FINANCIAL STATEMENTS ANALYSIS AND

INTERPRETATION

Meaning of Financial Analysis

Financial analysis is a process which involves reclassification and summarization of information

through the establishment of ratios and trends. Analysis of financial statement refers to the
examination of the statements for the purpose of acquiring additional information regarding
the activities of the business. The users of the financial information often find analysis
desirable for the interpretation of the firm’s activities.

Financial statement analysis can be referred as a process of understanding the risk and
profitability of a company by analyzing reported financial info, especially annual and quarterly
reports. Putting another way, financial statement analysis is a study about accounting ratios
among various items included in the balance sheet. These ratios include asset utilization
ratios, profitability ratios, leverage ratios, liquidity ratios, and valuation ratios. Moreover,
financial statement analysis is a quantifying method for determining the past, current, and
prospective performance of a company.

Financial analysis is certain procedures and methods applied to determine the past, present
and also the future status and performance of business with the aim to compare how the
business performed in the past, how it performs now and use such data for forecasting
purposes, making decisions about the business performance, manage it and control.

The overall objective of financial statement analysis is the examination of a firm’s financial
position and returns in relation to risk. This must be done with a view to forecasting the firm’s
future prospective.

We know business is mainly concerned with the financial activities. In order to ascertain the
financial status of the business every enterprise prepares certain statements, known as
financial statements. Financial statements are mainly prepared for decision making purposes.
But the information as is provided in the financial statements is not adequately helpful in
drawing a meaningful conclusion. Thus, an effective analysis and interpretation of financial
statements is required.

Analysis means establishing a meaningful relationship between various items of the two
financial statements with each other in such a way that a conclusion is drawn. By financial
statements we mean two statements:

(i) Profit and loss Account or Income Statement

(ii) Balance Sheet or Position Statement

These are prepared at the end of a given period of time. They are the indicators of profitability
and financial soundness of the business concern. The term financial analysis is also known as
analysis and interpretation of financial statements. It refers to the establishing meaningful
relationship between various items of the two financial statements i.e. Income statement and
position statement. It determines financial strength and weaknesses of the firm.

To summarize, financial statement analysis is concerned with analyzing the balance sheet and
the income statement of a business to interpret the business and financial ratios of a business
for financial representations, business evaluation, in addition to financial forecasting.
Objectives/Purposes of Financial Analysis

While learning how to perform a financial statement analysis, it is important to understand the
purpose of financial analysis.

The purpose of a financial analysis varies with the company conducting the analysis and the
users of financial analysis data. During a financial analysis, the relation between the various
elements of financial statements is established and also compared with the other information
obtained about the business. This is a very important tool and is used by the investors,
creditors and the management in determining the future prospects as well as the plans
regarding the company. This is also used to identify the areas that need improvement and also
solve any type of financial and operational problem. The prime aim of a financial analysis is to
analyze the current financial status and performance of the company, so that it will be possible
to judge on the future performance of the business.

The purpose of financial analysis usually differs depending on the users of this data. For
example, creditors are concerned with the solvency and liquidity because they are the ones
who purchase bonds and debt securities of the company. Therefore they want top know the
company’s ability to pay off the debts and interest. The investors (investing in the company’s
stock) are mainly concerned with the profitability of the company. They wish to know what
returns they are going to earn in the form of dividends and a higher stock value.

Analysis of financial statements is an attempt to assess the efficiency and performance of an

enterprise. Thus, the analysis and interpretation of financial statements is very essential to
measure the efficiency, profitability, financial soundness and future prospects of the business
units. Financial analysis serves the following purposes:

1. Measuring the profitability

The main objective of a business is to earn a satisfactory return on the funds invested in it.
Financial analysis helps in ascertaining whether adequate profits are being earned on the
capital invested in the business or not. It also helps in knowing the capacity to pay the interest
and dividend.

2. Indicating the trend of Achievements

Financial statements of the previous years can be compared and the trend regarding various
expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of
assets and liabilities can be compared and the future prospects of the business can be
envisaged.

3. Assessing the growth potential of the business

The trend and other analysis of the business provide sufficient information indicating the
growth potential of the business.

4. Comparative position in relation to other firms

The purpose of financial statements analysis is to help the management to make a
comparative study of the profitability of various firms engaged in similar businesses. Such
comparison also helps the management to study the position of their firm in respect of sales,
expenses, profitability and utilizing capital, etc.

5. Assess overall financial strength

The purpose of financial analysis is to assess the financial strength of the business. It also
helps in taking decisions, whether funds required for the purchase of new machines and
equipments are provided from internal sources of the business or not if yes, then how much
and also to assess how much funds have been received from external sources.
6. Assess solvency of the firm
The different tools of an analysis tell us whether the firm has sufficient funds to meet its short
term and long term liabilities or not.

