Financial Statement Analysis PDF

## FINANCIAL STATEMENTS ### CHAPTER OBJECTIVES - Understand the meaning, use and importance of financial statements. - Nature and limitations of financial statements. - Objectives of financial statements. - Types of financial statements. - Form and contents of income statement and balance sheet. -...

## FINANCIAL STATEMENTS ### CHAPTER OBJECTIVES - Understand the meaning, use and importance of financial statements. - Nature and limitations of financial statements. - Objectives of financial statements. - Types of financial statements. - Form and contents of income statement and balance sheet. - Basic knowledge of published accounts. - Characteristics of ideal financial statements. ### INTRODUCTION Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information. It involves recording, classifying, and summarizing various business transactions. The end products of business transactions are the financial statements comprising primarily the position statement or the balance sheet and the income statement or the profit and loss account. These statements are the outcome of summarizing process of accounting and are, therefore, the sources of information on the basis of which conclusions are drawn about the profitability and the financial position of a concern. Financial statements are the basis for decision making by the management as well as all other outsiders who are interested in the affairs of the firm such as investors, creditors, customers, suppliers, financial institutions, employees, potential investors, Government and the general public. The analysis and interpretation of financial statements depend upon the nature and type of information available in these statements. ### MEANING OF FINANCIAL STATEMENTS A financial statement is a collection of data organized 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 in 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 the two statements: (i) the position statement or the balance sheet; and (ii) the income statement or the profit and loss account. These statements are used to convey to management and other interested outsiders the profitability and financial position of a firm. Financial statements are the outcome of summarizing process of accounting. In the words of John N. Myer, "The financial statements provide a summary of the accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a certain date and the income statement showing the results of operations during a certain period." Financial statements are prepared as an end result of financial accounting and are the major sources of financial information of an enterprise. Smith and Asburne define financial statements as, "the end product of financial accounting in a set of financial statements prepared by the accountant of a business enterprise-that purport to reveal the financial position of the enterprise, the result of its recent activities, and an analysis of what has been done with earnings." Financial statements are also called financial reports. In the words of Anthony “ Financial statements, essentially, are interim reports, presented annually and reflect a division of the life of an enterprise into more or less arbitrary accounting period-more frequently a year." ### NATURE OF FINANCIAL STATEMENTS The financial statements are prepared on the basis of recorded facts. The recorded facts are those which can be expressed in monetary terms. The statements are prepared for a particular period, generally one year. The transactions are recorded in a chronological order, as and when the events happen. The accounting records and financial statements prepared from these records are based on historical costs. The financial statements, by nature, are summaries of the items recorded in the business and these statements are prepared periodically, generally for the accounting period. The American Institute of Certified Public Accountants states the nature of financial statements as "Financial Statements are prepared for the purpose of presenting a periodical review of report on progress by the management and deal with the status of investment in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting principles and personal judgements." The American Accounting Association expresses in its statement, "Every corporate statement should be based on accounting principles which are sufficiently uniform, objective and well understood to justify opinions as to the condition and progress of business enterprise. Its basic assumption was that the purpose of periodic financial statements of a corporation is to furnish information that is necessary for the formation of dependable judgements." According to John N.Myer, "The financial statements are composed of data which are the result of a combinations of (1) recorded facts concerning the business transactions, (2) conventions adopted to facilitate the accounting technique, (3) postulates, or assumptions made to and (4) personal judgements used in the application of the conventions and postulates." ### OBJECTIVES OF FINANCIAL STATEMENTS Financial statements are the sources of information on the basis of which conclusions are drawn about the profitability and financial position of a concern. They are the major means employed by firms to present their financial situation of owners, creditors and the general public. The primary objective of financial statements is to assist in decision making. The Accounting Principles Board of America (APB) states the following objectives of financial statements: - To provide reliable financial information about economic resources and obligations of a business firm. - To provide other needed information about changes in such economic