STATEMENTS

ANALYSIS OF
FINANCIAL

CHAPTER – 11

Financial Statement Analysis

Meaning of Financial Analysis (i) Horizontal Analysis- In such type of analysis, financial
Financial statements present a mass of complex data in statements for a number of years are reviewed and
absolute monetary terms and reveal little about the liquidity analysed. Figures for two or more years are contained
solvency and profitability of the business. In financial in such type of analysis and these figures are placed
analysis, the data given in financial statements is classified side-by-side to facilitate comparison. Such analysis
into simple groups and a comparison of various groups is indicates the increase or decrease in these items not
made with one another to pin-point the strong points and only in absolute figures but also in percentage form.
weaknesses of a business. For instance, if all items relating to Thus, it involves making comparisons and establishing
non-current assets are placed in one group while all items relationship among related items of an enterprise for a
relating to non-current liabilities are placed in another group, number of years. When data about sales, cost of
the comparison between the two groups will provide useful production, revenue, profits etc are compared for two or
information. Actually the figures given in financial statements more years of a firm, they indicate the areas of strength
do not speak anything themselves. The analysis of these and weakness of the enterprise. It also helps in knowing
figures helps the interested reader by giving tongue to these the trend of the business. Since such type of analysis is
mute heaps of figures. based on the data from year-to-year rather than only
In the words of Finney and Miller one year, it is also called ‘Dynamic Analysis’.
“Financial analysis consists in separating facts according to (ii) Vertical Analysis- In such type of analysis, financial
some definite plan, arranging them in groups according to statements for a single year or on a particular date are
certain circumstances and then presenting them in a reviewed and analysed with the help of proper devices
convenient and easily read and understandable form.” like ratios. It involves a study of the quantitative
The main features of financial analysis are: relationship among various items of Balance Sheet or
(i) To present the complex data contained in financial
Statement of Profit & Loss of a single period. The items
statements in simple and understandable form.
in the financial statement are expressed as a percentage
(ii) To classify the items contained in financial statements
to total and the total is taken as equivalent to 100.
in convenient and rational groups.
Statements containing such analysis are termed as
(iii) To make comparisons between various groups to draw
'Common Size Statements
various conclusions
The Common Size Statement of Profit & Loss shows each
element of Cost as a percentage of sales. It helps in
Types or Methods of Financial Analysis
analysing costs and operating results of the year
Two basic approaches or types of analysis are
Similarly, in a common size Balance Sheet various assets
(i) Horizontal Analysis
(ii) Vertical Analysis can be expressed as percentage of total assets.
 Since such type of analysis is based on the data of a (5) To Measure the Capability of Payment of Interest
single year. it is also called ‘Static Analysis’ Vertical and Dividend: The purpose of analysis is to assess
analysis is useful in comparing the performance of whether the firm will have sufficient profits to pay the
several companies of same group or departments in the amount of interest in time and whether it has the
same company. capacity to pay the dividend in future at a higher rate.
Analysis also indicates the number of times the profit is
Vertical analysis is not very useful for a proper analysis
in comparison to interest. Analysis further indicates the
of the company's financial position because it depends extent to which the profit of the firm may decrease
on the data of a single period whereas the business is a without in any way affecting its ability to meet interest
dynamic process. In comparison to vertical analysis, the and dividend obligations.
horizontal analysis is more useful because it brings out
more clearly the nature and trends of current changes (6) To Identify the Trend of the Business: When data
affecting the enterprise. Horizontal presentation about sales, cost of production, profitability etc are
emphasises the fact that statement for a series of compared for two or more years of a firm, they indicate
periods are far more significant than those for a single the direction in which a business is moving. If sales are
period and that the accounts for one period are but an increasing continuously along with increase in profit
margins, it is an indication of a good growth trend of the
instalment of what is essentially a continuous history.
business. Such analysis helps in ascertaining whether
the business is progressive or not
Objectives or Purpose of Financial Analysis
The purpose of financial analysis depends on the needs of the (7) To Judge the Efficiency of Management: The purpose
person who is analysing these statements. These varying of financial analysis is to judge that the financial policies
needs may be adopted by the management are proper or not. For
(1) To Measure the Earning Capacity or Profitability: example, if the actual ratios calculated on the basis of
The overall objective of a business is to earn a financial statements are in accordance with their
satisfactory return on the funds invested in it, consistent standard ratios, the policies of the management may be
with maintaining a sound financial position. Financial said to be proper and good.