Advantages of Financial Statements Analysis

The various advantages of financial statement analysis are:

1. Financial statements analysis helps the government agencies to analyze the taxation
due to the company.
2. Any company can analyze its own performance through financial statements analysis
over any period of time.

3. The investors get enough idea to decide about the investments of their funds in the
specific company.

4. The most important benefit if financial statement analysis is that it provides an idea to
the investors about deciding on investing their funds in a particular company.

5. Another advantage of financial statement analysis is that regulatory authorities like

IASB (International Accounting Standards Board) can ensure the company following
the required accounting standards.

6. Financial statement analysis is helpful to the government agencies in analyzing the

taxation owed to the firm.

7. Above all, the company is able to analyze its own performance over a specific time
period.

Disadvantages/Limitations of Financial Statements Analysis

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

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.

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 limitations before analyzing the financial statements of the company.

Tools/Techniques/Methods of Financial Analysis

A number of tools or methods or devices are used to study the relationship between financial
statements. However, the following are the important tools which are commonly used for
analyzing and interpreting financial statements:

 Comparative Financial Statements/Horizontal Analysis

 Common-size Statements/Vertical Analysis/Cross-Sectional Analysis
 Trend Analysis
 Ratio Analysis
 Funds Flow Analysis
 Cash Flow Analysis

1. Comparative Financial Statements/Horizontal Analysis:

In brief, comparative study of financial statements is the comparison of the financial

statements of the business with the previous year’s financial statements. It enables
identification of weak points and applying corrective measures. Practically, two financial
statements are prepared in comparative form for analysis purposes. They are as follows:

a) Comparative Balance Sheet

b) Comparative Income statement

a) Comparative Balance Sheet

The comparative balance sheet shows the different assets and liabilities of the firm on
different dates to make comparison of balances from one date to another. The comparative
balance sheet has two columns for the data of original balance sheets. A third column is used
to show change (increase/decrease) in figures. The fourth column may be added for giving
percentages of increase or decrease. While interpreting comparative Balance sheet, the
interpreter is expected to study the following aspects:

(i) Current financial position and Liquidity position

 (ii) Long-term financial position
(iii) Profitability of the concern

(i) For studying current financial position or liquidity position of a concern one should examine
the working capital in both the years. Working capital is the excess of current assets over
current liabilities.

(ii) For studying the long-term financial position of the concern, one should examine the
changes in fixed assets, long-term liabilities and capital.

(iii) The next aspect to be studied in a comparative balance sheet is the profitability of the
concern. The study of increase or decrease in profit will help the interpreter to observe
whether the profitability has improved or not.
After studying various assets and liabilities, an opinion should be formed about the financial
position of the concern.

b) Comparative Income Statement

The income statement provides the results of the operations of a business. This statement
traditionally is known as trading and profit and loss account. The important components of
income statement are net sales, cost of goods sold, selling expenses, office expenses etc. The
figures of the above components are matched with their corresponding figures of previous
years individually and changes are noted. The comparative income statement gives an idea of
the progress of a business over a period of time. The changes in money value and percentage
can be determined to analyze the profitability of the business. Like comparative balance sheet,
income statement also has four columns. The first two columns are shown figures of various
items for two years. Third and fourth columns are used to show increase or decrease in figures
in absolute amount and percentages respectively.

The analysis and interpretation of income statement will involve the following:

 The increase or decrease in sales should be compared with the increase or decrease in
cost of goods sold.
 To study the operating profits.
 The increase or decrease in net profit is calculated that will give an idea about the
overall profitability of the concern.

2. Common-size Statements/Vertical Analysis/Cross-Sectional Analysis:

The common size statements (Balance Sheet and Income Statement) are shown in analytical
percentages. The figures of these statements are shown as percentages of total assets, total
liabilities and total sales. In the balance sheet, the total assets are taken as 100 and different
assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a
part of total liabilities. Practically, two financial statements are prepared in common-size form
for analysis purposes. They are as follows:

a) Common-size Balance Sheet

b) Common-size Income statement

a) Common size balance sheet

It is a statement in which the balance sheet items are expressed as a percentage of total
assets and total liabilities. The assets are expressed as a percentage of the total assets and
the liabilities are expressed as a percentage of total liabilities. It is prepared in the following
ways:

i) The total assets or liabilities are taken as 100.

ii) The individual assets are expressed as a percentage of the total assets i.e.100.
Similarly, different liabilities are calculated as a percentage of total liabilities.
For example, if total assets are Rs10,00,000 and value of inventory is Rs1,00,000, and then
inventory will be 10% of total assets.

b) Common size income statement

It is a statement in which the income statement items are expressed as a percentage of total
sales. It shows the relations of each item of income statement to sales. It is prepared in the
following ways:

i) The total sales are taken as 100.

ii) The individual expenses and incomes are expressed as a percentage of the
total sales i.e.100.

