INTRODUCTION:

Financial Statement Analysis is the method of critically evaluating the financial details found
in financial statements in order to interpret and make decisions about the firm’s operations.
It is the analysis of the relationships between different financial facts and figures as
presented in a series of financial statements, as well as their interpretation, in order to gain
insight into the performance and operating efficiency of a company in order to evaluate its
financial health and future prospects. Both “analysis” and “interpretation” are included in
the phrase “financial analysis.” The word analysis refers to the methodical classification of
financial data in the financial statements, which simplifies the data. The term
“interpretation” refers to the process of explaining the purpose and significance of data.
These two are a good match for each other. Without interpretation, analysis is meaningless,
and interpretation without analysis is difficult, if not impossible. Financial statement analysis
is a decision-making method that seeks to forecast current and historical financial situations,
as well as the performance of an enterprise’s operations, with the primary goal of assessing
the best possible forecasts and projections regarding future conditions. It entails gathering
and analyzing information from financial statements in order to build relationships and shed
light on a company’s strengths and weaknesses, which can be useful in decision-making
including comparisons with other companies (cross sectional analysis) and with the
company’s own performance over time (time series analysis). A individual who spots a
business opportunity and starts a business is referred to as a business enterprise. There are
a variety of explanations why business ideas emerge. This is often due to a person’s belief
that they or others have an unmet need, a desire to make a social difference, or a desire to
make money. An entrepreneur is an individual who establishes a company. Many new
companies seek to fulfill a particular need or fill a market void. They do this by selling items
in the form of both goods and services. An entrepreneur can start a company because they
believe there is a market for the products or services they can offer. Businesses offer a wide
range of goods and services. Food, automobiles, televisions, and cell phones are examples
of products. Trains, taxi rides, cable, Wi-Fi, and haircuts are examples of utilities. The
significance of defining a popular legal concept of a business enterprise goes beyond legal
theory. It raises the issue of the legal theory of business, or, to put it another way, who is
the target of corporate law, the corporation, the entrepreneur, or the community
(company)?! There is no single approach or universal concept of a business enterprise. The
simple, general outlines are generally agreed upon by legal authors, but the variety begins
with any suggestion of further presition. The aim of this article is to provide a
comprehensive overview of all approaches to the concept of enterprise, address legislative
and economic proposals in this field, and, finally, provide a cohesive definition of the
enterprise

Chapter-2
Financial analysis may be classified based on the materials used or the analysis’ process.
According to Material Used

(a) External Analysis

Many that may not have access to the company’s accurate accounting reports are affected.
Investors, credit agencies, the government, and the general public rely almost exclusively on
publicly available financial statements. The position of external analysis has significantly
improved as a result of recent changes in government legislation requiring businesses to
make accurate information accessible to the public through audited accounts.

(b)Internal Analysis

Those with access to the books of accounts and some other information pertaining to the
business concern are responsible for this. Any financial review performed on a portion or
the whole unit. Executives and employees of business concerns, as well as federal bodies
with regulatory oversight and authority over those units, perform this form of review for
managerial purposes.

(B) According to Modus Operandi of Analysis

(a) Horizontal Analysis

The term “horizontal audit” refers to the review and analysis of financial statements over a
certain period of years. Dynamic analysis is another name for horizontal analysis. This is
focused on data or knowledge collected over a number of years rather than a single date or
time frame.

(b) Vertical Analysis

This is an examination of ratios developed for a single date and accounting period. Static
analysis is another name for vertical analysis. Vertical analysis does not allow for careful
analysis and interpretation of statistics in context, as well as comparisons over time. As a
result, financial analysts do not often use this method of analysis.

Advantages and Disadvantages of Methods of Financial Statements Analysis :

Horizontal or trend analysis and vertical analysis are the two primary approaches for
reviewing financial statements. These are listed below, along with the benefits and
drawbacks of each form.

Horizontal Analysis

Horizontal analysis compares a company’s current financial data to its historical financial
data over a number of reporting periods. It may also be based on financial data ratios
measured for the same time span. The main aim is to see whether the numbers are
particularly high or low in comparison to prior studies, so that any possible issues can be
investigated. This research method involves collecting all data and separating it into time
periods such as weeks, months, or years. Every year’s figures can also be expressed as a
percentage of the baseline(initially) year’s figures. The amounts given to the baseline year is
usually 100%. This form of analysis is also known as dynamic or pattern analysis.

