INSTITUTE OF HOTEL MANAGEMENT BHUBANESWAR

Est. By Ministry of Tourism, Government of India

FINANCIAL STATEMENT ANALYSIS AND

INTERPRETATION
Meaning

The process of determining financial strengths and weaknesses of a firm by establishing

strategic relationship between the items of the balance sheet, profit and loss account and
other operative data .

According to Metcalf & Titard

"It is a process of evaluating the relationship between component parts of a financial

statement to obtain a better understanding of a firm's position and performance."

Purpose:
To diagnose the information contained in financial statements so as to judge the profitability
and financial soundness of the firm. Purpose:-

Types of financial statement are :

On the basis of:

1.The materials used.

2.The method of operation followed in the analysis.

1.On the basis of Material used:

a)External and

b)Internal Analysis

a)External Analysis

This analysis is done by outsiders who do not have access to the detailed internal
accounting records of the business firm. (Investors, creditors, government agencies, credit
agencies and general public.)

b)Internal Analysis

This analysis is conducted by persons who have access to the internal accounting records of
a business firm. (Executives and employees of the organization and government agencies
which have statutory powers vested in them ).

B.sc in Hospitality and Hotel Administration Page 1 of 7

5th semester - Financial Management Analysis and Interpretation April ,2016

Prepared By Yuvraj(Asst.Lecturer)
 INSTITUTE OF HOTEL MANAGEMENT BHUBANESWAR
Est. By Ministry of Tourism, Government of India

2.The method of operation followed in the analysis.

a)Horizontal analysis.
b)Vertical analysis.

a)Horizontal analysis.

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. The figures of the various
years are compared with standard or base year. It also referred to a dynamic analysis.

Tools employed are:

Comparative statements.
Trend percentages.

b) Vertical analysis

The study of relationship of the various items in the financial statements of one accounting
period. Figures from financial statements of a year are compared with a base selected from
the same year s statement. It is also referred to Static Analysis.

Tools employed are:

Common-size Financial statements.
Financial ratios

Tools of Financial Analysis (Methods or Devices)

1. Comparative statements
2. Common size statements
3. Trend Analysis
4. Ratio Analysis
5. Fund Flow analysis
6. Cash Flow Analysis

1.Comparative Statement:

Comparative statements contain the changes (increase or decrease) in the financial

statements of two or more periods. The changes are shown in absolute figures and
percentages.

This comparison can be made only if the same accounting procedures are followed. If the
procedures are different it should be taken into account by the analyst while making the
analysis.

Comparative statement may show the following:

�� Absolute figures.
�� Changes in absolute figures ––increase or decrease.
�� Increase or decrease in terms of percentages.

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5th semester - Financial Management Analysis and Interpretation April ,2016

Prepared By Yuvraj(Asst.Lecturer)
 INSTITUTE OF HOTEL MANAGEMENT BHUBANESWAR
Est. By Ministry of Tourism, Government of India

Two Comparative statements are:

��Comparative Balance Sheet.

��Comparative Income Statement

Comparative Balance Sheet.

The comparative balance sheet analysis is the study of the trend of the same items, group of
items in two or more balance sheets of the same business enterprise on different dates.

The changes can be observed by comparison of the balance sheet at the beginning and at
the end of a period and these changes can help in forming an opinion about the progress of
an enterprise
The comparative balance sheet has two columns for the data of original balance sheet. A
third column is used to show increase in figures. The fourth column may be added for giving
percentages of increases or decreases.

Interpretation of Comparative Balance Sheet:

��Current financial position and liquidity position.

��Long term financial position.

��Profitability of the concern.

Comparative Income Statement

Comparative income statement reveals the profitability of the company. It states about the
progress of a company over a period of time. While comparing income statement an order of
comparison is gross profit, Operational Profit and finally the net profit.

Steps involved in the interpretation of Income Statements:

1.The increase or decrease in sales should be compared with the increase or decrease in
cost of goods sold. An increase in sales will not always mean increase in profits. The
profitability will improve if the increase in sales is more than the increase in cost of goods
sold.

2.An increase in operating profit will result from an increase in sales position and control of
operating expenses. At the same time a decrease in profit may be due to an increase in
operating expenses or a decrease in sales.

3.The increase or decrease in profit will give an idea about the overall profitability of the
concern. There are certain non operating expenses which will result in a decrease in the

B.sc in Hospitality and Hotel Administration Page 3 of 7

5th semester - Financial Management Analysis and Interpretation April ,2016

Prepared By Yuvraj(Asst.Lecturer)
 INSTITUTE OF HOTEL MANAGEMENT BHUBANESWAR
Est. By Ministry of Tourism, Government of India

operating profit. Such expenses are interest paid, loss on sale of asset, writing off deferred
expenses, payment of tax etc.
4.When all non operating expenses are deducted from the operating profit we get net profit.
Some non operating incomes may also be there which will increase net profit. An increase in
net profit will give us an idea about the progress of the concern. non-non-

5.An opinion should be formed about profitability of the concern and it should be given at the
end. It should be mentioned whether the overall profitability is good or not

2. Trend Analysis

The financial statements may be analyzed by computing trends of series of information. This
method determines the direction upwards or downwards and involves the computation of the
percentage relationship that statement item bears to the same item in base year. The
information for a number of years is taken up and one year, generally the first year, is taken
as a base year.

