FINANCIAL STATEMENTS ANALYSIS

INTRODUCTION & MEANING:

Financial statements require a careful & meticulous study to draw out meaningful conclusions with
regard to operational efficiency & financial soundness of the company. The term financial statement analysis refers to
the process of determining financial strengths & weakness of the firm by establishing strategic relationship between the
items of the balance sheet, profit & loss account & other operative data.

The term financial statement analysis includes both analysis & interpretation. Financial statements
represent the written reports (the statements of profit & loss account & the balance sheet) which substantially describe
the financial position & operational results of the organization.

DEFINITION:
“Evaluation of a firm’s financial statements in order to assess the firm’s worth and its ability to meet its
financial obligations.”

PARTIES INTERESTED IN FINANCIAL STATEMENTS ANALYSIS

PARTIES AREAS OF INTEREST
1. Management Short-term & long-term solvency, profitability
2. Suppliers Short-term solvency, financial position
3. Lenders Financial position, profitability
4. Investors Profitability, financial position
5. Employees Profitability, financial position
6. Researchers Growth, future prospectus

OBJECTIVES/PURPOSES OF FINANCIAL ANALYSIS:

1. Offers Simplified Presentation:
The foremost goal of financial statement analysis is to present data in a systematic, simple, summarised
and understandable form so that meaningful conclusions can be drawn. The analysis could be coupled with
diagrams and graphs for a clear presentation.
2. Ascertains Relative Importance of Components of Financial Position:
Financial analysis clearly emphasizes the different constituents (assets, liabilities, owners' equity, etc.) of
financial position, their status and interrelationships existing between them, and brings out the relative
significance.
3. Judges Operational Efficiency and Profitability:
A thorough financial analysis helps in clearly reviewing the efficiency of management in conducting
various operations. In this regard, various profitability ratios come in quite handy and bring to light the
competence and effectiveness of the management.
4. Assesses Short and Long-term Financial Position and Solvency:
Financial analysis helps in providing a concrete estimation of the financial position of the organization. A
sound short-term financial position requires that current assets should be plenty to meet the current liabilities.

OBJECTIVES/PURPOSES OF FINANCIAL ANALYSIS

Ascertains
Assesses Short Decides upon
Relative Judges Judges Ability
Offers and Long-term Forecasting, Indicates Measures
Importance of Operational of the Firm to Draws
Simplified Financial Budgeting and Trend of Growth
Components Efficiency and Repay its Comparisons
Presentation Position and Future Line of Achievement Potential
of Financial Profitability Debts
Solvency Action
Position

5. Judges Ability of the Firm to Repay its Debts:

A comprehensive financial analysis assists in ascertaining the firm's ability to repay its debt and assessing
the short-term as well as the long-term liquidity position of the firm.
 6. Draws Comparisons:
A comprehensive financial analysis may easily be put to use draw out comparison between firm's own
past and present (intra-firm) performance and that between competing firms (inter-firm) in the industry.
7. Decides upon Forecasting, Budgeting and Future Line of Action:
A comparison between actual and planned performance always provides cues to improvement by
drawing attention to weaknesses and pitfalls discovered during operations. The comparison is also useful as it
provides plenty of data for profitability, performance and financial soundness.
8. Indicates Trend of Achievement:
An assessment of previous years indicates patterns observed in variables like revenue from operations
(sales), purchases, expenses, gross profit, net profit, etc. Such trends are readily taken account of and based
upon them, several decisions and future prospects of the firm may be ascertained.
9. Measures Growth Potential:
A thorough trend analysis indicates the direction in which the firm is headed and thus also the growth
potential or the lack of it. When trend analysis presents a positive picture, growth is certainly going to be
achieved.

TYPES OF FINANCIAL ANALYSIS

Types of
financial analysis

On the basis of On the basis of On the basis of On the basis of

material used modus operandi entites involved time horizon

Horizontal Cross Sectional Long term

Internal Analysis
Analysis Inter Firm Analysis

Time Series Intra Short term

External Analysis Vertical Analysis
Firm analysis

1) ON THE BASIS OF MATERIAL USED

A) INTERNAL ANALYSIS:
The analysis conducted by persons who have access to the internal accounting records of a business
firm is known as internal analysis. Financial analysis for managerial purposes is the internal type of analysis.
B) EXTERNAL ANALYSIS:
The analysis done by the outsiders who don’t have access to the detailed internal accounting
records of the business firm is termed as external analysis. For financial analysis, the external parties almost
entirely depend on the published financial statements.
2) ON THE BASIS OF MODUS OPERANDI:
A) HORIZONTAL ANALYSIS:
It refers to the comparison of financial data of a company for several years. The figures for this type
of analysis are presented horizontally over a number of columns. This type of analysis is also called as
‘DYNAMIC ANALYSIS’. Comparative Statement is the tool employed in horizontal analysis.
B) VERTICAL ANALYSIS:
 It refers to the study of relationship of the various item in the financial statements of one
accounting period. In this type of analysis, the figures from financial statements of a year are compared
with a base selected financial statements & financial statement. It is also known as ‘STATIC ANALYSIS’.
3) ON THE BASIS OF ENTITIES INVOLVED
A) CROSS SECTIONAL INTER FIRM ANALYSIS:
It refers to the comparison of data of a firm with other firms or industry averages for the same time
period.
B) TIME SERIES INTRA FIRM ANALYSIS:
It involves the study of performance of the same firm over a period of time.
4) ON THE BASIS OF TIME HORIZON
A) SHORT-TERM ANALYSIS:
It measures the liquidity position of the firm. It also helps in measuring the short-term paying
capacity of a firm to meet its short-term obligations.
B) LONG-TERM ANALYSIS:
It involves the study of firm’s long-term solvency & also measures the firm’s ability to meets its
long-term obligations, repayment schedule of long-term obligations.

