INTRODUCTION OF FINANCIAL STATEMENT ANALYSIS

Financial statement analysis (or financial analysis) is the process of reviewing and analyzing a
company's financial statements to make better economic decisions. These statements include
the income statement, balance sheet, statement of cash flows, and astatement of retained earnings.
Financial statement analysis is a method or process involving specific techniques for evaluating
risks, performance, financial health, and future prospects of an organization. [1]
It is used by a variety of stakeholders, such as credit and equity investors, the government, the
public, and decision-makers within the organization. These stakeholders have different interests and
apply a variety of different techniques to meet their needs. For example, equity investors are
interested in the long-term earnings power of the organization and perhaps the sustainability and
growth of dividend payments. Creditors want to ensure the interest and principal is paid on the
organizations debt securities (e.g., bonds) when due.
Common methods of financial statement analysis include fundamental analysis, DuPont analysis,
horizontal and vertical analysis and the use of financial ratios. Historical information combined with a
series of assumptions and adjustments to the financial information may be used to project future
performance. The Chartered Financial Analyst designation is available for professional financial
analysts.
The major objectives of financial statement analysis are as follows
1.Assessment Of Past Performance
Past performance is a good indicator of future performance. Investors or creditors are interested in
the trend of past sales, cost of good sold, operating expenses, net income, cash flows and return on
investment. These trends offer a means for judging management's past performance and are
possible indicators of future performance.
2.Assessment of current position
Financial statement analysis shows the current position of the firm in terms of the types of assets
owned by a business firm and the different liabilities due against the enterprise.
3.Prediction of profitability and growth prospects
Financial statement analysis helps in assessing and predicting the earning prospects and growth
rates in earning which are used by investors while comparing investment alternatives and other
users in judging earning potential of business enterprise.

4.Prediction of bankruptcy and failure

Financial statement analysis is an important tool in assessing and predicting bankruptcy
andprobability of business failure.
5. Assessment of the operational efficiency
Financial statement analysis helps to assess the operational efficiency of the management of a
company. The actual performance of the firm which are revealed in the financial statements can be
compared with some standards set earlier and the deviation of any between standards and actual
performance can be used as the indicator of efficiency of the management.

Comparative Financial Statements: It is an important method of analysis

which is used to make comparison between two financial statements. Being a technique
of horizontal analysis and applicable to both financial statements, income statement and
balance sheet, it provides meaningful information when compared to the similar data of
prior periods. The comparative statement of income statements enables to review the
operational performance and to draw conclusions, whereas the balance
sheets, presenting a change in the financial position during the period, show the effects
of operations on the assets and liabilities. Thus, the absolute change from one period to
another may be determined.

Ratio Analysis: The most popular way to analyze the financial statements is
computing ratios. It is an important and widely used tool of analysis of
financial statements. While developing a meaningful relationship between
the individual items or group of items of balance sheets and income
statements, it highlights the key performance indicators, such as, liquidity,
solvency and profitability of a business entity. The tool of ratio analysis
performs in a way that it makes the process of comprehension of financial
statements simpler, at the same time, it reveals a lot about the changes in
the financial condition of a business entity.

It must be noted that Financial analysis is a continuous process being

applicable to every business to evaluate its past performance and current
financial position. It is useful in various situations to provide managers
the information that is needed for critical decisions. The process of financial
analysis provides the information about the ability of a business entity to
earn income while sustaining both short term and long term growth.

