CHAPTER I

INTRODUCTION OF FINANCIAL STATEMENT ANALYSIS

INTRODUCTION:
Financial statement analysis is the process of analyzing a company's financial
statements for decision-making purposes. External stakeholders use it to understand the overall
health of an organization as well as to evaluate financial performance and business value.
Internal constituents use it as a monitoring tool for managing the finances.
The financial statements of a company record important financial data on every aspect
of a business’s activities. As such they can be evaluated on the basis of past, current, and
projected performance.
In general, financial statements are centered around generally accepted accounting
principles (GAAP) in the U.S. These principles require a company to create and maintain three
main financial statements: the balance sheet, the income statement, and the cash flow statement.
Public companies have stricter standards for financial statement reporting. Public companies
must follow GAAP standards which requires accrual accounting. Private companies have
greater flexibility in their financial statement preparation and also have the option to use either
accrual or cash accounting.
Several techniques are commonly used as part of financial statement analysis. Three of
the most important techniques include horizontal analysis, vertical analysis, and ratio analysis.
Horizontal analysis compares data horizontally, by analyzing values of line items across two
or more years. Vertical analysis looks at the vertical affects line items have on other parts of
the business and also the business’s proportions. Ratio analysis uses important ratio metrics to
calculate statistical relationships.

MEANING OF FINANCIAL STATEMENT 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. “Analyzing financial statements,” according to Metcalf and
Titard, “is a

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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.
The term ‘financial statement analysis’ includes both ‘analysis’, and ‘interpretation’. A
distinction should, therefore, be made between the two terms. While the term ‘analysis’ is used
to mean the simplification of financial data by methodical classification of the data given in the
financial statements, ‘interpretation’ means, ‘explaining the meaning and significance of the
data so simplified. ’However, both’ analysis and interpretation’ are interlinked and
complimentary to each other Analysis is useless without interpretation and interpretation
without analysis is difficult or even impossible.
Most of the authors have used the term ‘analysis’ only to cover the meanings of both
analysis and interpretation as the objective of analysis is to study the relationship between
various items of financial statements by interpretation. We have also used the term ‘Financial
statement Analysis or simply ‘Financial Analysis’ to cover the meaning of both analysis and
interpretation.

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TYPES OF FINANCIAL STATEMENT ANALYSIS:
The process of financial statement analysis is of different types. The process of analysis
is classified on the basis of information used and ‘modus operandi’ of analysis.
The classification is as under:
1) On the Basis of Information:
a) External Analysis: This analysis is based on published financial statements of a firm.
Outsiders have limited access to internal records of the concern. Therefore, they depend
on published financial statements. Thus, the analysis done by outsiders namely,
creditors, suppliers, investors and government agencies are known as external analysis.
This analysis serves a very limited purpose.
b) Internal Analysis: This analysis is done on the basis of internal and unpublished
records. It is done by executives or other authorized officials. It is very much useful and
significant to employees and management.
2) On the Basis of ‘Modus Operandi’ of Analysis:
a) Horizontal Analysis: This analysis is also known as ‘dynamic’ or ‘trend’ analysis. The
analysis is done by analyzing the statements of a number of years. According to John N.
Myer “the horizontal analysis consists of a study of the behavior of each of the entities
in the statement”. Thus, under horizontal analysis we study the behavior of each item
shown in the financial statements.
We examine as to what has been the periodical trend of various items shown in
the statements i.e., whether they have increased or decreased over a period of time. If
the comparative statements are prepared for more than two periods, then one of the
years is taken as basis to calculate the percentage of increase or decrease. Some analysts
prefer to choose earliest year as basis, while some others prefer to take just the
preceding year as basis.
b) Vertical Analysis: Vertical analysis is also known as ‘static analysis’ or ‘structural
analysis’. This analysis is made on the basis of a single set of financial statements
prepared on a particular date.

Under vertical analysis, quantitative relationship is established between

different items shown in a particular statement. Common-size statements are a form of
vertical analysis. Different items shown in the statement are expressed as a percentage
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 to any one item as base.
Use of both the methods of analysis is very much required for proper analysis.
Each method provides specific type of information and in fact both methods constitute
the backbone of financial analysis.

OBJECTIVES 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.
Objectives of Financial Statements:
Shareholders of a company heavily rely on financial statements to understand its
functioning. They portray the true state of affairs of the company. Here are some objectives of
financial statements:
➢ These statements show an accurate state of a company’s economic assets and liabilities.
External shareholders like investors and authorities generally do not possess this
information otherwise.
➢ They help in predicting the extent of a company’s capacity to earn profits.
➢ Shareholders and investors can use this data to make their financial decisions.
➢ These statements depict the effectiveness of a company’s management. How well
a company is performing depends on its profitability, which these statements show.
➢ They even help readers of these statements know the accounting policies used in them.
This helps in understanding statements more comprehensively.
➢ These statements also provide information relating to the company’s cash flows.
Investors and creditors can use this data to predict the company’s liquidity and cash
requirements.
➢ Finally, they explain the social impact of businesses. This is because it shows how
the company’s external factors affect its functioning.