analysis helps in ascertaining whether adequate profits (8) To Provide Useful Informations to the Management:
are being earned on the capital invested in the business. The object of financial analysis is to find out the
It is also disclosed by analysis of financial statements weaknesses of the business, so that the management
whether these profits are increasing or decreasing over can take remedial measures to remove those
the years. weaknesses.
(2) To Measure the Solvency: It can be ascertained from
financial analysis whether the business is in a position Uses of Financial Analysis:
to pay its short-term and long-term liabilities in time Financial analysis can be used to take variety of decisions in
For example, the liquidity ratios (current ratio and the following areas
quick ratio) are calculated to ascertain whether the (1) For taking Investment Decisions: Analysis of financial
business enterprise has sufficient liquid funds to meet statements helps an investor to know whether the firm
its short term liabilities and Debt Equity Ratio is is fulfilling his expectations regarding the payment of
calculated to ascertain whether the business enterprise dividend, increase in the value of investments made by
has got the ability to repay the long term liabilities. him and safety of his investment. It helps him to take
(3) To Measure the Financial Strength: The purpose of decision about continuation or discontinuation of his
financial analysis is to assess the financial potential of investment in the firm.
the business. Analysis helps in providing answers to the (2) For taking Credit Decisions: Analysis of financial
statements is useful in making a decision whether to
following questions
grant or extend credit to a customer
(i) Funds required for the purchase of new
(3) For taking Dividend Decisions: Such analysis is useful
machinery, furniture and equipments will be
in deciding about how much portion of the profit is to be
available from internal resources of the business
distributed as dividend and how much to retain for
or not?
future uses.
(ii) Based on the current goodwill of the business, how (4) For Estimating Trend of the Business: Analysis of
much funds can be raised from external sources? financial statements for a number of years reveals the
(4) To Make Comparative Study with other Firms: The trend of cost of production, sales, profits etc. It helps in
purpose of financial analysis is to help the management assessing the future growth potential of the firm.
to make a comparative study of the profitability of (5) For Taking Various Managerial Decisions- Analysis
various firms engaged in same trade. Such comparison of financial statements discloses the liquidity solvency
helps the management to study the position of their firm and profitability of the business enterprise. It helps in
in respect of sales, expenses, profits and working capital locating the weak spots of the business. Such
etc in comparison to other firms. information enables the management to take various
decisions.
Significance or Importance of Financial Analysis (5) Significance for Financial Institutions: All the
At present, the analysis of financial statements has become of financial institutions which provide finance to the
general interest Various parties have become interested in industries such as Banks, Insurance companies, Unit
the financial of a company due to various reasons Different Trust etc. want to know the profit earning capacity of
persons look at the same financial statement from different the business and its long-term solvency. They want to
angles ie., there are different users of financial statements, all assess not only the present position of the business
of them using the same statement but for a different purpose. enterprise but also its likely position in the future
For example a shareholder would be interested in the Analysis of financial statements helps them in
profitability and increase in value of his investment whereas ascertaining this.
a short-term creditor would be concerned about the liquidity
i.e., the firm's ability to pay its current liabilities. (6) Significance for Employees: Analysis of financial
(1) Significance for Management- Management of a firm statements helps the employees in determining the
is always interested in the solvency profitability and the profitability of the business enterprise. They can
capital structure of the firm. They want to make sure ascertain as to how much bonus and increase in their
that the business must be in a solvent position to pay the salary is possible from the profits of the company.
debts as and when they fall due. Similarly, they are
(7) Significance for Stock Exchange Authorities- They
interested not only in the current years' profit but also
analyse the financial statements of a company to
in the capacity of the business to earn more profits in
future. determine its price earning ratio and earning per share
(E.P S.). With the help of such analysis, the market price
(2) Significance for Investors- Investors and shareholders of a company's share is determined.
of the business are interested in the longevity of the
business enterprise and therefore, they want to know (8) Significance for Taxation Authorities- They analyse
the earning capacity of the business and its prospects the financial statements of a company to know whether
for future growth and prosperity. Analysis of financial the financial statements have been prepared in
statements of a company helps them a great deal in accordance with the legal provisions and whether the
assessing the capacity of the business to pay dividend at figures of production, sales and profits are correct for
a higher rate and also the safety of their investments the purpose of assessment of excise duties, sales tax and