resources and obligations. - To provide reliable information about changes in net resources (resources less obligations) arising out of business activities. - To provide financial information that assists in estimating the earning potentials of business. - To disclose, to the extent possible, other information related to the financial statements that is relevant to the needs of the users of these statements. ### ANATOMY/TYPES OF FINANCIAL STATEMENTS Financial statements primarily comprise two basic statements: (i) the position statement or the balance sheet; and (ii) the income statement or the profit and loss account However, Generally Accepted Accounting Principles (GAAP) specify that a complete set of financial statements must include: - A balance sheet, - An income statement, - A statement of changes in owners' accounts, and - A statement of changes in financial position. Before we discuss the form and contents of these statements, Let us briefly explain the meaning and significance of each of these statements. **1. Balance Sheet**. The American Institute of Certified Public Accountants defines Balance Sheet as, "A tabular statement of summary of balances (debits and credits) carried forward after an actual and constructive closing of books of account and kept according to principles of accounting." The purpose of the balance sheet is to show the resources that the company has, i.e., its assets, and from where those resources come from, i.e. its liabilities and investments by owners and outsiders. The balance sheet is one of the important statements depicting the financial strength of the concern. It shows on the one hand the properties that it utilises and on other hand the sources of those properties. The balance sheet shows all the assets owned by the concern and all the liabilities and claims it owes to owners and outsiders. The balance sheet is prepared on a particular date. The right hand side shows properties and assets. Normally there is no particular sequence for showing various assets and liabilities. The Companies Act, 1956 has prescribed a particular form for showing assets and liabilities in the balance sheet for companies registered under this act. These companies are also required to give figures for the previous year along with the current year's figures. **2. Income Statement (Or Profit and Loss Account)**. Income statement 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. If there is excess of revenues over expenditures it will show a profit and if the expenditures are more than the income then there will be a loss. The income statement is prepared for a particular period, generally a year. When income statement is prepared for the year ending on 31st December 2014 then all revenues and expenditures falling due in that year will be taken into account irrespective of their receipt or payment. **3. Statement of Changes in Owners' Equity (Or Retained Earnings)**. The term 'owners equity' refers to the claims of the owners of the business (shareholders) against the assets of the firm. It consists of two elements; (i) paid-up share capital, i.e. the initial amount of funds invested by the shareholders; and (ii) retained earnings/ reserves and surplus representing undistributed profits. The statement of changes in owners' equity simply shows the beginning balance of each owner's equity account, the reasons for increases and decreases in each, and its ending balance. However, in most cases, the only owner's equity account that changes significantly is Retained Earnings and hence the statement of changes in owners' equity becomes merely a statement of retained earnings. A statement of retained earnings is also known as Profit and Loss Appropriation Account or Income Disposal Statement. As the name suggests it shows appropriations of earnings. The previous year's balance is first brought forward. The net profit during the current year is added to this balance. On the debit side, appropriations like interim dividend paid, proposed dividend on preference and equity share capital, amounts transferred to debenture redemption fund, capital redemption funds, general reserve, etc. are shown. The balance in this account will show the amount of profit retained in hand and carried forward. The appropriations cannot be more than the profits so this account will not have a debit balance. There cannot be appropriations without profits. **4. Statement of Changes in Financial Position**. The basic financial statements, i.e., the balance sheet and the profit and loss account or income statement of a business reveal the net effect of the various transactions on the operational and financial position of the company. The balance sheet gives a static view of the resources of a business and the uses to which these resources have been put at a certain point of time. The profit and loss account in a general way, indicates the resources provided by operations. But there are many transactions that do not operate through profit and loss account. Thus, for a better understanding another statement called statement of changes in financial position has to be prepared to show the changes in assets and liabilities from the end of one period to the end of another point of time. The objective of this statement is to show the movement of funds (working capital or cash) during a particular period. The statement of changes in financial position may take any of the following two forms: - **Funds Flow Statement**. The funds flow statement is designed to analyse the changes in the financial condition of a business enterprise between two periods. The word 'Fund' is used to denote working capital. This statement will show the sources from which the funds