LIMITATIONS OF FSA
Although analysis of financial statement is essential to obtain relevant information for making several
decisions and formulatingcorporate plans and policies, it should be carefully performed as it suffers
from a number of the following limitations.
1. Mislead the user
The accuracy of financial information largely depends on how accurately financialstatements are
prepared. If their preparation is wrong, the information obtained from their analysis will also be wrong
which may mislead the user in making decisions.
2. Not useful for planning
Since financial statements are prepared by using historical financial data, therefore,
the informationderived from such statements may not be effective in corporate planning, if the
previous situation does not prevail.
3. Qualitative aspects
Then financial statement analysis provides only quantitative information about the company's
financial affairs. However, it fails to provide qualitative information such as management labour
relation, customer's satisfaction, management's skills and so on which are also equally important for
decision making.
4. Comparison not possible
The financial statements are based on historical data. Therefore comparative analysis of

financialstatements of different years can not be done as inflation distorts the view presented by
thestatements of different years.
5. Wrong judgement
The skills used in the analysis without adequate knowledge of the subject matter may lead to
negative direction . Similarly, biased attitude of the analyst may also lead to wrong judgement and
conclusion.
The limitations mentioned above about financial statement analysis make it clear that the analysis is
a means to an end and not an end to itself. The users and analysts
must understand the limitationsbefore analyzing the financial statements of the company.

Statement of Cash Flows

The statement of cash flows is a relatively new financial statement in comparison to the income
statement or the balance sheet. This may explain why there are not as many well-established
financial ratios associated with the statement of cash flows.

Introduction to Cash Flow Statement

The official name for the cash flow statement is the statement of cash flows. We will use both names
throughout AccountingCoach.com.
The statement of cash flows is one of the main financial statements. (The other financial statements
are the balance sheet, income statement, and statement of stockholders' equity.)
The cash flow statement reports the cash generated and used during the time interval specified in
its heading. The period of time that the statement covers is chosen by the company. For example,
the heading may state "For the Three Months Ended December 31, 2014" or "The Fiscal Year Ended
September 30, 2014".
The cash flow statement organizes and reports the cash generated and used in the following
categories:

What is the purpose of the cash flow statement?

The purpose of the cash flow statement or statement of cash flows is to provide
information about a company's gross receipts and gross payments for a specified
period of time.
The gross receipts and gross payments will be reported in the cash flow statement
according to one of the following classifications: operating activities, investing
activities, and financing activities. The net change from these three classifications
should equal the change in a company's cash and cash equivalents during the
reporting period. For instance, the cash flow statement for the calendar year 2013
will report the causes of the change in a company's cash and cash
equivalents between its balance sheets of December 31, 2012 and December 31,
2013.
In addition to the cash amounts being reported as operating, investing,
and financing activities, the cash flow statement must disclose other information,
including the amount of interest paid, the amount of income taxes paid, and any
significant investing and financing activities which did not require the use of cash.
The statement of cash flows is to be distributed along with a company's income
statement and balance sheet.

What Can The Statement of Cash

Flows Tell Us?
Because the income statement is prepared under the accrual basis of accounting, the revenues
reported may not have been collected. Similarly, the expenses reported on the income statement
might not have been paid. You could review the balance sheet changes to determine the facts, but
the cash flow statement already has integrated all that information. As a result, savvy business
people and investors utilize this important financial statement.
Here are a few ways the statement of cash flows is used.
1. The cash from operating activities is compared to the company's net income. If
the cash from operating activities is consistently greater than the net income, the
company's net income or earnings are said to be of a "high quality". If the cash
from operating activities is less than net income, a red flag is raised as to why
the reported net income is not turning into cash.
2. Some investors believe that "cash is king". The cash flow statement identifies the
cash that is flowing in and out of the company. If a company is consistently
generating more cash than it is using, the company will be able to increase its
dividend, buy back some of its stock, reduce debt, or acquire another company.
All of these are perceived to be good for stockholder value.
3. Some financial models are based upon cash flow.

Format of the Statement of Cash Flows

The statement of cash flows has four distinct sections:
1.
2.
3.
4.

Cash involving operating activities

Cash involving investing activities
Cash involving financing activities
Supplemental information.

Assuming that the cash flow statement is being prepared using the indirect method (the method
used by most companies) the differences in a company's balance sheet accounts will provide much
of the needed information. For example, if the statement of cash flows is for the year 2014, the
balance sheet accounts at December 31, 2014 will be compared to the balance sheet accounts at

December 31, 2013. The changesor differencesin these account balances will likely be entered
in one of the sections of the statement of cash flows.
Shown below is each of the four sections of the statement of cash flows, followed by a list of those
balance sheet accounts which affect it.

