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Financial statement analysis
What is a financial statement?
The term financial statement refers to statement of Changes in financial position, Statement of Retained Earnings, Balance Sheet, Profit and Loss Account, etc. But, generally, the financial statements include only two statements; they are profit and Loss Account and Balance Sheet. It is observed that the mere presentation of these statements does not serve the purpose of anybody in anyway. The importance of these statements lies in their analysis and interpretation. In the beginning, analysis was done only for extending credit, but now it is being used as most important function of Management Accountant for providing various useful information to many persons. Some of the schedules are prepared and submitted along with the financial statements for meaningful presentation. Such schedules are schedule of fixed assets, schedule of debtors, schedule of creditors, schedule of investments and the like.
Nature of Financial Statements
Generally, financial statements are prepared in order to disclose the financial position of business concerns at a point of time and also operating results during the period under review. The interested parties of the financial statements are thinking that the values shown in the financial statements to be real and absolute. But, this is not correct understanding. The values shown in the financial statements never convey the current or economic values. The data shown in the financial statements are greatly affected by the following facts.
- Recorded Facts : All the business transactions which are having financial character alone recorded in the books of accounts (Journals, Ledger and other Subsidiary Books). Such recorded information are used for preparing financial statements. After some gradual passage of time, these recorded information become historical in nature. Besides, the financial statements are showing results of the various transactions which are taken place at various dates. There is no place for their current value in the financial statements which is neither justified nor logical. For example: If a plant and machinery is purchased in 2005 and another plant and machinery is purchased in 2010, then the total amount paid at both dates shall be shown under “ Plant and Machinery Account ” in the books. The purchasing power of money in 2005 is not the same in 2010. Hence, the recording the value of plant and machinery in the books of account is not valid and correct. Besides, the assets are shown in the Balance Sheet either on Straight Line Method or Written Down Value Method. Market value or replacement cost is not shown in the financial statement.
- Accounting Conventions : There are four types of accounting conventions. They are convention of conservatism, convention of full disclosure, convention of consistency and convention of materiality. These are used for valuation of raw materials, stock of finished goods,
debtors and the like. Many companies does not follow same pattern of conventions throughout its life. Hence, the financial statements fail to satisfy the essential elements of comparison.
- Postulates : There are some postulates and assumptions just like accounting concepts and conventions. Such postulates and assumptions are used for preparing. financial statements. In other words, the conventions used in financial statements are based on certain postulates. It is assumed that the purchasing power of money is constant for all the period. Hence, the management accountants are recording all the business transactions in rupee value on different dates without making any distinction between the rupee value of two dates.
- Personal Judgement : Personal judgement plays a vital role in the preparation of financial records and financial statements. The management accountants may use their judgement in choosing the method of valuation of closing inventory, in calculating the provision for bad debts and in choosing the method of charging the depreciation of fixed assets. Likewise, the application of various accounting concepts and conventions depends upon the personal judgement of the management accountant. Therefore, different meaning and results can be obtained from the financial statements of the same company. Based on the different results, different recommendations may be provided for the growth and development of a business concern. Features of Financial Statements
The important features of financial statements are as follows.
- Financial Statements are prepared at the end of the accounting period.
- Financial Statements disclose both facts and opinions.
- Financial statements are prepared on the going concern value..
- Financial statements are recorded facts of financial transactions based on historical cost.
- Financial statements are greatly affected by personal judgement of the accountants.
Objectives of Financial Statements
The different types of people are using the financial statements. They need different types of information. Hence, the main objective of financial statements is fulfilling the needs of such people. Even though, some other objectives are briefly explained below.
- To provide an accurate and reliable financial information about the resources and usage in a business unit within the stipulated time.
- To provide overall changes made in the financial information relating to resources and usage for a particular period.
- To provide accurate and reliable financial information relating to net changes made between resources and usage for a particular period arising out of business activities.
- To measure the managerial efficiency under various business situations.
- To estimate the performance evaluation of different departments over a period of time.
- To measure short term and long term solvency position of the business organization with the help of Balance Sheet.