are received and the uses to which these have been put. This statement enables the management to have an idea about the sources of funds and their uses for various purposes. This statement helps the management in policy formulation and performance appraisal. - **Cash Flow Statement**. A statement of changes in the financial position of a firm on cash basis is called Cash Flow Statement. It summarises the causes of changes in cash position of a business enterprise between dates of two balances sheets. This statement is very much similar to the statement of changes in working capital, i.e., funds flow statement. A cash flow statement focuses attention on cash changes only. It describes the sources of cash and its uses. The preparation and use of fund flow and cash flow statements have been discussed in detail as separate chapters later in the book. However, the form and content of the other financial statements has been explained in this chapter. ### FORM AND CONTENTS OF BALANCE SHEET There is no specific form for the preparation of Balance Sheet in the case of proprietory concerns and partnership firms. The balance sheet is generally divided into three parts, i.e. assets, liabilities and capital The balance sheet is usually prepared in a horizontal form. The assets are shown on the right hand side and capital and liabilities are shown on the left hand side. The order of assets and liabilities is either (i) on liquidity basis or (ii) on permanency basis. When balance sheet is prepared on liquidity basis then more liquid assets like cash in hand, cast at bank, investments, etc., are shown first and the least liquid assets will be shown at last. On liabilities side, the liabilities to be paid in the short period are shown first, long-term liabilities next and capital on the last. The liquidity form is suitable for the banking and other financial companies. When balance sheet is prepared on permanency basis, on assets side fixed assets are shown first and liquid assets are shown at last. On liabilities side the capital is shown first, 'long-term liabilities next, short term and current liabilities in the last. The Companies Act has adopted permanency form for preparing balance sheet. The Companies Act, 1956 has prescribed a form for the preparation of Balance Sheet. This form is set out in Part I of Schedule VI or as near thereto as circumstances admit. Section 211 (i) states that every balance sheet of a company shall give a true and fair view of the state of affairs of the company as at the end of the financial year and shall, subject to the provisions of the sections, be in the form set out in Part I of Schedule VI, or as near thereto as circumstances admit or in such other form as may be approved by the Central Government either generally or in particular case; and in preparing the balance sheet due regard shall be had, as far as may be to be general instructions for preparation of balance sheet under the heading "Notes" at the end of that Part. Provided that nothing contained in this sub-section shall apply to any insurance or banking company or any company engaged in the generation or supply of electricity or to any other class of company for which a form of balance sheet has been specified in or under the Act governing such class of companies. Ministry of Corporate Affairs (MCA) has revised schedule VI of the Companies Act, 1956 and this new schedule is effective from 1st April 2011. While both vertical and horizontal forms of presentation were allowed under old schedule, only vertical form is allowed under Revised Schedule VI. The new form of Balance Sheet as per revised schedule is as follows: ### GENERAL INSTRUCTIONS FOR PREPARATION OF BALANCE SHEET 1. An asset shall be classified as current when it satisfies any of the following criteria: - it is expected to be realized in, or is intended for sale or consumption in, the company's normal operating cycle; - it is held primarily for the purpose of being traded; - it is expected to be realized within twelve months after the reporting date; or - it is cash or cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date. All other assets shall be classified as non-current. 2. An operating cycle is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. Where the normal operating cycle cannot be identified, it is assumed to have a duration of 12 months. 3. A liability shall be classified as current when it satisfies any of the following criteria. - it is expected to be settled in the company's normal operating cycle; - it is held primarily for the purpose of being traded; - it is due to be settled within twelve months after the reporting date; or - the company does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting date. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. All other liabilities shall be classified as non-current. 4. A receivable shall be classified as a 'trade receivable' if it is in respect of the amount due on account of goods sold or services rendered in the normal course of business. 