Advantages and Disadvantages of Horizontal Analysis

When all financial statements are analyzed at the same time, the full effect of operating
operations on the company’s financial position over the time span under consideration can
be seen. The organization can analyze its output in relation to previous periods and gauge
how it is performing based on past results, which is a direct benefit of using horizontal
analysis.

Horizontal analysis has the downside of causing variances to creep up as account balances
are compared over periods because the aggregated details reflected in the financial
statements could have changed over time. Horizontal analysis may be used to misinterpret
findings as well. It can be manipulated to show similarities through time spans, making the
company’s results appear to be excellent.

Vertical Analysis

Vertical analysis is performed on financial statements for only one time span. For a certain
time span, normally a year, each item in the statement is shown as a base figure of another
item in the statement. Typically, every item on an income and loss statement is expressed as
a percentage of gross revenue, while every item on a balance sheet is expressed as a
percentage of the firm’s total assets. Since it is performed over a single time frame, vertical
analysis is also known as static analysis.

Advantages and Disadvantages of Vertical Analysis

Financial statements for a single reporting period are all that is needed for vertical analysis.
It can be used to compare output between firms or departments because proportional
proportions of account balances can be seen, regardless of the size of the company or
department. Since simple vertical analysis is limited to a single time period, it suffers from
the drawback of being unable to compare results through time periods. This can be solved
by combining it with timeline analysis, which reveals how developments in the financial
statements have changed over time, such as a three-year comparative analysis. For
example, if in the past, the cost of revenue was only 30 percent of sales, but this year it is 45
percent, it would be cause for concern.

Components of Financial Analysis

The first step toward improving financial literacy is to conduct a financial analysis of
your business. A proper analysis consists of five key areas, each containing its own set
of data points and ratios.

1. Revenues
Revenues are probably your business’s main source of cash. The quantity, quality and
timing of revenues can determine long-term success.

Revenue growth (revenue this period - revenue last period) ÷ revenue last period. When
calculating revenue growth, don’t include one-time revenues, which can distort the
analysis.

Revenue concentration (revenue from client ÷ total revenue). If a single customer generates
a high percentage of your revenues, you could face financial difficulty if that customer
stops buying. No client should represent more than 10 percent of your total revenues.

Revenue per employee (revenue ÷ average number of employees). This ratio measures your
business’s productivity. The higher the ratio, the better. Many highly successful companies
achieve over one million Dinar in annual revenue per employee.

2. Profits

If you can’t produce quality profits consistently, your business may not survive in the long
rbette

Gross profit margin (revenues – cost of goods sold) ÷ revenues. A healthy gross profit
margin allows you to absorb shocks to revenues or cost of goods sold without losing the
ability to pay for ongoing expenses.

Operating profit margin (revenues – cost of goods sold – operating expenses) ÷

revenues. Operating expenses don’t include interest or taxes. This determines your
company‘s ability to make a profit regardless of how you finance operations (debt or
equity). The higher, the better.

Net profit margin (revenues – cost of goods sold – operating expenses – all other expenses)
÷ revenues. This is what remains for reinvestment into your business and for distribution to
owners in the form of dividends.

3. Operational Efficiency

Operational efficiency measures how well you’re using the company‘s resources. A lack
of operational efficiency leads to smaller profits and weaker growth.

Accounts receivables turnover (net credit sales ÷ average accounts receivable). This
measures how efficiently you manage the credit you extend to customers. A higher number
means your company is managing credit well; a lower number is a warning sign you should
improve how you collect from customers.

Inventory turnover (cost of goods sold ÷ average inventory). This measures how
efficiently you manage inventory. A higher number is a good sign; a lower number means
you either aren’t selling well or are producing too much for your current level of sales.

4. Capital Efficiency and Solvency

 Capital efficiency and solvency are of interest to lenders and investors.

Return on equity (net income ÷ shareholder’s equity). This represents the return investors
are generating from your business.

Debt to equity (debt ÷ equity). The definitions of debt and equity can vary, but generally
this indicates how much leverage you’re using to operate. Leverage should not exceed
what’s reasonable for your business.

5. Liquidity

Liquidity analysis addresses your ability to generate sufficient cash to cover cash expenses.
No amount of revenue growth or profits can compensate for poor liquidity. Current ratio
(current assets ÷ current liabilities). This measures your ability to pay off short-term
obligations from cash and other current assets. A value less than 1 means your company
doesn’t have sufficient liquid resources to do this. A ratio above 2 is best.