(3) Significance for Creditors: There are two types of income tax respectively
creditors, (i) Short-term creditors, and (ii) Long-term (9) Significance for Researchers: Analysis of financial
creditors statements of a company is of much importance to a
(i) Short-term creditors want to know the liquidity of researcher who is conducting research in respect of the
the business, i.e., to know whether the company profitability, solvency, efficiency, financial soundness
will have sufficient current assets and cash to pay and future growth potential of that company
their debts of not. Current ratio and quick ratio
calculated on the basis of financial statements help (10) Significance for Other Parties: Some other parties
them in assessing this. may also be interested in the analysis of financial
(ii) Long-term creditors want to know two things statements of a company from their own point of view,
namely :(1) Whether the company will be able to such as, economists, trade associations, consumer
pay the interest consistently and (2) Whether the organisations etc
company will be able to pay their debts when they Limitations of Financial Analysis
fall due. On the basis of interest coverage ratio they (1) Limitations of Financial Statements: Financial
can ascertain whether the company will be able to analysis is based on financial statements. But financial
pay the interest regularly or not and on the basis statements themselves suffer from certain limitations,
of debt-equity ratio they can ascertain whether the hence the limitations of financial statements are also the
company will be able to pay their debts on limitations of their analysis. For example, Sometimes
maturity. the informations given in financial statements are
(4) Significance for Government: Government can judge incomplete and unauthentic.
on the basis of analysis of financial statements, which
industry is progressing on the desired lines and which (2) Affected by Window-dressing: Some firms resort to
industry needs the financial help. Government can take window-dressing their financial statements to cover up
a decision to reduce the excise duty in those industries bad financial position on the eve of accounting date For
where the profit margins are low in comparison to the example, they may not record the purchases made at the
cost of production. On the contrary if the profit margins end of the year or they may overvalue their closing
are too high in comparison to the cost of production. stock. In such cases, the results obtained by analysis of
Government can increase the excise duty or can enforce financial statements will be misleading.
the price regulations.
(3) Do not Reflect Changes in Price Level: Figures given (6) Difficulty in Forecasting: Financial statements are a
in financial statements do not show the effect of changes record of past events and historical facts In the fast
in price level. As such, the comparison of past year changing and developing modern business, the analysis
figures with current year figures may lead to misleading of past information may not be of much use in future
conclusions. For example if in 2012 a firm sells 20,000 forecasting. Continuous changes take place in the
metre of cloth for 25 lakhs and the same firm in 2013 demand of the product, policies adopted by the firm, the
sells the same type of 10,000 metre of cloth for 37.5 position of competition etc. As such, no estimate based
lakhs. it discloses an increase of 50% in sales, whereas, on the analysis of historical facts can be made for future
in actual, the sales have not increased at all. As such, (7) Lack of Qualitative Analysis: Financial statements
sufficient adjustments must be made for changes in record only those events and transactions which can be
price level before making the analysis expressed in terms of money. Qualitative aspects of
(4) Different Accounting Policies: If two firms adopt business units are omitted from the books at all as these
different accounting policies, the comparison between cannot be expressed in monetary terms. Thus, changes
the two will be unreliable. For example, one firm may in management, reputation of the business, cordial
provide depreciation on original cost method, whereas management-labour relations, firm's ability to develop
the other firm may adopt the written-down value new products, efficiency of management, satisfaction of
method for providing the depreciation. firm's customers etc which have a vital bearing on the
profitability of the company are all ignored and omitted
(5) Effect of Personal Ability and Bias of the Analyst:
Figures given in financial statements do not speak by from being recorded because all of these are qualitative
in nature.
themselves, hence, any conclusion can be drawn from
these figures. Conclusions obtained from the analysis of (8) Limited Use of Single Year's Analysis of Financial
these figures are affected to a great extent by the Statements Results obtained from financial analysis
personal ability and knowledge of the analyst. For assume significance only when compared with the
example for calculating return on capital' one analyst figures of previous periods. For example. the profit of a
may consider the profits after taxes, whereas, the other firm to sales is 12%, whether this is satisfactory or not
analyst may consider the profits before taxes. Similarly depend upon the figures of previous years. If the firm
the term 'Capital' may mean only the 'Shareholder's earned 10% of sales as profit in the previous year, it may
Funds' for one analyst, whereas the other analyst may be considered to have done better this year However,
take the 'Shareholder's Funds and Long Term Debts as the financial statements of two years may not be
capital. comparable due to the changes in accounting policies.