5. A payable shall be classified as a 'trade payable' if it is in respect of the amount due on account of goods purchased or services received in the normal course of business. ### FORM AND CONTENTS OF INCOME STATEMENT OR STATEMENT OF PROFIT AND LOSS The income statement or profit and loss account is prepared according to the nature of business. A trading concern will prepare trading and profit and loss account for finding out gross profit and net profit respectively. A manufacturing concern will first prepare manufacturing account for finding out the cost of production and then it will prepare trading and profit and loss account. In case of sole proprietory and partnership concerns there are no prescribed forms for income statement. The preparation of this statement is not compulsory but desirable. In case of joint stock companies the preparation of income statement for every financial year is compulsory. Section 211 of the Act prescribes the contents to be disclosed in this statement. Section 211 (2) says that profit and loss account of a company shall give a true and fair view of the profit and loss of the company for the financial year and shall comply with the requirements of PartII of Schedule VI. A specific form for income statement is given for banking company and Insurance company by the Banking Companies Act and Insurance Companies Act respectively. The format of Profit and Loss statement as per Revised Schedule VI is given as follows: #### GENERAL INSTRUCTIONS FOR PREPARATION OF STATEMENT OF PROFIT AND LOSS 1. The provisions of this part shall apply to the income and expenditure account referred to in sub-section (2) of Section 210 of the Act, in like manner as they apply to a statement of profit and loss. 2. (A) In respect of a company other than a finance company revenue from operations shall disclose separately in the notes revenue from - sale of products; - sale of services; - other operating revenues; Less: - Excise duty. (B) In respect of a finance company, revenue from operations shall include revenue from - Interest; and - Other financial services Revenue under each of the above heads shall be disclosed separately by way of notes to accounts to the extent applicable. 3. Finance Costs Finance costs shall be classified as: - Interest expenses; - Other borrowing costs; - Applicable net gain/loss on foreign currency transactions and translation. 4. Other Income Other income shall be classified as: - Interest income (in case of a company other than a finance company); - Dividend income - Net gain/loss on sale of investments - Other non-operating income (net of expenses directly attributable to such income). 5. Additional Information A company shall disclose by way of notes additional information regarding aggregate expenditure and income on the following items: - (a) Employee Benefits Expense [showing separately (i) salaries and wages, (ii) contribution to provident and other funds, (iii) expense on Employee Stock Option Scheme (ESOP) and Employee Stock Purchase Plan (ESPP), (iv) Staff welfare expenses]. - (b) Depreciation and amortization expense; - (c) Any item of income or expenditure which exceeds one per cent of the revenue from operations or Rs.1,00,000, which ever is higher; - (d) Interest Income; - (e) Interest Expense; - (f) Dividend Income; - (g) Net gain/loss on sale of investments; - (h) Adjustments to the carrying amount of investments; - (i) Net gain or loss on foreign currency transaction and translation (other than considered as finance costs); - (j) Payments to the auditor as (a) auditor, (b) for taxation matters, (c) for company law matters, (d) for management services, (e) for other services, (f)for reimbursement of expenses; - (k) Details for items of exceptional and extraordinary nature; - (i) Prior period items; - (ii) (a) In the case of manufacturing companies; - (1) Raw materials under broad heads. - (2) Goods purchased under broad heads. - (b) In the case of trading companies, purchases in respect of goods traded in by the company under broad heads. - (c) In the case of companies rendering or supplying services, gross income derived from services rendered or supplied under broad heads. - (d) In the case of a company, which falls under more than one of the categories mentioned in (a), (b) and (c) above, it shall be sufficient compliance with the requirements heere in if purchases, sales and consumption of raw material and the gross income from services rendered is shown under broad heads. - (e) In the case of other companies, gross income derived under broad heads. - (iii) In the case of all concerns having works in progress, works-in-progress under broad heads. - (iv) (a) The aggregate, if material, of any amounts set aside or proposed to be set aside, to reserve, but not including provisions made to meet any specific liability, contingency or commitment known to exist at the date as to which the balance-sheet is made up. - (b) The aggregate, if material, of any amounts withdrawn from such reserves. - (v) (a)The aggregate, if material, of the amounts set aside to provisions made for meeting specific liabilities, contingencies or commitments. - (b) The aggregate, if material, of the amounts withdrawn from such provisions, as no longer required. - (vi) Expenditure incurred on each of the following items, separately for each item: - (a) Consumption of stores and spare parts. - (b) Power and fuel. - (c) Rent. - (d) Repairs to buildings. - (e) Repairs to machinery. - (f) Insurance - (g) Rates and taxes, excluding, taxes on Income. - (i) Miscellaneous expenses. - (vii) (a) Dividends from subsidiary companies. - (b) Provisions for losses of subsidiary companies. - (viii) The profit and loss account shall also contain by way of a note the following information, namely: - (a) Value of imports calculated on C.I.F. basis by the company during the financial year in respect of - I. Raw materials; - II. Components and spare parts; - III. Capital goods; - (b) Expenditure in foreign currency during the financial year on account of royalty, know-how, professional and consultation fees, interest, and other matters; - (c) Total value if all imported raw materials, spare parts and components consumed during the financial year and the total value of all indigenous raw materials, spare parts and components similarly consumed and the percentage of each to the total consumption; - (d) The amount remitted during the year in foreign currencies on account of dividends with a specific mention of the total number of non-resident shareholders, the total number of shares held by them on which the dividends were due and the year to which the dividends related; - (e) Earnings in foreign exchange classified under the following heads, namely: - I. Export of goods calculated on F.O.B. basis; - II. Royalty, know-how, professional and consultation fees; - III. Interest and dividend; - IV. Other income, indicating the nature thereof. **Note.