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IMPORTANCE OF FINANCIAL STATEMENT ANALYSIS:
Financial statements are prepared using facts relating to events, which are recorded
chronologically. Thus, we have to first record all these facts in monetary terms. Then, we have
to process them using all applicable rules and procedures. Finally, we can now use all this data
to generate financial statements.
Based on this understanding, the importance of financial statements depends on the following points:
1. Recorded facts: We need to first record facts in monetary form to create the statements.
For this, we need to account for figures of accounts like fixed assets, cash, trade receivables,
etc.
2. Accounting conventions: Accounting Standards prescribe certain conventions applicable
in the process of accounting. We have to apply these conventions while preparing these
statements. For example, the valuation of inventory at cost price or market price, depending
on whichever is lower.
3. Postulates: Apart from conventions, even postulates play a big role in the preparation of
these statements. Postulates are basically presumptions that we must make in accounting.
For example, the going concern postulate presumes a business will exist for a long time.
Hence, we have to treat assets on a historical cost basis.
4. Personal judgments: Even personal opinions and judgments play a big role in the
preparation of these statements. Thus, we have to rely on our own estimates while
calculating things like depreciation.
Now that we understand the meaning and nature of financial statements, a glance at their
objectives would be appreciable.

TYPES OF FINANCIAL STATEMENT

1. Balance Sheet
2. Income Statement
3. Cash flow Statement
4. Statement of Owner's Equity
5. Free Cash Flow and Other Valuation Statements
1. Balance Sheet
The balance sheet is a report of a company's financial worth in terms of book value. It
is broken into three parts to include a company’s assets, liabilities, and shareholders' equity.
Short- term assets such as cash and accounts receivable can tell a lot about a company’s
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operational efficiency.
Liabilities include its expense arrangements and the debt capital it is paying off.
Shareholder’s equity includes details on equity capital investments and retained earnings from
periodic net income. The balance sheet must balance with assets minus liabilities equaling
shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value.
This value is an important performance metric that increases or decreases with the financial
activities of a company.
2. Income Statement
The income statement breaks down the revenue a company earns against the expenses
involved in its business to provide a bottom line, net income profit or loss. The income
statement is broken into three parts which help to analyze business efficiency at three different
points. It begins with revenue and the direct costs associated with revenue to identify gross
profit. It then moves to operating profit which subtracts indirect expenses such as marketing
costs, general costs, and depreciation. Finally, it ends with net profit which deducts interest and
taxes.
Basic analysis of the income statement usually involves the calculation of gross profit
margin, operating profit margin, and net profit margin which each divide profit by revenue.
Profit margin helps to show where company costs are low or high at different points of the
operations.
3. Cash Flow Statement
The cash flow statement provides an overview of the company's cash flows from
operating activities, investing activities, and financing activities. Net income is carried over to
the cash flow statement where it is included as the top line item for operating activities. Like
its title, investing activities include cash flows involved with firmwide investments. The
financing activities section includes cash flow from both debt and equity financing. The bottom
line shows how much cash a company has available.

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 4. Statement of Owner's Equity
The fourth financial statement that a business needs is a statement of owner's equity,
also known as a statement of changes in equity, or a statement of shareholders' equity. It shows
the business's retained earnings—the profit kept, or retained, within a business rather than
distributed to owners or shareholders—both at the beginning and at the end of a specific
reporting period.
Retained earnings are often used to either reinvest in the company, or to pay off the
business's debt obligations. It provides users with information regarding the financial health of
a business, as it shows whether the business is capable of meeting ongoing financial and
operating obligations without requiring its owners to contribute more capital. By preparing
each of these financial statements, not only will you be able to provide a prospective investor
or creditor with important information that they need to assess your business, but also you will
be able to identify trends in your business's performance that will help you to position your
business for continued success.

5. Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation
statements to analyze the value of a company. Free cash flow statements arrive at a net present
value by discounting the free cash flow a company is estimated to generate over time. Private
companies may keep a valuation statement as they progress toward potentially going public.

PROCEDURE OF FINANCIAL STATEMENT ANALYSIS

A common procedure is followed for financial statement analysis. Such procedure is briefly
explained below.

1. Objective of Analysis: The objective of analysis is differing from one interested party to
another. In other words, the user of financial statement analysis fixes or determines the
objectives of analysis.

2. Decide the Extent of Analysis: The extent of analysis is also decided by the interested
party. For example: Shareholder considers long term solvency of the business concern. The
debenture holder considers short term solvency of thebusiness concern.

3. Scope of Analysis: It means that an analyst should determine the depth of the analysis.
This can be decided depending upon the nature of problem.
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 4. Going through the Financial Statements: The analyst should go through every item of
the financial statements. If not so, the hidden facts cannot be found out through analysis.

