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Analysis of
Financial Statements
8
Introduction
Purpose of Financial Analysis
Main Objective of Financial Analysis
Users of Financial Analysis
Types of Financial Analysis
Horizontal Analysis
Vertical Analysis
8.1 INTRODUCTION
The basic limitation of the traditional financial statements, comprising balance sheet and profit and
loss account, is they do not give all the relevant and required information for knowing the strength
and weakness of a firm. Still, they provide extremely useful information to the extent that the
balance sheet mirrors the financial position on a particular date, in terms of structure of assets,
liabilities and owners equity, like a snap shot. The profit and loss account shows the operational
results during a particular period, in terms of the revenue generated and costs incurred for achieving
2 Accounting for Managers
them. As the financial information is in absolute terms, every one may not, readily, understand
them. The answer is Analysis of Financial Statements.
Analysis of financial statements refers to the application of different tools to know the
behaviour of the accounting information.
Much can be learnt by analysing the financial statements.
Different parties are interested in the financial statements for different purposes and look to them
from their own angle. The objective of the different parties is not the same. Their requirements are
not uniform. So, every one is interested to use them for his own requirement. A lender is interested
for repayment of the money lent and interest, assured at the time of lending. Shareholder is
concerned for earnings and appreciation of the investment, he has made. It is very clear their
objectives are not common so their approach and information, they look for, would be different.
Financial analysis can be undertaken by the management of the firm or interested parties, outside
the firm. The outsiders of the firm are owners (shareholders), creditors, intending investors and
others, in particular potential lenders.
Nature of Analysis: The nature of the analysis depends upon their purpose
or requirement. They make the necessary analysis and take the decision,
based on their assessment of the results obtained.
Trade creditors are those who have supplied goods and services to the firm. They are
interested in their timely repayment. So, before they supply or render service, they want to be sure
that the firm would be in a position to pay their dues, in a short period, as assured to them. They
Analysis of Financial Statements 3
analyse the firms short-term liquidity position. The term liquidity refers to the ability of the firm
to pay, as and when the demands and debts fall due for payment.
Firm would be in a position to meet the current obligations, if the cash receipts match
payments, in terms of time.
Suppliers of long-term debt are those who provide loans for a long period. They are concerned
with the firms long-term solvency and survival, which depends on profitability and cash
generation. Before they lend, they want to assure themselves that the organisation would be able to
generate adequate liquid funds to pay the loan installment and interest. They are more concerned
with the future outlook, rather than the past, based on the projections of the firm. They analyse the
historical data, based on the financial statements, to determine the basis and reasonableness of the
projections to decide the future financial standing of the firm.
Shareholders and investors invest their money in the firms shares to earn dividend and
appreciation of share value. They are concerned with the firms present and future profitability.
The ability of the company to pay dividends depends on the future prospects and earning capacity
of the organisation. They would have more confidence in those firms, which show steady growth
in earnings. They are also interested in the firms financial structure to the extent it influences the
firms earning ability.
Employees and Management: The importance of trust and harmonious relationship between
the employees and management requires no more emphasis for accelerated growth of the firm. If
the employees feel confident of more salaries, retirement benefits and fast track career growth, in
future, their loyalty would be assured. Employees look for stability and profitability in financial
statements.
Management of the firm would be interested in every aspect of financial analysis. Management
is concerned with the effective and efficient utilisation of resources, analysing the financial
statements and other information available to them.
Government regulates the functioning of all organisations for the benefit of public. It has to
generate adequate revenue for this purpose. Collection of taxes and information for deciding future
policies are based on the financial statements of the firms.
It is clear that the different users need the financial statements for different purposes.
Requirements of users of financial statements are different, not uniform. The
aim of the financial statements is to provide the information required for their
divergent needs.
8.5 TYPES OF FINANCIAL ANALYSIS
(i) On the basis of Material used: According to this category, financial analysis can be of two
types. They are:
(A) External Analysis: Those people who do not have access to the internal records of the firm
do this analysis. Basically, they are creditors, present and potential investors, credit agencies
and the general public. Normally, except select employees in the firm, all others do not have
access to the internal records. There is always a time lag for the publication of accounts, after
their preparation. So, updated or recent information is not available for analysis. Due to this
inherent limitation, this type of analysis serves a limited purpose as the analysis is based on
the published financial accounts, audited or un-audited. However, of late, the position has,
significantly, improved due to government regulations to make the published accounts more
frequent, transparent and detailed.
(B) Internal Analysis: Those persons, who have the access to the books of accounts, financial
and other records of the firm, do this analysis. Basically, the employees and executives of the
firm who have access to the records can do this analysis. Even, the Government agencies also
can do when they have the statutory powers to access the records. This analysis would be more
meaningful and useful as the analysis is made on the basis of full records and with a specific
objective. The management of the firm would, invariably, adopt internal analysis for
managerial purposes.
(ii) Method of Analysis: Based on the method, financial analysis can be of two types. They are
Horizontal analysis and Vertical Analysis.
Horizontal Analysis: When financial statements of a number of years of the same firm are
compared and reviewed, it is known as Horizontal Analysis. Horizontal analysis helps to observe
the changes in the financial variables, across the years. For this analysis, first base or standard year
is chosen as a starting point. Any year may be taken as the base year, but, generally, the starting or
initial year is taken as the base year. All the financial figures are presented in a horizontal manner.
Keeping the data of base year in the beginning, the data of the different years are kept in separate
columns.
Analysis of Financial Statements 5
Various tools or techniques are used in the financial analysis. The main objective of any analytical
method is simple presentation of data, in a relevant manner, even for a complex problem for quick
understanding. Basic purpose is attention of the management should be focussed only on the
problem area for solution.