** "Broad heads shall be decided taking into account the concept of materiality and presentation of true and fair view of financial statements." ### CHARACTERISTICS OF IDEAL FINANCIAL STATEMENTS The financial statements are prepared with a view to depict financial position of the concern. A proper analysis and interpretation of these statements enables a person to judge the profitability and financial strength of the business. The financial statements should be prepared in such a way that they are able to give a clear and orderly picture of the concern. The ideal financial statements have the following characteristics: - **Depict True Financial Position**. The information contained in the financial statements should be such that a true and correct idea is taken about the financial position of the concern. No material information should be withheld while preparing these statements. - **Effective Presentation**. The financial statements should be presented in a simple and lucid way so as to make them easily understandable. A person who is not well versed with accounting terminology should also be able to understand the statements without much difficulty. This characteristic will enhance the utility of these statements. - **Relevance**. Financial statements should be relevant to the objectives of the enterprise. This will be possible when the person preparing these statements is able to properly utilise the accounting information. The information which is not relevant to the statements should be avoided, otherwise it will be difficult to make a distinction between relevant and irrelevant data. - **Attractive**. The financial statements should be prepared in such a way that important information is underlined so that it attracts the eye of the reader. - **Easiness**. Financial statements should be easily prepared. The balances of different ledger accounts should be easily taken to these statements. The calculation work should be minimum possible while preparing these statements. The size of the statements should not be very large. The columns to be used for giving the information should also be less. This will enable the saving of time in preparing the statements. - **Comparability**. The results of financial analysis should be in a way that can be compared to the previous years statements. The statement can also be compared with the figures of other concerns of the same nature. Sometimes budgeted figures are given along with the present figures. The comparable figures will make the statements more useful. The Indian Companies Act, 1956 has made it obligatory to give previous year's figures in the balance sheet. The comparison of figures will enable a proper assessment for the working of the concern. - **Analytical Representation**. The information should be analysed in such a way that similar data is presented at the same place. A relationship can be established in similar type of information. This will be helpful in analysis and interpretation of data. - **Brief**. If possible, the financial statements should be presented in brief. The reader will be able to form an idea about the figures. On the other hand, if figures are given in details then it will become difficult to judge the working of the business. - **Promptness**. The financial statements should be prepared and presented at the earlist possible. Immediately at the close of the financial year, statements should be ready. ### USE AND IMPORTANCE OF FINANCIAL STATEMENTS The financial statements are mirror which reflects the financial position and operating strength or weakness of the concern. These statements are useful to management, investors, creditors, bankers, workers, government and public at large. George O. May points out the following major uses of financial statements - As a report of stewardship; - As a basis for fiscal policy; - To determine the legality of dividends; - As guide to advise dividend action; - As a basis for the granting of credit; - As informative for prospective investors in an enterprise; - As a guide to the value of investment already made; - As an aid to government supervision; - As a basis for price or rate regulation; - As a basis for taxation. The utility of financial statements to different parties is discussed in detail as follows: - **Management**. The financial statements are useful for assessing the efficiency for different cost centres. The management is able to exercise cost control through these statements. The efficient and inefficient spots are brought to the notice of the management. The management is able to decide the course of action to be adopted in future. - **Creditors**. The trade creditors are to be paid in a short period. This liability is met out of current assets. The creditors will be interested in current solvency of the concern. The calculation of current ratio and liquid ratio will enable the creditors to assess the current financial position of the concern in relation to their debts. - **Bankers**. The banker is interested to see that the loan amount is secure and the customer is also able to pay the interest regularly. The banker will analyse the balance sheet to determine financial