1. Cash Provided From or Used By

Operating Activities
This section of the cash flow statement reports the company's net income and then converts it from
the accrual basis to the cash basis by using the changes in the balances of current
asset and current liability accounts, such as:
Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Other Current Assets
Notes Payble
Accounts Payable
Wages Payable
Payroll Taxes Payable
Interest Payable
Income Taxes Payable
Unearned Revenues
Other Current Liabilities
In addition to using the changes in current assets and current liabilities, the operating activities
section has adjustments for depreciation expense and for the gains and losses on the sale of longterm assets.

2. Cash Provided From or Used By

Investing Activities
This section of the cash flow statement reports changes in the balances of long-term
asset accounts, such as:

Long-term Investments
Land
Buildings
Equipment
Furniture & Fixtures
Vehicles
In short, investing activities involve the purchase and/or sale of long-term investments and property,
plant, and equipment.

3. Cash Provided From or Used By

Financing Activities
This section of the cash flow statement reports changes in balances of the long-term
liability and stockholders' equity accounts, such as:
Notes Payable (generally due after one year)
Bonds Payable
Deferred Income Taxes
Preferred Stock
Paid-in Capital in Excess of Par-Preferred Stock
Common Stock
Paid-in Capital in Excess of Par-Common Stock
Paid-in Capital from Treasury Stock
Retained Earnings
Treasury Stock
In short, financing activities involve the issuance and/or the repurchase of a company's own bonds or
stock as well as short-term and long-term borrowings and repayments.

4. Supplemental Information
This section of the cash flow statement discloses the amount of interest and income taxes paid. Also
reported are significant exchanges not involving cash. For example, the exchange of company stock
for company bonds would be reported in this section.

What Are the Two Methods Used in Reporting Net

Cash Flow From Operating Activities?
The Financial Accounting Standards Board's Summary of Statement No. 95 requires a
company to report a statement of cash flows as part of its full set of financial statements.
Net cash flow from operating activities shows the amount of cash a company generates
through its normal course of business. Accounting rules allow companies to report their cash
flow statement using the direct or indirect method, and both methods report net cash flow
from operating activities.

Direct Method
The direct method is easier to comprehend, as it takes into account all major classes of cash
payments and receipts to arrive at a net cash position for cash from operating, investing,
and financing activities. For example, under cash from operating activities, a company
agglomerates all of its sales receipts, deducting from theses all cash payments it made for
such expenses as inventory purchases and salaries.

Indirect Method
The indirect method uses a company's net income, as reported from its income statement,
as a starting point before making adjustments for all cash and non-cash related items to
arrive at a cash position. Cash from operating activities lists net income and adds non-cash
expenses such as depreciation to net income. Because the company actually does not spend
cash when it depreciates equipment, financial analysts view this as an addition to the cash
position. An increase in accounts receivable is a cash expense, as the company must finance
its sales before it collects the actual money from the sale. Conversely, an increase in
accounts payable is a net increase in cash since the company defers making a payment until
a later period.

INTERPRETING CASH FLOWS

1. Cash flow from Operating Activities
This segment summarizes cash inflows and outflows associated to the firms fundamental operations.
Cash flow from operating activities is calculated by adjusting net income to mirror changes in depreciation
& amortization, accounts receivable, inventory, prepaid expenses, accounts payable and accruals.
Increases in accounts receivable, inventory and prepaid expenses are subtracted from net income while
decreases are added. Decreases in accounts payable and accruals are subtracted from net income while
increases are added.

2. Cash Flow from Investing Activities

This segment summarizes cash inflows and outflows associated to the purchase and sales of non-current
assets. Such activities may include the firms property, plant and equipment, sales of investment
securities and collection of principal on loans.