QUESTIONS FOR PRACTICE

(a) Dynamic (b) Horizontal
MCQ (c) Vertical (d) Internal

1. Bankers and Lenders are interested in financial analysis 5. Which of the following is not a objective of Financial
to judge: Statement Analysis?
(a) Profitability (b) Liquidity (a) To judge the efficiency of management
(b) To help the management in decision making
(c) Solvency (d) Both (b) and (c)
(c) To assess liquidity and solvency of business
2. Main objective of analysis of financial statements is: (d) To measure price level changes
(a) to make comparative study with others
6. For whom, analysis of financial statements is not
(b) to make the financial strength significant?
(c) to know the efficiency of management (a) Share market (b) Taxing officer
(d) All of these (c) Chief Military Officer (d) Shareholder
3. Which of the following is a limitation of financial 7. Analysis of financial statements is significant for :
analysis? (a) Investors (b) Financial Institutions
(a) It does not reflect price level changes. (c) Management (d) All of these
(b) It judges the ability of the firm to repay debts.
8. Why is creditor interested in analysis of financial
(c) It identifies the reason for change in financial statements?
position. (a) To decide whether or not the borrower has the
(d) It ascertains the relative importance of different ability to repay interest and principal on borrowed
components of the financial position of the firm. funds.
4. _____ analysis deals with different items of same period. (b) To determine the concern’s capital structure
 (c) To determine the concern’s future earning stream (c) It identifies the reasons for change in financial
(d) To decide whether or not the concern has operated position.
profitably or not. (d) It ascertains the relative importance of different
9. Which of the following is a limitation of financial components of the financial position of the firm.
analysis?
10. _____ analysis deals with same items of different period.
(a) It is just a study of reports of the company.
(a) Static (b) Horizontal
(b) It judges the ability of the firm to repay its debts.
(c) Vertical (d) Internal

SUBJECTIVE QUESTIONS
1. What is meant by Financial Analysis"? 10. Give two areas of interest for management while
2. List any one objective of analysing the financial analysing the financial statements.
statements. 11. How can the financial strength of a business enterprise
3. What is Horizontal Analysis? be judged?
4. What is Vertical Analysis? 12. How the solvency of a business is assessed by Financial
5. List any two uses of analysing the financial statements Statement Analysis?
6. Give one limitation of financial analysis. 13. How the 'Earning Capacity of a business' is assessed by
7. What is the interest of shareholders or Investors in the Financial Statement Analysis?
analysis of financial statements?
14. How is 'window dressing a limitation of Financial
8. State the interest of tax authorities in the analysis of Statement Analysis?
financial statements.
15. How does 'subjectivity' become a limitation of Financial
9. What is the interest of lenders or Bankers in the analysis
of financial statements? Statement Analysis?

SOLUTION FOR PRACTICE QUESTIONS

SOLUTION FOR MCQ QUESTIONS

1. (d) 3. (a) 5. (d) 7. (d) 9. (a)

2. (d) 4. (c) 6. (c) 8. (a) 10. (b)

SOLUTIONS FOR SUBJECTIVE

QUESTIONS

1. Financial analysis is a systematic process of classifying and the total is taken as equivalent to 100. Statements
the data into simple groups and making a comparison of containing such analysis are termed as 'Common Size
various groups with one another to pin-point the strong Statements'
points and weaknesses of the business. 5. (i) Helpful in taking investment decisions.
2. (i) To measure the earning capacity of the business. (ii) Helpful in taking credit decisions.
(ii) To make comparative study with other firms. 6. (i) Do not reflect price level changes.
3. When financial statements for a number of years are (ii) Comparison is unreliable if different firms adopt
analysed, the analysis is called horizontal analysis. Such different accounting policies.
analysis is mostly in the form of Comparative financial 7. (i) They want to judge the present and future earning
statements capacity of the business.
4. When financial statements for a single year are analysed, (ii) They want to judge the safety of their investment.
the analysis is called vertical analysis. The items in the 8. (i) To judge whether the financial statements have been
financial statement are expressed as a percentage to total prepared in accordance with the legal provisions.
 (ii) To judge whether various types of taxes have been 12. Solvency of a business is assessed through solvency
paid appropriately ratios, debt equity ratio, total assets to debt ratio and
9. (i) To judge the financial soundness of the business to proprietary ratio.
repay their debts at maturity 13. Earning Capacity is assessed through 'Profitability'
(ii) To judge that the enterprise has sufficient profits so ratios.
as to make payment of interest regularly throughout
the term of loan. 14. Window dressing refers to the manipulation of accounts
to conceal vital facts and presentation of the 'Financial
10. (i) To know the profitability of the business enterprise.
Statements' in a way so as to show a position better than
(ii) To know the short-term and long-term solvency
what it actually is. On account of such a situation financial
position of the statements.
analysis may give false information to the users
11. The financial strength of a business enterprise can be
15. Subjectivity means using personal judgment in making a
judged on the basis of
choice out of alternatives available, i.e., choice in the
(i) its earning capacity. i.e., profitability, and method of depreciation or choice in the method of
(ii) its ability to repay the loans and pay dividends. inventory valuation. Since the subjectivity is inherent in
personal judgment, the financial statements are not free
from bias.