5. Pooling of Relevant Data: The analyst should collect relevant data from the financial
statements. If not so, he/she can get relevant information from the published financial
statements.

6. Rearrangement of Financial Data: The contents of the financial statements are

rearranged before making actual analysis and interpretation. Under this step, approximation
of figures, consolidation of items etc. is done.

7. Understanding: The analyst should go through financial documents and other documents
for clearly understand the problem.

8. Classification: After understanding the problem, the collected relevant data are to be
classified according to the needs of the problem to find out a correct solution.

9. Analysis: After making above preparation, actual analysis is done. Any one of the tools or
techniques of financial statement analysis can be used.

10. Interpretation and Conclusion: The interpretation is made and the inferences are drawn
only on the basis of analysis.
11. Report Form: All the inferences and interpretation should be presented in a report form
to the management.

SOURCES OF FINANCIAL INFORMATION

Published financial statements provide the primary source of data about any organization’s
financial condition and performance. A company’s annual report, quarterlyreports, and
financial news releases provide a wealth of information about the firm. A brief discussion is
given below.

1. Company Reports: Every company publishes annual reports. These contain director’s
report, financial statements, schedules and notes to the financial statements, auditors’
report etc.

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 2. Stock Exchanges: Stock exchanges maintain a library of annual reports of companies.
They publish consolidated reports of company’s performance.
3. Business Periodicals: Business newspapers such as Business Standard, Economic
Times; business magazines such as Business India, Business World, Dalal Street
Journal are also source of financial information.

ROLE OF FINANCIAL ANALYST

Financial Analysts use the company’s financial statements (i.e. income statement,
balance sheet and cash flow statements). One of the most common approaches is to use
financial ratios (e.g., profitability ratios, debt ratios) to compare against those of another
company or against the company’s own historical performance. The Financial Analyst
researches and models macroeconomic and microeconomic conditions and company
fundamentals to make business, sector and industry recommendations and decisions. The
Financial Analyst collects and analyzes financial information such as budgets, operations
performance data, economic forecasts, trading volumes and cash flow to provide advice for
their company or their company’s clients.
Financial Analysts are employed across industries, including the financial services
sector (e.g. in banks, brokerage houses, insurance companies and mutual fund companies).
They sit within corporate finance departments, in particular lines of business or work for a
specific product or service team. Despite the variety of employment settings, the core functions
of a Financial Analyst remain the same.While the core of the Financial Analyst role may be the
same, there are different types of financial analysts, depending on their area of focus: For
example:

1. Corporate Finance: There are often several areas of specialization for analysts in the
corporate finance department.

2. Financial Reporting Analyst: These Analysts are involved in analyzing their firm’s
financial statements (e.g. income statement, balance sheet, statement of retained
earnings, cash flow statement) or various components of the statements. They look at
trends and/or variances in the financial data (actual versus budget) and generate
possible explanations.
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 3. Management Reporting/Performance Analyst: These Analysts play a role in
analyzing the performance of specific parts of a firm. They may analyze financial data
by product line, department, or geography. For example, a property and casualty
insurance company may have analysts to review the performance of both the firm’s
car insurance and home insurance lines of business. The products may be analyzed
against performance measures such as revenue/premiums, claims payout and industry
profitability ratios.

4. Treasury Analyst: These analysts focus on analyzing the cash flow of the firm. They
may reconcile bank deposits and withdrawals against bank statements, expenditures
against cash balances, produce interest schedules, or track inter- company loans and the
related interest payments to ensure that the organization and its departments have
adequate cash flow.

5. Taxation Analyst: These analysts play a role in helping the organization meet their
income tax reporting and compliance obligations. They may be responsible for portions
of the Canadian quarterly tax provision process, assist in the preparation of federal and
provincial income tax returns or collect data from other areas of the organization to build
the tax fact base.

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 (depending upon their investment philosophies).
• 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,
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 profit by product, and so forth).

• Regulatory authorities. If a company is publicly held, its financial statements are

examined by the Securities and Exchange Commission (if the company files in the
United States) to see if its statements conform to the various accounting standards and
the rules of the SEC

RECENT TRENDS OF FINANCIAL ANALYSIS:

Trends analysis of financial statement helps information users to discern percentage

changes over time in the selected data.

For example, users can see whether a firm’s net profit is increasing, decreasing, or stable or
whether there are fluctuations over the years.

EXPLANATION:

Horizontal analysis of financial statements can easily be expanded to include more than a
single change from one year to the next. This is known as trends analysis in many cases, it is
important to examining changes over a specific period because this enables the evaluation of
emerging trend that may influence performance in future years.

The five years summary of selected financial data, as found in all annual report is useful in
this regard when more than two years or included index number or used instead of percentage
changes. Essentially, one year is selected as the base year and is set to 100%. All other years are
represented of the base year.

All in all, a person who is interested in assessing the earning capacity of an enterprise may
compare sale and earnings for time horizons of 3,5 and 7 years using the principles and techniques
of trend analysis.

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