Interest coverage (earnings before interest and taxes ÷ interest expense). This
measures your ability to pay interest expense from the cash you generate. A value less than
1.5 is cause for concern to lenders

THE BASIC STRUCTURE OF FINANCIAL STATEMENTS

The details required for review is provided by financial statements. They compile a report on
management’s success and summarize the company’s transactions. In general, there are
four financial statements that are used in financial analysis:

1. The balance sheet—as of a certain date, it shows what the corporation holds (assets)
and what it owes (liabilities).
2. The income statement is a financial statement that shows a company’s revenue and
expenditures over time (a year, for example).
3. The declaration of stockholders’ equity is a financial statement that shows how a
company’s ownership interests have changed over time.
4. The statement of cash flows is a financial statement that shows a company’s cash
inflows and outflows over time.

BALANCE SHEET:

One of the three basic financial statements, the balance sheet is crucial for financial
modeling and accounting. The balance sheet depicts the company’s total assets as well as
how they are financed, whether by debt or equity. It’s also known as a financial status
report or a net worth statement. Assets = Liabilities + Equity is the underlying equation that
the balance sheet is based on.

INCOME STATEMENT:
The income statement is one of three key financial statements used to disclose a company’s
financial performance over a given accounting period, the other two being the balance
sheet and statement of cash flows. The income statement, also known as the profit and loss
statement or the statement of revenue and cost, is a financial statement that shows a
company’s earnings and expenses for a period of time.

THE STATEMENT OF SHAREHOLDERS EQUITY:

The declaration of shareholders’ equity is a financial document that is part of the balance
sheet of a company. It depicts the shift in the value of stockholders’ or shareholders’ equity,
or ownership interest in a business, from the start to the end of a given accounting period.
The declaration of shareholders’ equity usually monitors progress from the beginning to the
end of the fiscal year.

THE STATEMENT OF CASH FLOW:

A cash flow statement is a financial statement that lists all cash inflows a company receives
from ongoing operations and foreign investment sources. It also includes all cash outflows
for business and investment activities over a specified time period.

METHODS OF ANALYSING FINANCIAL STATEMENTS

Financial statement review entails a study of relationships and patterns in order to assess if
the company’s financial status, results of operations, and financial success are acceptable or
unsatisfactory. The analytical methods or instruments mentioned below are used to
determine or quantify the relationships between financial statement items in a single
collection of statements, as well as adjustments in these items as reflected in subsequent
financial statements. Any analytical method’s primary goal is to simplify or minimize the
data under consideration to more understandable words.

Analytical methods and devices used in analysing financial statements are as follows:

1. Comparative Statements

Both the comparative Profit and Loss Account and the comparative Balance sheet are
covered in this form of comparative financial statement. These comparative statements are
prepared to compare the varying statistics of two or more years, as well as the relationship
between the different elements embodied in the profit and loss account and balance sheet.
It allows for the study and understanding of operating performance and financial soundness
of the company.

(2) Common Size Statements

This form of analysis is structured to escape the limitations of Comparative Statement.

Financial statements are examined using this approach to determine the relationship
between different figures and a common foundation. As a result, the Common Size Profit
and Loss Account is based on net revenue, and other goods are calculated as a percentage
of sales. The total assets or total liabilities are used as the general basis for a Standard Size
Balance Sheet, and all other components are measured as a percentage of the total assets
and liabilities

(3) Trend Analysis

One of the most critical techniques for analyzing and interpreting financial statements is
trend analysis. In order to determine the percentage relationship of different items in the
financial statements compared to the items in the base year, this approach requires
selecting a timeframe for a number of years. When using this approach to assess a pattern,
the earliest year or first year is used as the base year. The relevant things in the base year
are set to 100, and the proportion of corresponding figures in the other years’ financial
statements is calculated based on this pattern. This research aids in the formulation of
appropriate policies and planning in the future.

(4) Fund Flow Analysis

Fund flow analysis is one of the most critical approaches for evaluating and interpreting
financial statements. This is a statement that is added to the profit and loss account and the
balance sheet to complete the image. Fund Flow Analysis aids in determining whether or
not a company’s financial position has improved on a working capital and cash basis. It also
shares information about the funds’ sources, as well as how they were used or recruited
over time.

(5) Ratio Analysis

Ratio analysis is one of the most effective tools for establishing a relationship between two
interrelated accounting figures in financial statements. The findings of this study assist
management in making decisions. The ratio analysis is a good way to figure out a company’s
liquidity and operating efficiency.

