.

The two comparative statements are
(i) Balance sheet, and
(ii) Income statement.<br>

COMPARATIVE BALANCE SHEET Comparative balance sheet of an enterprise is prepared to show different assets, liabilities and capital as on two or more dates so as to compare and ascertain any increase or decrease in absolute items and also percentages changes.
A comparative balance sheet contains the following columns :
(i) Particulars column.
(ii) Data of Previous period/year’s balance sheet.
(iii) Data of the current year’s balance sheet.
(iv) Increase or decrease in the absolute data.
(v) Percentage change of increase or decrease in data.<br>

FORMAT OF COMPARATIVE BALANCE SHEET<br>

COMPARATIVE INCOME STATEMENT OR STATEMENT OF PROFIT AND LOSS The income statement gives the results of the operations of a business. It shows the net profit or net loss on account of business operations. The comparative income statement gives an idea of the progress of a business over a period of time.
A comparative income statement, contains the following columns :
Particulars column.
Data of previous period/year’s statement of profit and loss.
Data of current period/year’s statement of profit and loss.
Increase or decrease in the absolute data.
Percentage change of increase or decrease.<br>

FORMAT OF COMPARATIVE STATEMENT OF PROFIT AND LOSS<br>

COMMON–SIZE BALANCE SHEET A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common–size balance sheet.<br>

COMMON SIZE STATEMENT OF PROFIT AND LOSS The items in statement of profit and loss can be shown as percentages of revenue from operations (sales) to show the relation of each item to sales. A significant relationship can be established between items of income statement and volume of sales.<br>

TREND ANALYSIS The financial statements may be analysed by computing trends of series of information. This method determines the direction upwards or downwards and involves the computation of the percentage relationship that each statement item bears to the same item in base year. The information for a number of years is taken up and one year, generally the first year, is taken as a base year. The figures of the base year are taken as 100 and trend ratios for other years are calculated on the basis of base year. The analyst is able to see the trend of figures, whether upward or downward.<br>

Limitations of Financial Analysis It is only a study of interim reports
Financial analysis is based upon only monetary information and non–monetary factors are ignored.
It does not consider changes in price levels.
As the financial statements are prepared on the basis of a going concern, it does not give exact position. Thus accounting concepts and conventions cause a serious limitation to financial analysis.
Changes in accounting procedure by a firm may often make financial analysis misleading.
Analysis is only a means and not an end in itself. The analyst has to make interpretation and draw his own conclusions. Different people may interpret the same analysis in different ways.<br>