strength of the concern and profit and loss account will also be studied to find out the earning position. A banker has a large number of customers and it is not possible to supervise their business activities. It is through the financial statements that a banker can keep a watch on the business plans and performances of its customers. These statements also help the banker to determine the amount of securities it will ask from the customers as a cover for the loans. - **Investors**. The investors include both short-term and long-term investors. They are interested in the security of the principal amount of loan and regular interest payments by the concern. The investors will study the long-term solvency of the concern with the help of financial statements. The investors will not only analyse the present financial position but will also study future prospects and expansion plans of the concern. The possibility of paying back the loan amount in the face of liquidation of the concern is also taken into consideration. - **Government**. The financial statements are used to assess tax liability of business enterprises. The government studies economic situation of the country from these statements. These statements enable the government to find out whether business is following various rules and regulations or not. These statements also become a base for framing and amending various laws for the regulation of business. - **Trade Associations**. These associations provide service and protection to the members. They may analyse the financial statements for the purpose of providing facilities to these members. They may develop standard ratios and design uniform system of accounts. - **Stock Exchange**. The stock exchanges deal in purchase and sale of securities of different companies. The financial statements enable the stock brokers to judge the financial position of different concerns. The fixation of prices for securities, etc., is also based on these statements. ### LIMITATIONS OF FINANCIAL STATEMENTS Though financial statements are relevant and useful for the concern, still they do not present a final picture of the concern. The utility of these statements is dependent upon a number of factors. The analysis and interpretation of these statements should be done very carefully otherwise misleading conclusions may be drawn. The financial statements suffer from the following limitations: - **Only Interim Reports**. These statements do not give a final picture of the concern. The data given in these statements is only approximate. The actual position can only be determined when the business is sold or liquidated. However, the statements have to be prepared for different accounting periods, generally one year, during the life time of the concern. The costs and incomes be apportioned to different periods with a view to determine profits etc. The allocation of expenses and incomes will depend upon the personal judgement of the accountant. The existence of contingent assets and liabilities also makes the statements imprecise. So financial statements do not give the final picture and they are at the most interim reports. - **Do not give Exact Position**. The financial statements are expressed in monetary values, so they appear to give final and accurate position. The value of fixed assets in the balance sheet neither represents the value for which fixed assets can be sold nor the amount which will be required to replace these assets. The balance sheet is prepared on the presumption of a going concern. The concern is expected to continue in the future. So, fixed assets are shown at cost less accumulated depreciation. There are certain assets in the balance sheet such as preliminary expenses, goodwill, discount on issue of shares which will realise nothing at the time of liquidation though they are shown in the balance sheet. - **Historical Costs**. The financial statements are prepared on the basis of historical costs or original costs. The value of assets decreases with the passage of time current price changes are not taken into account. The statements are not prepared keeping in view the present economic conditions. The balance sheet loses the significance of being an index of current economic realities. Similarly, the profitability shown by the income statement may not represent the earning capacity of the concern. The increase in profits may be due to an increase in prices or due to some abnormal causes and not due to increase in efficiency. The conclusions drawn form financial statements may not give a fair picture of the concern. - **Impact of Non-monetary Factors Ignored**. There are certain factors which have a bearing on the financial position and operating results of the business but they do not become a part of these statements because they cannot be measured in monetary terms. Such factors may include the reputation of the management, credit worthiness of the concern, sources and commitments for purchases and sales, co-operation of the employees, etc. The financial statements only show the position of the financial accounting for business and not the financial position. - **No Precision**. The precision of financial statement data is not possible because the statements deal with matters which cannot be precisely stated. The data are recorded by conventional procedures followed over the years. Various conventions, postulates, personal judgements etc. are used for developing the data. ## FINANCIAL STATEMENTS ANALYSIS ### CHAPTER OBJECTIVES - Focus on determining financial strengths and weaknesses of a firm. - Meaning and concept of financial analysis. - Comparative statements, trend analysis, and common size statements. - Objectives and importance of financial analysis - Parties interested in financial analysis. - Types of financial analysis. - Limitations of financial analysis. ### INTRODUCTION Financial statements are prepared primarily for decision-making. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements. Financial analysis is 'the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.' There are various methods or techniques used in analysing financial statements, such as comparative statements, trend analysis, common-size statements, schedule of changes in working capital, funds flow and cash flow analysis, cost-volume-profit analysis and ratio analysis. ### MEANING AND CONCEPT OF FINANCIAL ANALYSIS The term 'financial analysis', also known as analysis and interpretation of financial statements', refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data. "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." The purpose of financial analysis is to diagnose the information contained in financial statements so as to judge the profitability and financial soundness of the firm. Just like a doctor examines his patient by recording his body temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment, a financial analyst analysis the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise. The analysis and interpretation of financial statements is essential to bring out the mystery behind the figures in financial statements. Financial statements analysis is an attempt to determine the significance and meaning of the financial statement data so that forecast may be made of the future earnings, ability to pay interest and debt maturities (both current and long-term) and profitability of a sound dividend policy'. ### OBJECTIVES AND IMPORTANCE OF FINANCIAL STATEMENT ANALYSIS The primary objective of financial statement analysis is to understand and diagnose the information contained in financial statement with a view to judge the profitability and financial soundness of the firm, and to make forecast about future prospects of the firm. The purpose of analysis depends upon the person interested in such analysis and his object. However, the following purposes or objectives of financial statements analysis may be stated to bring out the significance of such 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. ### PARTIES INTERESTED IN FINANCIAL ANALYSIS The following parties are interested in the analysis of financial statements: - Investors or potential investors. - Management. - Creditors or suppliers. - Bankers and financial institutions. - Employees. - Government. - Trade associations. - Stock exchanges. - Economists and researchers. - Taxation authorities The utility of the financial analysis to the above vested interests has been discussed in chapter 2 on Financial Statements as well as chapter 4 on Ratio Analysis. ### TYPES OF FINANCIAL ANALYSIS We have studied in the previous chapter that various users of financial statements study them from different angles for different purposes. However, we can classify various types of financial analysis into different categories depending upon (i) the material used, and (ii) the method of operation followed in the analysis or the modus operandi of analysis. (i) On the basis of material used. According to material used, financial analysis can be of two types: - external analysis, and - internal analysis. (ii) On the basis of modus operandi. According to the method of operation followed in the analysis, financial analysis can also be of two types: (a) horizontal analysis and (b) vertical analysis. - **Horizontal Analysis**. Horizontal analysis refers to the comparison of financial data of a company for several years. The figures for this type of analysis are presented horizontally over a number of columns. The figures of the various years are compared with standard or base year. A base year is a year chosen as beginning point. This type of analysis is also called ‘Dynamic Analysis' as it is based on the data from year to year rather than on data of any one year. The horizontal analysis makes it possible to focus attention on items that have changed significantly during the period under review. Comparison of an item over several periods with a base year may show a trend developing. Comparative statements and trend percentages are two tools employed in horizontal analysis. - **Vertical Analysis**. Vertical analysis refers to the study of relationship of the various items in the financial statements of one accounting period. In this types of analysis the figures from financial statement of a year are compared with a base selected from the same year's statement. It is also known as ‘Static Analysis'. Common-size financial statements and financial ratios are the two tools employed in vertical analysis. Since vertical analysis considers data for one time period only, it is not very conducive to a proper analysis of financial statements. However, it may be used along with horizontal analysis to make it more effective and meaningful. In addition to the above primary classification of financial analysis, the following other types of financial analysis are also discussed: (iii) On the basis of entities involved. On the basis of entities involved in the analysis, financial analysis can also be of two types (a) cross sectional or inter-firm analysis, and (b) time series or intra-firm analysis. - **Cross Sectional or Inter-firm Analysis**. Cross sectional analysis involves comparison of financial data of a firm with other firms (competitors) or industry averages for the same time period. - **Time Series or Intra-firm Analysis**. Time series analysis involves the study of performance of the same firm over a period of time. (iv)