- To examine the source of finance and way of utilizing the available finance.
- To determine earning capacity and future prospects of the business concern.
- To identify the way of utilizing fixed assets and the role of fixed assets on maintaining the earning capacity of the business concern.
- To investigate the future potential of the business concern.
- To compare operational efficiency of similar concerns engaged in the same industry.
- To identify the growth trend of the business organization. Importance of Analysis and Interpretation
All the quantitative information i.e. financial accounting information are intelligibly analyzed and interpreted so that significant facts and relationship concerning various aspects of financial life of a business concern is known to everybody. In this way, various factors have increased the importance of the analysis and interpretation of financial statements.
- Wrong and defective decisions are taken by the top management in the absence of analysis and interpretation.
- Sometimes, hasty and intuitive decisions are also taken by the various responsible executives.
- Everybody has limited experience in business activities. Hence, one can easily understand the complexities of business activities through analysis and interpretation.
- If any decision is taken on the basis of intuition or conclusion derived, there is no meaning in decision and nobody understands the decision. In other words, if the decisions are based on scientific analysis and interpretation, everybody understands the decision very easily.
- Analysis and interpretation are necessary to verify and examine the correctness and accuracy of the decisions already taken on the basis of intuition
Financial statement analysis (or financial analysis) is the process of reviewing and analyzing a company's financial statements to make better economic decisions. These statements include the income statement, balance sheet, statement of cash flows, and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.
“Analyzing 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.”
Users of Financial Statement Analysis
There are a number of users of financial statement analysis. They are:
Creditors : Anyone who has lent funds to a company is interested in its ability to pay back the debt, and so will focus on various cash flow measures. Investors : Both current and prospective investors examine financial statements to learn about a company's ability to continue issuing dividends, or to generate cash flow, or to continue growing at its historical rate Management : The company controller prepares an ongoing analysis of the company's financial results, particularly in relation to a number of operational metrics that are not seen by outside entities (such as the cost per delivery, cost per distribution channel, profit by product, and so forth). Regulatory authorities : If a company is publicly held, its financial statements are examined by the Securities and Exchange board to see if its statements conform to the various accounting standards. Others : Bankers and financial institutions Employees. Government. Trade associations. Economists and researchers. Taxation authorities
Methods of Financial Statement Analysis:
There are two key methods for analyzing financial statements.
The first method is the use of horizontal and vertical analysis. Horizontal analysis is the comparison of financial information over a series of reporting periods, while vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. Thus, horizontal analysis is the review of the results of multiple time periods; while vertical analysis is the review of the proportion of accounts to each other within a single period.
Margin of safety. Calculates the amount by which sales must drop before a company reaches its breakeven point. Net profit ratio. Calculates the amount of profit after taxes and all expenses have been deducted from net sales. Return on equity. Shows company profit as a percentage of equity. Return on net assets. Shows company profits as a percentage of fixed assets and working capital. Return on operating assets. Shows company profit as percentage of assets utilized.
Problems with Financial Statement Analysis
While financial statement analysis is an excellent tool, there are several issues to be aware of that can interfere with your interpretation of the analysis results. These issues are:
Comparability between periods****. The company preparing the financial statements may have changed the accounts in which it stores financial information, so that results may differ from period to period. For example, an expense may appear in the cost of goods sold in one period, and in administrative expenses in another period. Comparability between companies. An analyst frequently compares the financial ratios of different companies in order to see how they match up against each other. However, each company may aggregate financial information differently, so that the results of their ratios are not really comparable. This can lead an analyst to draw incorrect conclusions about the results of a company in comparison to its competitors. Operational information. Financial analysis only reviews a company's financial information, not its operational information, so you cannot see a variety of key indicators of future performance, such as the size of the order backlog, or changes in warranty claims. Thus, financial analysis only presents part of the total picture.
Some of the others important limitations of financial analysis are, however, summed up as below: (i) It is only a study of interim reports
(ii) Financial analysis is based upon only monetary information and non-monetary factors are ignored.
(iii) It does not consider changes in price levels.
(iv) 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.
