ANALYSIS OF FINANCIAL
STATEMENTS
A firm has to prepare financial statements and provide the
needed information to the user and it should contain the summarized information
of the firm’s financial affairs organized in a systematic manner. It is the
responsibility of the concerned accounting department to prepare these
statements commonly known as profit & loss account and balance sheet.
Analysis is a process of examining critically the accounting
information given in the financial statements. Financial statements prepared to
depict the financial health of a business in terms of profits position as on a
certain date. Financial reports on the other hand are prepared and presented by
the business on the conduct of business during the accounting period.
In order to analyze the financial statements individual
items are studied and their inter relationship with other related figures are
established to have a better understanding of the information provided with the
help of certain techniques.
‘Analysis of financial statements is a process of evaluating
relationships between components of financial statements to have a better
understanding of the firm’s performance.
’
The financial statements which are generally analyzed are
profit & loss account and balance sheet.
OBJECTIVES OF FINANCIAL ANALYSIS
Financial statements are analyzed & interpreted for
different purposes. They are helpful in accessing the profitability and the
financial position of a concern. Different persons analyze financial statements
for their different purposes to achieve their certain objectives. For example,
shareholders of a company analyze financial statements to find out the
profitability, the financial strength and future prospects of the company. Similarly the creditors may analyse these statements
to ascertain the liquidity position of the company. The financial statements
are analysed with the following objectives:
1. To
judge the financial stability of a business concern.
2. To
measure the operational efficiency of the concern.
3. To
ascertain the future prospects of a concern.
4. To
assess the short term & the long term solvency of the concern.
5. To
assess the significance of financial data.
STEPS INVOLVED IN THE ANALYSIS OF
FINANCIAL STATEMENTS
It involves three important steps. They are:
1. Analysis:
It means regrouping the figures available in the financial statements into
comparable & homogeneous parts. For e.g. , if a person want to ascertain the
position of the current liabilities out of current assets he takes the current
assets and the currents liabilities to analyse and study the relationship in
order to draw conclusions.
2. Comparison: Comparison is the process of studying the
extent of relationship of the component parts for e.g., in order to know the
position of the current assets to meet its current liabilities, then the
analyst has to study the extent of relationship between the current assets
& current liabilities.
3. Interpretation:
It means formation of rational judgments and drawing proper conclusion about
the financial position and the future prospectus of the business through a
careful study of the relationship of component parts obtained through the
analysis and comparison.
TYPES OF
FINANCIAL ANALYSIS
The financial statements can be analysed on the basis of
(i) The
materials used for analysis and the people interested in the analysis
(ii) The
objectives of the analysis
(iii) The
modus operandi followed in the analysis.
(b) Internal
analysis – It is made by those people who have access to the books of the
accounts and the internal records of the business. They are the members of the
organization like the executive and the employees.
(a) Short
term analysis – It is made to determine the short term solvency, liquidity and
earning capacity of the business. The purpose of this analysis is to know
whether the business will have the sufficient funds to meet its short term
requirements. This is made on the basis of the current assets & current
liabilities available to know the current position.
(b) Long
term analysis – This analysis is made to determine the long term solvency, stability
& future earning capacity of a business. The purpose of this analysis is to
know whether a business will be able to earn sufficient amount of rate of
return on investment so as to provide funds for growth, expansion, development
of the business. This type of analysis helps the business in the long term
financial planning.
(a) Vertical
(Static) Analysis – This analysis is made to review and analyse the financial
statements of one particular year only. It is done by using the tools like
ratio analysis. Vertical analysis is useful to compare the performance of
various companies or different departments in the same company.
(b) Horizontal
(Dynamic) Analysis – This analysis is made when the financial statements of a
number of years are analyzed. This is very useful for long term planning and is
more useful than vertical analysis. It provides a considerable insight of the
business and the strength and weakness of an enterprise.
METHODS /
TOOLS OR TECHNIQUES OF FINANCIAL ANALYSIS
1) Comparative Financial Statement
Analysis – It refers to those statements of financial affairs
of a business which are prepared to provide time prospective in the various
elements of financial statements. This statement of two or more years is
prepared to show the absolute data of two or more years in terms of % which may
increase & decrease. This statement can be prepared for both profit &
loss account and balance sheet. The limitation of comparative statement is that
it does not show the changes that takes place from year to year in relation to
total assets & liabilities and capital.
For
example : from the following profit & loss a/c of SADIQ company ltd., for
the year ended 2003 & 2004, you are required to prepare a comparative
income statement.
2003 (Rs.)
|
2004 (Rs.)
|
2003(Rs.)
|
2004 (Rs.)
|
||
To cost of goods sold
|
6,00,000
|
7,50,000
|
By net sales
|
8,00,000
|
10,00,000
|
To operating expenses:
|
|||||
Administrative
|
20,000
|
20,000
|
|||
Selling
|
30,000
|
40,000
|
|||
To net profit
|
1,50,000
|
1,90,000
|
|||
8,00,000
|
10,00,000
|
8,00,000
|
10,00,000
|
Solution
- :
SADIQ COMPANY LTD.