ILLUSTRATION:

Illustration 1

1) A) Ram & Sons. Comparative Balance Sheet (as on 31st March, 2013 and 2014)

Particulars 31.3.2013 31.3.2014 Increase (+) Increase (+)

(rs) (rs) or Decrease or Decrease
(–) in (–) in %age
amounts (rs)
Current
Assets
 1,18,000 10,000 (–)1,08,000 (–) 92
Cash in hand
and at bank
Receivable
on 2,09,000 1,90,000 (-)19,000 (-)9
customer’s
accounts and
bills
Inventory of
materials,
goods in 1,60,000 1,90,000 (-)30,000 (-)19
process and
finished
stock
Prepaid 3000 3000 - -
expenses
Other 29,000 10,000 (-)19,000 (-)66
current
assets
Total Current 5,19,000 3,43,000 (-)1,76,000 (-) 34
Assets
Fixed Assets

Land and 2,70,000 1,70,000 (-)1,00,00 (-)137

buildings
Plant and 3,10,000 7,86,000 (-)4,76,000 (+)150
machinery
Furniture 9000 18,000 (+)9000 (+)100
and fixtures
Other fixed 20,000 30,000 (+)1000 (+)50
assets
Total Fixed 6,09,000 10,04,000 (+)3,95,000 +28
Assets
Investments 46,000 59,000 (+13,000 (-)20
Total Assets 11,74,000 14,06,000 (+)2,32,000 (-)54
Liabilities
and Capital
Current
Liabilities
Accounts 2,55,000 1,17,000 (-)1,38,000 (+)43
payable
(sundry trade
 creditors and
bills payable)
Other short- 7000 10,000 (+)3000 (-)52
term
liabilities
Total Current 2,62,000 1,27,000 (-)1,35,000 (+)100
Liabilities
Debentures 50,000 1,00,000 (+)50,000 (+)50
Long-term 1,50,00 2,25,000 (+)75,000
loans on
mortgage
Total 4,62,000 4,52,000 (-)10,000 (-)2
Liabilities
Capital

Equity share 4,00,000 6,00,000 (+)2,00,000 (+)50

capital
Reserve and 3,12,000 3,54,000 (+)42,000 (+)13
surplus
Total 11,74,000 14,06,000 (+)2,32,000 (+) 20
Liabilities
and Capital

An analysis and interpretation of the above balance sheet reveals:

1. Current assets have decreased by `1,76,000 between 2013 and 2014, while current
liabilities have decreased only by `1,35,000. But this has no adverse affect on current ratio
because the percentage decrease in current assets (34%) is much less than the percentage
decrease in current liabilities (52%).

2. Non current assets have increased by `3,95,000, major increase being a plant and
machinery of `4,76,000, which amounts to the increase in production and profit earning
capacities. Increase in fixed assets appears to have been partly financed by an increase in
equity capital (`2,00,000), partly by release of working capital, and partly by increase in
debentures and long-term borrowings (`1,25,000).

3. The increase in reserves and surpluses (`42,000) may be the result of profits retained,
and has gone to account for increase in long-term loans and fixed assets.

4. There has been a drastic fall in cash balance (`1,08,000). This reflects an adverse cash
position.

The balance sheet of S Ltd are given for the year 2014 and 2015 convert them into common
size balance sheet and interpret the changes.
*Illustration 2

The balance sheet of S Ltd are given for the year 2014 and 2015 convert them into
common size balance sheet and interpret the changes.

*Balance sheet*

*Common size Balance Sheet*

Liabilities 2014 Rs. 2015 Rs. Assets 2014 Rs 2015Rs

Equity share 1, 1,46,800 1,91,000 Buildings 1,80,000 2,00,000

Capital 50,000 70,000 Plant and 40,000 55,000

reserve machinery

Revenue 20,000 30,000 Furniture 10,000 20,000

reserve &
surplus Freehold 20,000 12,000
property
Trade 30,000 40,000 Goodwill 25,000 30,000
creditors
Cash balance 25,000 20,000
Bills payable 80,000 60,000
Sunday debtors 30,000 35.000
Bank 90,000 80,000
overdraft Inventories
Bills receivable 70,000 57,000
Provisions 30,000 20,000 (temporary)