(v) Changes in accounting procedure by a firm may often make financial analysis misleading.
(vi) 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.
Techniques to use to analyze your financial statements:
Trend analysis:
Trend analysis is also called time-series analysis. Trend analysis helps a firm's financial manager determine how the firm is likely to perform over time. Trend analysis is based on historical data from the firm's financial statements and forecasted data from the firm's pro forma, or forward- looking, financial statements.
One popular way of doing trend analysis is by using financial ratio analysis. If you calculate financial ratios for a business firm, you have to calculate at least two years of ratios in order for them to mean anything. Ratios are meaningless unless you have something to compare them to, in this case other years of data. Trend analysis is even more powerful if you have and use several years of financial ratios.
Common size financial statement analysis: Common size financial statement analysis is analyzing the balance sheet and income statement using percentages. All income statement line items are stated as a percentage of sales. All balance sheet line items are stated as a percentage of total assets. For example, on the income statement, every line item is divided by sales and on the balance sheet, every line item is divided by total assets. This type of analysis enables the financial manager to view the income statement and balance sheet in a percentage format which is easy to interpret.
Percentage Change Financial Statement Analysis: Percentage change financial statement analysis gets a little more complicated. When you use this form of analysis, you calculate growth rates for all income statement items and balance sheet accounts relative to a base year. This is a very powerful form of financial statement analysis. You can actually see how different income statement items and balance sheet accounts grew or declined relative to grows or declines in sales and total assets.
Benchmarking: Benchmarking is also called industry analysis. It involves comparing a company to other companies in the same industry in order to see how one company is doing financially compared to the industry. This type of analysis is very helpful to the financial manager as it helps to see if any financial adjustments need to be made.
3. Prediction of Bankruptcy and Failure: Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. After being aware about probable failure, both managers and investors can take preventive measures to avoid/minimise losses.
Corporate managements can effect changes in operating policy, reorganize financial structure or even go for voluntary liquidation to shorten the length of time losses.
In accounting and finance area, empirical studies conducted have suggested a set of financial ratios which can give early signal of corporate failure. Such a prediction model based on financial statement analysis is useful to managers, investors and creditors. Managers may use the ratios prediction model to assess the solvency position of their firms and thus can take appropriate corrective actions.
Investors and shareholders can use the model to make the optimum portfolio selection and to bring changes in the investment strategy in accordance with their investment goals. Similarly, creditors can apply the prediction model while evaluating the creditworthiness of business enterprises.
4. Loan Decision by Financial Institutions and Banks: Financial statement analysis is used by financial institutions, loaning agencies, banks and others to make sound loan or credit decision. In this way, they can make proper allocation of credit among the different borrowers. Financial statement analysis helps in determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date etc.
However, objectives of financial statements analysis may be stated to bring out the significance of such analysis: (i) To assess the earning capacity or profitability of the firm.
(ii) To assess the operational efficiency and managerial effectiveness.
(iii) To assess the short term as well as long term solvency position of the firm.
(iv) To identify the reasons for change in profitability and financial position of the firm.
(v) To make inter-firm comparison.
(vi) To make forecasts about future prospects of the firm.
(vii) To assess the progress of the firm over a period of time.
(viii) To help in decision making and control.
(ix) To guide or determine the dividend action.
(x) To provide important information for granting credit.
IMPORTANCE OF ANALYSIS OF FINANCIAL STATEMENT
Financial statement is prepared at a certain point of time according to established convention. These statements are prepared to suit the requirement of the proprietor. For measuring the financial soundness, efficiency, profitability and future prospects of the concern, it is necessary to analyze the financial statement. Following purposes are served by the Financial analysis: -
Help in Evaluating the operational efficiency of the Concern:- It is necessary to analyze the financial statement for matching the total expenses incurred in manufacturing, Advertising, selling and distribution of the finished goods and total financial expanses of the current year comparing with the total expanses of the previous year and evaluate the managerial efficiency of concern. Help in Evaluating the short and long term financial position:- It is necessary to analyze the financial statement for comparing the current assets and current liabilities to evaluate the short term and long term financial soundness. Help in calculating the profitability:- It is necessary to analyze the financial statement to know the gross profit and net profit. Help in indicating the trend of achievements:- Analysis of financial statement helps in comparing the Financial position of previous year and also compare various expenses, purchases and sales growth, gross and net profit. Cost of goods sold, total value of assets and liabilities can be compare easily with the help of Analysis of financial statement. Forecasting, budgeting and deciding future line of action:- The potential growth of the business can be predicts by the analysis of financial statement which helps in deciding future line of action. Comparisons of actual performance with target show all the shortcomings.