COMPARATIVE INCOME
STATEMENT
For the year ended 31st
December 2003 & 2004
Increase or Decrease
|
||||
2003
|
2004
|
Absolute
|
Percentage
|
|
Net sales
|
8,00,000
|
10,00,000
|
+2,00,000
|
+25
|
Less: Cost of goods sold
|
6,00,000
|
7,50,000
|
+1,50,000
|
+25
|
Gross profit (A)
|
2,00,000
|
2,50,000
|
+50,000
|
+25
|
Less: Operating expenses:
|
||||
Administrative
|
20,000
|
20,000
|
------
|
-----
|
Selling
|
30,000
|
40,000
|
+10,000
|
+33.3
|
Total Operating Expenses (B)
|
50,000
|
60,000
|
+10,000
|
+20
|
Operating Profit (A-B)
|
1,50,000
|
1,90,000
|
+40,000
|
+26.7
|
Note: % change is calculated as Absolute change × 100
Previous year Value
2) Common size statement Analysis – The common size
statement analysis can be done for one year or over a period of years. It is a
statement in which the figures reported in financial statements are converted
into % taking some common base. Generally in this the net sales are taken as
100% in case of income statement (i.e. Trading & P/L a/c) while total
assets & total liabilities are taken as 100% in order to study the
relationship. It may include common size income statement & common size
balance sheet.
In common size income
statement net sales are taken as 100% and all other items of income statements
are expressed as a percentage of net sales. Similarly in case of common size of
balance sheet, the total assets or the total of liabilities & capital is taken
as 100% and all items of balance sheet are expressed as a % of total assets or
the total of liabilities & capital.
Common size financial statements
are useful for studying the comparative financial position of two or more
business units or two or more years of the same business.
For example: From the following data, prepare a common-size Balance
sheet of the Hindustan ltd.
31st December 2003
|
31st December 2004
|
|
Share Capital
|
60,000
|
60,000
|
Reserves
|
15,000
|
30,000
|
Loans
|
5,000
|
20,000
|
Sundry Creditors
|
20,000
|
10,000
|
Buildings
|
40,000
|
60,000
|
Plant
|
30,000
|
40,000
|
Stock
|
20,000
|
10,000
|
Debtors
|
8,000
|
6,000
|
Cash at bank
|
2,000
|
4,000
|
Solution - :
Particulars
|
2003
|
2004
|
||
Amount (Rs.)
|
Percentage
|
Amount (Rs.)
|
Percentage
|
|
Liabilities:
|
||||
Share Capital
|
60,000
|
60
|
60,000
|
50
|
Reserves
|
15,000
|
15
|
30,000
|
25
|
Long Term Liabilities
|
||||
Loan
|
5,000
|
5
|
20,000
|
16.67
|
Current Liabilities
|
||||
Sundry Creditors
|
20,000
|
20
|
10,000
|
8.33
|
1,00,000
|
100
|
1,20,000
|
100
|
|
Assets:
|
||||
Fixed Assets-
|
||||
Buildings
|
40,000
|
40
|
60,000
|
50
|
Plant
|
30,000
|
30
|
40,000
|
33.34
|
Current Assets-
|
||||
Stock
|
20,000
|
20
|
10,000
|
8.33
|
Debtors
|
8,000
|
8
|
6,000
|
5
|
Cash at Bank
|
2,000
|
2
|
4,000
|
3.33
|
1,00,000
|
100
|
1,20,000
|
100
|
|
3) Trend Analysis – This method is important technique
of analyzing the financial statement. The calculation of trend percentage
involves the ascertainment of arithmetical relationship with each item of
several years to the same item of base year. Thus one particular year is taken
as base year.
For Example - From the following
information, interpret the results of operations of manufacturing concern using
trend ratios:
For the year ended 31st
March
|
|||
2002
|
2003
|
2004
|
|
Sales
|
1,00,000
|
95,000
|
1,20,000
|
Cost of Goods sold
|
60,000
|
58,900
|
69,600
|
Gross Profit
|
40,000
|
36,100
|
50,400
|
Selling Expenses
|
10,000
|
9,700
|
11,000
|
Net Operating Profit
|
30,000
|
26,400
|
39,400
|
Solution –
Trend Ratios
31st March 2002-2004
For
the Year ended 31st March
|
|||
2002
|
2003
|
2004
|
|
Sales
|
100
|
95
|
120
|
Cost of Goods Sold
|
100
|
98
|
116
|
Gross Profit
|
100
|
90
|
126
|
Selling Expenses
|
100
|
97
|
110
|
Net operating Profit
|
100
|
88
|
131
|
Working Note: 2003 2004
Sales : 95,000 × 100 = 95 ; 1, 20,000 × 100 = 120
1, 00,000 1, 00,000
(Calculate the value of other items in the same manner as shown for sales.)
1) Ratio
Analysis – Ratio analysis is used to develop relationship between the
individual or group items shown in the periodical financial statements. It is a
technique of calculating a number of accounting ratios from the figures found
in financial statements. Ratios cannot be calculated between two unrelated
figures as they do not serve any purpose.
2) Fund
Flow analysis – It is prepared to reveal the different sources from where the
funds are procured and the uses to which these funds are put to use during a
particular period. A fund flow statement states the changes in the amount of
fund that takes place between the two financial years.
3) Cash
Flow analysis – It is prepared to know the different items of inflow &
outflow of cash. Generally this statement is an important tool for the analysis
of short term finances and is very useful to evaluate the current liquidity
position of a business. It also helps the managers of a business to have
efficient cash management by analyzing the inflow & outflow of cash.
LIMITATIONS OF ANALYSIS OF FINANCIAL STATEMENTS:
Financial
statements suffer from a number of limitations due to accounting conventions,
personal judgment of accountants etc. They are:
1) Financial
statements are based on historical facts. They do not take into account the
accounting data that may occur in future.
2) Analysis
of Financial statements is a tool which can be profitability used by experts
and are influenced by the personal judgments.
3) Financial
statements depict only quantitative information expressed in terms of money.
But qualitative factors like honesty, efficiency etc which are not depicted in
the financial statements.
4) Financial
statements are prepared based on accounting concepts and conventions which may
became unrealistic.
5) The
analysis of financial statement belonging to a particular year may have limited
use. Hence it is not advisable to fully depend on such analysis.
6) Most
of the time the figures shown in the financial statements are manipulated which
are questionable.
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