The most important tools for financial analysis are:
(a) Comparative Financial Statements
(b) Trend Analysis or Trend Ratios
(c) Common Size Statements
(d) Ratio Analysis
(e) Fund Flow Analysis
(f) Cash Flow Analysis
Analysis of Financial Statements 7
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Absolute figures are difficult to understand, in particular when they are big amounts. One can
understand better and immediately if the statement says that there has been an increase of 10% in
sales, rather than mentioning the absolute amount of sales for both the years.
10 Accounting for Managers
Absolute amounts of large numbers are substituted by percentages to show brevity and ready
readability for management.
Illustration No. 2
From the following data of Sathyavathi & Co, calculate the percentage, taking the year 2006 as the
base. Judge which years performance is better, if the base year is 2006.
(Rs.)
> w >PNNT> w >PNNU> w >PNNV>
The common-size statements, balance sheet and income statement are shown in analytical
percentages. The CSS represents the relationship of different items, contained in a financial
statement, with some common item by expressing each item as a percentage of the common item.
The common-size statements may be prepared in the following ways:
(1) The totals of assets and liabilities in the balance sheet are taken as 100.
(2) The individual assets are expressed as a percentage of total assets. i.e., 100. Different
liabilities are calculated in relation to total liabilities. For example, if total assets are Rs. 10
lakh and debtors value is Rs. 1, 00,000. Debtors will be 10% of total assets.
10 1,,00,00000,000 100
(3) Similarly, in Common Size Income Statement, each item is stated as percentage of the Net
Sales. The percentages for different items are computed by dividing the absolute amount of
that item by the Common base (i.e., Net Sales) and then multiplying by 100. The percentages,
so calculated, can be easily compared with the corresponding percentages, in some other
period.
Purpose: Impact of increase or decrease is immediately known as every item is compared to a
common standard base of a fixed value i.e., 100. The CSS is useful not only in intra-firm
comparisons over a series of different years but also in making inter-firm comparisons for the same
year or several years.
The common size statements are the most valuable in making comparisons between the firms
in the same industry as well as series of years for the same firm as each individual item is compared
as a percentage to the total, which is taken as 100 always.
Illustration No. 3
Following are the Income Statement and Balance Sheet of Theer & Co. for the year 2005 and 2006.
Prepare the CBS and CIS for these two years.
Draw tentative conclusions.
Income Statements for the year 2005 2006
(Figures in Rs.)
> PNNS> PNNT> > PNNS> PNNT>
r>>>>> SJNNJNNN> QJUSJNNN> `>l>q > TJNNJNNN> SJNNJNNN>
r>e >c-> ONJNNN> ONJNNN> > > >
r>q>c-> OSJNNN> PNJNNN> > > >
12 Accounting for Managers
# $ %
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14 Accounting for Managers
+ )+$
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p>> OJSNJNNN> UPJSNN> PQLNV> WLSR>
l>u>FQG> RJSNJNNN> RJUPJSNN> TWLPQ> TPLOU>
q>j >> SNJNNN> USJNNN> ULUN> WLVU>
a> OJNNJNNN> OJQUJSNN> OSLQU> OVLNW>
m >c-> SNJNNN> USJNNN> ULUN> WLVU>
r >j >FRG> PJNNJNNN> PJVUJSNN> QNLUU> QULVQ>
l>>I>r > > > > >
j >FQIRG> TJSNJNNN> UJTNJNNN> ONN> ONN>
Tentative Conclusions:
1. Sales have gone down by Rs. 1,00,000. However, net profit has increased by 6.5% [12.5%
(2005) to 19% (2006)]. The net increase is due to combination of reduction of cost of goods
sold by 8.33% [83.33% (2005) to 75% (2006)] and increase of total operating expenses by
1.83%. This indicates that the firm has concentrated on the improvement of profitability, even
at the cost of reduction in sales.
15
2. There has been significant improvement in reducing the cost of production in 2006, compared
to 2005 as cost of sales has gone down from 83.33 (2005) to 75% (2006).
3. For further improving profitability, control on operating expenses is required. Inventory
control would improve the profitability, further.
4. Finished stock % has gone up from 15.39% to 19.75%, despite fall in sales. This indicates that
the firm is experiencing accumulation of stocks.
Descriptive Questions
1. What is the need of Analysis of Financial Statements? (8.1 and 8.2)
2. What is meant by Financial Analysis? Discuss the utility and significance of the Analysis of
Financial Statements to the management and others, interested in the business? (8.1 to 8.3)
3. What are the objectives of Analysis of Financial Statements? Who are the Users of Financial
Analysis? (8.3 and 8.4)
4. Explain the different types of Financial Analysis? (8.5)
5. Explain common-size statements? Explain the technique of preparing the common size
balance sheet? (8.8)
6. What are the major tools of Financial Analysis and explain any three of them? (8.6 to 8.8)
Answers
1. (c) 2. (c) 3. (e)
Interview Questions
Q.1. What is the basic purpose of analysis of financial statements?
Ans. Management is interested to know the strength and weakness of the firm, in terms of finance.
Absolute figures in the financial statements Profit and Loss Account and Balance Sheet-
are always big and difficult to understand, easily. Analysis of financial statements helps the
management in understanding the figures better for quicker and meaningful decisions.
Q.2. Name some of the tools available for analysis of financial statements?
Ans. The most important tools for financial analysis are:
(a) Comparative financial statements
(b) Trend Analysis or Trend Ratios
(c) Common Size statements
(d) Ratio Analysis
(e) Fund Flow Analysis
(f) Cash Flow Analysis
Q.3. What do you understand by Trend Analysis?
17
Ans. Trend Analysis helps in understanding the direction of movement of the firm, in terms of
operational results and financial position.
18