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12 views4 pages

CH 2

Uploaded by

folev42046
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Financial Statement Analysis

Analysis of Financial Statements is a systematic process of analysing the


financial information in the financial statements to understand and take economic
decisions.

Tools/Techniques

1. Comparative Statements
2. Common-Size Statements
3. Ratio Analysis
4. Cash Flow Statements

Types

1. External Analysis
Conducted by those who do not have access to the detailed records of
an enterprise and, therefore, have to depend on published accounts,
i.e., Balance Sheet, Statement of Profit & Loss, Directors’ and
Auditor’s Reports. Such type of analysis made by investors, lenders,
creditors, government agencies and research scholars.

2. Internal Analysis
Conducted by the management to know the financial position and
operational efficiency of the organisation. As management has access
to all information of the enterprise and, therefore, the analysis is more
detailed, extensive and accurate. Meant for management.

3. Horizontal (Dynamic) Analysis


Made to review and analyse financial statements for a number of
years. It is a Time Series Analysis. Shows comparison of financial data
for several years against a chosen base year. Useful for trend analysis
and long-term planning. Comparative Statements are an example.

4. Vertical (Static) Analysis


Made to review and analyse the financial statement of one year only. It
is a Cross-sectional Analysis. Useful in comparing the performance of
several companies of the same type or divisions or departments in one
enterprise. Ratio Analysis an example.

Process
Rearrangement
of Financial Comparison Analysis Interpretation
Statements
Objectives and Significance

1. Assessing the Earning Capacity or Profitability


On the basis of financial analysis, the earning capacity or profitability
of an enterprise can be assessed. In addition, the earning capacity of
the enterprise, in coming years, may also be forecast. All the external
users of financial statements, especially investors and potential
investors, are interested in earning capacity and forecast.

2. Assessing the Managerial Efficiency


Financial statement analysis reveals managerial efficiency by
scrutinizing accounting ratios, exposing production, administrative,
and marketing expense proportions. Variations, whether favorable or
unfavorable, are pinpointed, offering insights into effective or
ineffective management.

3. Assessing the Short-term and Long-term Solvency of


the Enterprise
Financial statement analysis evaluates an enterprise's short and long
term solvency. Creditors assess short-term liquidity for meeting
liabilities, while debenture holders examine long-term and short-term
solvency to gauge the company's ability to repay principal and
interest.

4. Inter-firm Comparison
Inter-firm comparison becomes easy with the help of financial
analysis. It helps an enterprise in assessing its own performance as
well as that of others, if mergers and acquisitions are to be considered.

5. Forecasting and Preparing Budgets


Analyzing past financial statements aids in forecasting future profits,
guiding budget preparation. Past earning capacity informs predictions,
offering insights into potential developments, particularly within the
upcoming year, benefiting investment decisions and financial
planning.

6. Explainable and Understandable


Financial analysis helps the users of the financial statements to
understand the complicate matter in a simplified manner. Financial
data can be made more comprehensive by charts, graphs and
diagrams, which can be easily explained and understood.
Uses

1. Securities Analysis
It is a process by which the investor comes to know whether the firm
is fulfilling his expectations with regard to payment of dividend,
capital appreciation and security of money. Such analysis is done by a
securities analyst who is interested in cash-generating ability, dividend
payout policy and the behaviour of share prices.

2. Credit Analysis
Such analysis is useful when a firm offers credit to a new customer or
a dealer. The manager of the firm would like to know whether to allow
or extend credit to them or not. Such analysis is also useful for a bank
before granting loan.

3. Debt Analysis
Such analysis is done by the firm to know its borrowing capacity.

4. Dividend Decision
Financial analysis helps the firm in deciding about the rate of
dividend. The management would have to decide about how much
portion of the earnings to distribute and how much to retain. Such
decisions indicate the profitability of the firm and hence, to some
extent affect the behaviour of share prices.

5. General Business Analysis


Financial analysis can be used to identify the key profit drivers and
business risks in order to assess the profit potential of the firm. It helps
in future growth scenarios for the firm.
Limitations

1. Historical Analysis
Financial statement analysis is a historical analysis. It analyses what
has happened till date and does not reflect the future. People like
shareholders, investors, etc., are more interested in knowing the likely
position in future.

2. Ignores Price Level Changes


Price level changes and purchasing power of money are inversely
related. A change in the price level makes analysis of financial
statements of different accounting years invalid because accounting
records ignore change in value of money.

3. Ignores the Qualitative Aspect


Since the financial statements are confined to monetary matters alone,
the qualitative aspects like quality of management, quality of staff,
public relations are ignored while carrying out the analysis of financial
statements.

4. Suffers from the Limitations of Financial Statements


Analysis of financial statements is based on the information given in
the financial statements. Hence, this analysis suffers from all such
limitations from which the financial statements suffer. Therefore,
unless the basic data given in the financial statements is reliable, the
conclusions derived on the basis of the analysis of this data cannot be
reliable.

5. Not Free from Personal Bias


In many situations, the accountant has to make a choice out of
alternatives available, e.g., choice in the method of inventory
valuation, choice in the method of depreciation (straight line or written
down value), etc. Since the subjectivity is inherent in personal
judgment, the financial statements are, therefore, not free from bias.

6. Variation in Accounting Practices


For inter-firm comparison, it is necessary that accounting practices
followed by the firms do not vary significantly. As there may be
variations in accounting practices followed by different firms, a
meaningful comparison of their financial statements is not possible.

7. Window Dressing
Window dressing refers to the presentation of a better financial
position than what it actually is by manipulating the books of account.
On account of such a situation, financial analysis may give false
information to the users.

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