4,46,800 4,91,000 4 4,46,800 4,91,000

Assets 2014 2015

Amt. (Rs) Percentage Amt. (Rs) Percentage
A. Current
Assets

Sundry Debtor 30,000 6.71 35,000 7.13

Cash balance 25,000 5.59 20,000 4.07

Inventories 70,000 15.71 57,000 11.60

Investment 36,500 8.17 42,000 8.55
(Temporary) 

Bill Receivable 10,300 2.30 20,000 4.08

Total A 1,71,800 38.44 1,74,000 35.43

B. Fixed Assets

Building 1,80,000  40.29 2,00,000 40.75 

  
Plant and Machinery 40,000 8.95 55,000 11.20

Furniture 10,000  2.24 20,000  4.07 

Freehold Property 20,000 4.48 12,000 2.44

Goodwill 25,000 5.60 30,000 6.11

Total (B) 2,75,000 61.5 3,17,000 64.57

Total Assets (A+B) 4,46,800 100.00 4,91,000 100.00

Liabilities

C. Current Liabilities

Trade Creditors 30,000 6.17 40,000 8.15

Bill Payable 80,000 17.91 60,000 12.22

Bank Overdraft 90,000 20.14 80,000 16.29

 30,000 6.71  20.000 4.07
Provision
 2,30,000 51.47 2,00,000 40.73
Total (C)
D. Long-term
Liabilities

Equity Share 1,46,800 32.86 1,90,000 38.90

Capital Reserve 50,000  11.19 70,000 14.26

Revenue Reserve 20,000 4.48 30,000 6.11

and Surplus

Total (D) 2,16,800 48.53 2,91,000 59.27

4,46,800 100.00 4,91,000 100.00
Total Liabilities
(C+D)

*Interpretation :* 1. Out of every rupee of sales 60.72 per cent in 2014 and 63.63 per cent in
2015 account for cost of goods sold. 2. The percentage ratio of gross profit to sales was 39.28
per cent in 2014 which was reduced to 36.37 percent 2015. 3. The operating expenses
increased from 15.71 per cent of sales in 2014 to 16.37 per cent in 2015 all this reduced the
percentage ratio of net income after tax to sales from 14.15 per cent in 2014 to 12.00 per cent
in 2015. 4. The operating expenses increased from 15.71 per cent of sales in 2014 to 16.37
per cent in 2015 all this reduced to percentage ratio of net income after tax to sales from
14.15 per cent in 2015. In the ultimate analysis it can be said that the operating efficiency of
the concern has not been satisfactory during the period under study

*Illustration 3* :
From the following data, calculate trend percentages(2013 as the base)

Particulars Rs.
2013 2014 2015
Cash 200 240 160
Debtors 400 500 650
Stock 600 800 700
Other current assets 450 600 750
Land 800 800 1,000
Buildings 1,600 1,600 2,400
Plant 2,000 2,000 2,400

Trend percentages (Base year)

Current Assets 2013 2014 2015 2013 2014 2015

(Rs.) (Rs.) (Rs.)

Cash 200 240 160 100 120 80

Debtors 400 500 650 100 125 163

Stock 600 800 700 100 133 117

Other current assets 450 600 750 100 133 167

TOTAL Current Assets 1,650 2,14 2,260 100 130 137

0
 Fixed Assets
Land 800 1,000 1,000 100 125 125
Buildings 1,600 2,000 2,400 100 125 150
Plant 2,000 2,000 2,400 100 100 120
TOTAL Fixed Assets 4,400 5,000 5,800 100 114 11

Conclusion

The primary purpose of financial statements is to provide information about an

organization's activities, financial condition, and cash flows. Readers use the details in
financial statements to make resource allocation decisions. At a more comprehensive level,
each of the financial statements serves a particular purpose. When reviewed over many
time periods, the income statement may be used to determine trends in the performance of
company operations.

The balance sheet's aim is to notify the reader about the current state of the company as of
the balance sheet's date. This data is used to estimate an entity's liquidity, financing, and
debt status, and it's the foundation for a variety of liquidity ratios..

People from all walks of life will benefit from financial analysis, not just financial managers.
It may be used by a credit manager to look at a prospective customer's specific financial
ratios and determine whether or not to increase the credit cap. It is used by a security
analyst to determine the investment value of securities. The methods of financial analysis
assist a banker in determining whether or not to approve loans. Similarly, unions use it to
assess the status of particular employers, and students use it to assess their career options.
In these research project we discussed a lot about Financial statement analysis like their
types, advantages and disadvantages, their components, basic structure of Financial
Analysis and their methods or tools with some of the illustrations.