For Example

If sales figures for the year 1995 to 1999 are to be studied, then sales of 1995 will be taken
as 100 and the percentage of sales for all other years will be calculated in relation to the
base year, i.e., 1995.

Interpretation of Trend Analysis:

1.The mere increase or decrease in trend percentage may give misleading results if studied
in isolation. An increase of 20% in current assets may be treated favourable. If this increase
in current asset is accompanied by an increase in current liabilities, then the increase.

2.An increase in sales may not increase profits if the cost of production has also gone up.

3.The base period should be a normal period. The price level changes in subsequent years
may reduce the utility of trend ratios. If the figure of the base period is very small, then the
ratios calculated on this basis may not give a true idea about the financial data. The
accounting procedures and conventions used should be similar, otherwise the figures will not
be comparable.
Financial statements are analyzed for the purpose of measuring financial soundness and
operational efficiency of a business concern.

3.Common Size Statement.

The common common-size statements, balance sheet and income statement, are shown in
analytical percentages. The figures are shown as percentages of total assets, total liabilities
and total sales.

Two types:
• COMMON COMMON-SIZE BALANCE SHEET

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5th semester - Financial Management Analysis and Interpretation April ,2016

Prepared By Yuvraj(Asst.Lecturer)
 INSTITUTE OF HOTEL MANAGEMENT BHUBANESWAR
Est. By Ministry of Tourism, Government of India

• COMMON COMMON-SIZE INCOME STATEMENT

COMMON-SIZE BALANCE SHEET

A statement in which balance sheet items are expressed as the ratio of each asset to total
assets and the ratio of each liability is expressed as a ratio of total liabilities is called
common size balance sheet. common-
The common size balance sheet can be used to compare companies of differing size. The
comparison of figures in different periods is not useful because total figures may be affected
by a number of factors.

COMMON-SIZE INCOME STATEMENT

The items in income statement can be shown as percentages of sales to show the relation of
each item to sales. A significant relationship can be established between items of income
statement and volume of sales.

does not classify expenses. Financial analysis requires expenses to be classified into
operating expenses , administrative expenses ,etc. Such classification enables financial
analysis to establish the relationship between expenses and sales. Thus a proper financial
analysis is possible only if the profit is disclosed step by step, that is, gross profit, then net
operating profit, followed by net profit before tax and profits disstributed and retained. This is
useful in financial analysis, especially in ratio analysis. This is done through the vertical
income statement.
Ratio Analysis: Expression of relationship between two figures which are mutually
interdependent.

Trend Analysis : Comparative statement and common size statement compare the figures
of the second year with those of first year , the figure of third year with those of second year
and so on. Trend analysis on the other hand, treats the first year as the base compare the
figures of all the other years against it. It is useful because
a- while comparative statement shows the size of change , trend analysis shows the
direction (up or down )of the change.
b- It is easy to calculate and interpret;
c-It is quick method of analysis;
d-It is more accurate because it is based on percentage and not absolute figures'-

Limitations of financial Statement

Although analysis of financial statements is essential to obtain the relevant information for
making several decisions and formulating corporate plans and policies, it should be carefully
performed as it suffers from the following limitations:

1. Mislead the user

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5th semester - Financial Management Analysis and Interpretation April ,2016

Prepared By Yuvraj(Asst.Lecturer)
 INSTITUTE OF HOTEL MANAGEMENT BHUBANESWAR
Est. By Ministry of Tourism, Government of India

The accuracy of financial information largely depends on how accurately financial

statements 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
information derived 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, and 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
financial statements of different years can not be done as inflation distorts the view
presented by the statements of different years.

5. Wrong Judgment

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.

6. No strong financial future

Strong financial statement analysis does not necessarily mean that the organization
has a strong financial future. Financial statement analysis might look good, but there
may be other factors that can cause an organization to collapse..

Advantages of preparing Financial Statement

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5th semester - Financial Management Analysis and Interpretation April ,2016

Prepared By Yuvraj(Asst.Lecturer)
 INSTITUTE OF HOTEL MANAGEMENT BHUBANESWAR
Est. By Ministry of Tourism, Government of India

1. Management : Management wants to analyse the financial statement to know the

deviation from the budgeted figures and to compare with the previous quarters, years
etc, figures and to compare with other competitive business houses./companies.
2. Share Holders: Share holders have a statutory rights to know the present and future
earning of the company and its comparison with previous years earning and with
budgeted earnings estimates.
3. Investors: General public who may be interested in investing in the company's
equity or lending the money are interested in knowing the present, future earning of
company and future business proposal.
4. Debentures holders: Before buying debentures of a company from open market or
to buy from the company during public offers , the investors would like to know the
financial status of the company. The debentures holders would also like to know
whether the company will able to pay them the promised interest on debentures.

5. Financial institution: Banks and non banking financial institution /Corporation

invests money after knowing the present and future financial status of the company.
The large business houses need billion of rupees to implement large businesses. It is
not practically possible to raise 100% funds through equity or internal recourses and
they look upon financial institution for debt participation.
6. Researches: The financial statement are of great value to scholar undertaking
research in business affairs and practice.
7. Taxation Authorities: Various taxation authorities like income tax, value added tax
,Excise, Customs, etc would like to have the financial statement of a company in
order to ensure that the right tax is being paid by individual and companies.

B.sc in Hospitality and Hotel Administration Page 7 of 7

5th semester - Financial Management Analysis and Interpretation April ,2016

Prepared By Yuvraj(Asst.Lecturer)