Meaning of Common-Size Statement: The common-size statements, balance sheet and income statement are shown in analytical percentages. The figures are shown as percentages of total assets, total liabilities and total sales. The total assets are taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a part of total liabilities.
These statements are also known as component percentage or 100 per cent statements because every individual item is stated as a percentage of the total 100. The short-comings in comparative statements and trend percentages where changes in items could not be compared with the totals have been covered up. The analyst is able to assess the figures in relation to total values.
The common-size statements may be prepared in the following way:
Comments: (1) An analysis of pattern of financing of both the companies shows that K &Co. is more traditionally financed as compared to S&Co. The former company has depended more on its own funds as is shown by balance sheet. Out of total investments, 71.53% of the funds are proprietor’s funds and outsiders’ funds account only for 28.47%.
In S & Co. proprietors’ funds are 64.83% while outsiders’ share is 35.17% which shows that this company has depended more upon outsiders funds. In the present day economic world,
generally, companies depend more on outsiders’ funds. In this context both the companies have good financial planning but K& Co. is more financed on traditional lines.
(2) Both the companies are suffering from inadequacy of working capital. The percentage of current liabilities is more than the percentage of current assets in both the companies. The first company is suffering more from working capital position than the second company because current liabilities are more than current assets by 3.44% and this percentage is 1.86% in the case of second company.
(3) A close look at the balance sheets shows that investments in fixed assets have been financed from working capital in both the companies. In S & Co. fixed assets account for 94.52% of total assets while long- term funds account for 91.08% of total funds. In K& Co. fixed assets account for 89.48% whereas long term funds account for 87.62% of total funds Instead of using long- term funds for working capital purposes the companies have used working capital for purchasing fixed assets.
(4) Both the companies face working capital problem and immediate steps should be taken to issue more capital or raise long-term loans to raise working capital position.
(ii) Common Size Income Statement: The items in income statement can be shown as percentages of 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. The increase in sales will certainly increase selling expenses and not administrative or financial expenses.
In case the volume of sales increases to a considerable extent, administrative and financial expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise.
(4) Net profits have decreased both in absolute figures and as a percentage in 2011 as compared to 2010.
(5) The overall profitability has decreased in 2011 and the reason is a rise in cost of sales. The company should take immediate steps to control its cost of sales, otherwise the company will be in trouble.
Trend analysis : involves the collection of information from multiple time periods and plotting the information on a horizontal line for further review. The intent of this analysis is to spot actionable patterns in the presented information.
In business, trend analysis is typically used in two ways, which are as follows:
Revenue and cost analysis. Revenue and cost information from a company's income statements can be arranged on a trend line for multiple reporting periods and examined for trends and inconsistencies. For example, a sudden spike in expense in one period followed by a sharp decline in the next period can indicate that an expense was booked twice in the first month. Thus, trend analysis is quite useful for examining preliminary financial statements for inaccuracies, to see if adjustments should be made before the statements are released for general use. Investment analysis. An investor can create a trend line of historical share prices, and use this information to predict future changes in the price of a stock. The trend line can be associated with other information for which a cause-and-effect relationship may exist, to see if the causal relationship can be used as a predictor of future stock prices. Trend analysis can also be used for the entire stock market, to detect signs of a impending change from a bull to a bear market, or the reverse.