PROCEDURE FOR FINANCIAL ANALYSIS:

1. Reclassification & Rearrangement of categorized data
2. Comparative study of comparative data of past records
3. Analysis of comparative data for financial traits such as liquidity, solvency, profitability etc.
4. Interpretation of financial data

LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS:

1. Not a Substitute of Judgement:

An analysis of financial statement cannot take place Not a Substitute of
Judgement
of sound judgement. It is only a means to reach conclusions.
Ultimately, the judgements are taken by an interested party
or analyst on his/ her intelligence and skill.
Based on past data
2. Based on past data:
Only past data of accounting information is included
in the financial statements, which are analysed. The future
Problem in comparability
cannot be just like past. Hence, the analysis of financial
statements cannot provide a basis for future estimation,
forecasting, budgeting and planning.
3. Problem in comparability: Reliability of figures
The size of business concern is varying according to LIMITATIONS OF FINANCIAL
the volume of transactions. Hence, the figures of different STATEMENTS ANALYSIS
Various method of
financial statements lose the characteristic of comparability. accounting & financing
4. Reliability of figures:
Sometimes, the contents of the financial statements
are manipulated by window dressing. If so, the analysis of Change in accounting
methods
financial statements results in misleading or meaningless.
5. Various method of accounting & financing;
The closing stock of raw material is valued at Changes in the value of
purchase cost. The closing stock of finished goods is value at money

market price or cost price whichever is less. So; an analyst

should keep in view these points while making analysis and
Change in business condition
interpretation otherwise the results would be misleading.
6. Change in accounting methods:
There must be uniform accounting policies and
methods for number of years. If there are frequent changes,
the figures of different periods will be different and incomparable.
 7. Changes in the value of money:
The purchasing power of money is reduced from one year to subsequent year due to inflation. It creates
problems in comparative study of financial statements of different years.
8. Change in business condition:
The conditions and circumstances of one firm can never be similar to another firm. Likewise, the
business condition and circumstances of one year to subsequent can never be similar. Hence, it is very difficult
for analysis and comparison of one firm with another.

TOOLS OR TECHNIQUES OF FINANCIAL ANALYSIS:

The common tools used in financial analysis are listed as follows:
1. COMMON SIZE FINANCIAL STATEMENTS
2. COMPARATIVE FINANCIAL STATEMENTS
3. TREND ANALYSIS
4. RATIO ANALYSIS
5. CASH FLOW STATEMENT

COMMON SIZE FINANCIAL STATEMENTS:

The use of common-size statements facilitates vertical analysis of a company's financial statements. The
calculation for common-size percentages is: (Amount / Base amount) and multiply by 100 to get a percentage.
Remember, on the balance sheet the base is total assets and on the income statement the base is net sales.

COMMON SIZE BALANCE SHEET:

1. A common size balance sheet is a balance sheet that displays both the numeric value and relative percentage for
total assets, total liabilities, and equity accounts.
2. Common size balance sheets are used by internal and external analysts. These are not a reporting requirement
of generally accepted accounting principles (GAAP).
3. Common size balance sheets are more useful than traditional ones in identifying trends and patterns in a
company’s financial performance.

COMMON SIZE INCOME STATEMENT:

1. A statement that shows the percentage relation of each income/expense to the Revenue from Operations (Net
Sales), is known as a Common-size Income Statement.
2. To express the amounts as the percentage of the total, Revenue from Operations (Net Sales) is taken as 100.
4. With the help of the comparison between the Common-size Income Statements of different periods, one can
understand the efficiency in earning revenues and incurring expenses.

COMPARATIVE FINANCIAL STATEMENTS:

A statement that helps in the comparative study of the components of a company’s balance sheet and
income statement over a period of two or more years, both in absolute and percentage form, is known as a Comparative
Statement. It is a horizontal type of analysis and not only provides the absolute figures of various years but also, the
columns to indicate any increase or decrease in these figures from one year to another in absolute and in percentage
form.
Schedule III to the Companies Act, 2013 deals with the form of Balance Sheet and Profit and Loss
Account.

COMPARATIVE BALANCE SHEET:

1. A technique of comparing financial statements through which the balance sheet of a company is analysed by
comparing its Asset, and Equity and Liabilities for two or more two accounting periods is known as Comparative
Balance Sheet.
2. It is a horizontal analysis of Balance Sheet.
3. A comparative balance sheet is a statement that shows the financial position of an organization over different
periods for which comparison is made or required.

COMPARATIVE INCOME STATEMENT:

 1. A comparative income statement presents the results of multiple accounting periods in separate columns.
2. Comparative Income Statement or Comparative Statement of Profit & Loss is a horizontal analysis of the Income
Statement showing operating results for more than one accounting year.
3. In simple terms, it shows the absolute change and percentage change in the figures from one period to another.

TREND ANALYSIS:
1. Trend analysis is a technique used to examine and predict movements of an item based on current and historical
data.
2. One can use trend analysis to improve your business using trend data to inform your decision-making.
3. Trend analysis helps you compare your business against other businesses to establish a benchmark of how your
business should be operating, at both the initial stage and ongoing, or developing.
4. There are some limitations to trend analysis, for example:
a) external financial crises and recessions, and the effects of a pandemic
b) factors that have changed results during the recorded period, such as purchasing new equipment or
outsourcing
c) adjustments for inflation.
5. Trend analysis is 'working on the business', rather than 'in the business'.
6. Examples of Trend Analysis:
Examining sales patterns to see if sales are declining because of specific customers or products or sales regions.