When used internally (the revenue and cost analysis function), trend analysis is one of the most useful management tools available. The following are examples of this type of usage:
Examine revenue patterns to see if sales are declining for certain products, customers, or sales regions. Examine expense report claims for evidence of fraudulent claims. Examine expense line items to see if there are any unusual expenditures in a reporting period that require additional investigation. Extend revenue and expense line items into the future for budgeting purposes, to estimate future results.
When trend analysis is being used to predict the future, keep in mind that the factors formerly impacting a data point may no longer be doing so to the same extent. This means that an extrapolation of a historical time series will not necessarily yield a valid prediction of the future.
Thus, a considerable amount of additional research should accompany trend analysis when using it to make predictions.
Comparative Statements:
Meaning of 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. Any statement prepared in a comparative form will be covered in comparative statements.
From practical point of view, generally, two financial statements (balance sheet and income statement) are prepared in comparative form for financial analysis purposes. Not only the comparison of the figures of two periods but also be relationship between balance sheet and income statement enables an in depth study of financial position and operative results.
The comparative statement may show: (i) Absolute figures (rupee amounts).
(ii) Changes in absolute figures i.e., increase or decrease in absolute figures.
(iii) Absolute data in terms of percentages.
(iv) Increase or decrease in terms of percentages.
The analyst is able to draw useful conclusions when figures are given in a comparative position. The figures of sales for a quarter, half -year or one year may tell only the present position of sales efforts. When sales figures of previous periods are given along with the figures of current periods then the analyst will be able to study the trends of sales over different periods of time. Similarly, comparative figures will indicate the trend and direction of financial position and operating results.
The financial data will be comparative only when same accounting principles are used in preparing these statements. In case of any deviation in the use of accounting principles this fact must be mentioned at the foot of financial statements and the analyst should be careful in using these statements.
Types of Comparative Statements: The two comparative statements are (i) Balance sheet, and
(ii) Income statement.
finance fixed assets by the issue of either long-term securities such as debentures, bonds, loans from financial institutions or issue of fresh share capital.
An increase in fixed assets should be compared to the increase in long-term loans and capital. If the increase in fixed assets is more than the increase in long term securities then part of fixed assets has been financed from the working capital. On the other hand, if the increase in long-term securities is more than the increase in fixed assets then fixed assets have not only been financed from long-term sources but part of working capital has also been financed from long-term sources. A wise policy will be to finance fixed assets by raising long-term funds.
The nature of assets which have increased or decreased should also be studied to form an opinion about the future production possibilities. The increase in plant and machinery will increase production capacity of the concern. On the liabilities side, the increase in loaned funds will mean an increase in interest liability whereas an increase in share capital will not increase any liability for paying interest. An opinion about the long-term financial position should be formed after taking into consideration above-mentioned aspects.
(3) The next aspect to be studied in a comparative balance sheet question is the profitability of the concern. The study of increase or decrease in retained earnings, various resources and surpluses, etc. will enable the interpreter to see whether the profitability has improved or not. An increase in the balance of Profit and Loss Account and other resources created from profits will mean an increase in profitability to the concern. The decrease in such accounts may mean issue of dividend, issue of bonus shares or deterioration in profitability of the concern.
(4) After studying various assets and liabilities an opinion should be formed about the financial position of the concern. One cannot say if short-term financial position is good then long-term financial position will also be good or vice-versa. A concluding word about the overall financial position must be given at the end.
Illustration 1: From the following information, prepare a comparative Balance Sheet of Deepti Ltd.:
(ii) Comparative Income Statement: The Income statement gives the results of the operations of a business. The comparative income statement gives an idea of the progress of a business over a period of time. The changes in absolute data in money values and percentages can be determined to analyze the profitability of the business. Like comparative balance sheet, income statement also has four columns. First two columns give figures of various items for two years. Third and fourth columns are used to show increase or decrease in figures in absolute amounts and percentages respectively.
Guidelines for Interpretation of Income Statements: The analysis and interpretation of income statement will involve the following steps: (1) The increase or decrease in sales should be compared with the increase or decrease in cost of goods sold. An increase in sales will not always mean an increase in profit. The profitability will improve if increase in sales is more than the increase in cost of goods sold. The amount of gross profit should be studied in the first step.