3. Trend Analysis/Trend Percentage Analysis (TPA)

The trend analysis is a technique of studying several financial statements over a series of
years. In this analysis, the trend percentages are calculated for each item over a series of
years by taking the figure of that item for the base year. The base year’s figure is taken as
100 and the trend percentages for other years are calculated in relation to the base year.
Generally, the first year is taken as the base year. After calculating the trend percentages, the
analyst becomes able to see the trend of figures, whether moving upward or downward.

Trend analysis is the type of analysis in which the information for a single company is
compared over time. Over the course of the business cycle, sales and profitability of a
company may expand and contract. So the ratio analysis for one year may not present an
accurate picture of the firm. Therefore we look at trend analysis of performance over a
number of years. However, without industry comparisons even trend analysis may not present
a complete picture.

Illustration:

From the following data relating to ABC Hotel for the year 2004 to 2007, calculate trend
percentages (taking 2004 as base year):

Particulars 2004 2005 2006 2007

Net sales 200,000 190,000 249,000 260,000

Less : Cost of goods sold 120,000 117,800 139,200 145,600
Gross profit 80,000 72,000 100,800 114,400
Less : Expenses 20,000 19,400 22,000 24,000
Net profit 60,000 52,800 78,800 90,400

Solution:

Particulars 2004 2005 2006 2007

Net sales 100 95.0 124.5 130.0

Less : Cost of goods sold 100 98.2 116.0 121.3
Gross profit 100 90.3 126.0 143.0
Less : Expenses 100 97.0 110.0 120.0
Net profit 100 88.0 131.3 150.6
Interpretation:

 On the whole, 2005 was a bad year but the recovery was made during 2006. In this
year there is increase in sales as well as profit.
 The figure of 2005, when compared with 2004, reveal that the sales have come down
by 5%. However, the cost of goods sold and the expenses have decreased only by
1.8% and 3% respectively. This has resulted in decrease in Net profit by 12%.
 The position was recovered in 2006 with a positive growth in both 2006 and 2007.
Moreover, the increase in profit by 31.3% (2006) and 50.6% (2007) is much more
than the increased in sales by 20% and 30% respectively. This shows major portion of
cost of goods sold and expenses is of fixed nature.

4. Ratio Analysis:

Ratio analysis is essentially concerned with the calculation of relationships which after proper
identification and interpretation may provide information about the operations and state of
affairs of a business enterprise. The analysis is used to provide indicators of past performance
in terms of critical success factors of a business. This assistance in decision-making reduces
reliance on guesswork and intuition and establishes a basis for sound judgment.The
significance of a ratio can be appreciated only when:

 It is compared with other ratios in the same set of financial statements.

 It is compared with the same ratio in previous financial statements (trend analysis).
 It is compared with a standard of performance (industry average).Such a standard
may be either the ratio which represents the typical performance of the trade or
industry, or the ratio which represents the target set by management as desirable for
the business.

5. Funds Flow Analysis:

Flow of funds refers to change in fund. Increase of funds of any transaction is a source and
decrease of funds in any transaction is application or uses of funds. Fund being working
capital, funds flow refers to the flow of working capital between two points of time. It involves
information relating to the various transformations undergone by working capital (i.e. the
changes that have taken place in working capital) during the period involved between the two
points of time.

Every change in working capital is associated with (or is on account of) a flow either an inflow
or an outflow. Thus, funds flow involves information relating to the inflows and outflows that
resulted in a change in working capital between the two points of time.

Funds flow statement is a statement which depicts the sources from which funds were
obtained and the uses to which they have been put. It speaks about the changes in financial
items of balance sheets prepared at two different dates. Therefore, the funds flow analysis
studies the movement of funds (inflows and outflows of funds) during a given period,
generally a year. Thus it exhibits the movements of funds in both the directions – inside and
outside the business. In other words, the term ‘flow’ in the context of funds flow analysis
indicates the transfer of cash or cash equivalent from asset to equity or from one equity to
equity or from one asset to another asset.

6. Cash Flow Analysis:

Cash flow is essentially the movement of cash into and out of a business firm. It is the cycle of
cash inflows and cash outflows that determine the firm’s solvency. Cash flow analysis is the
study of the changes in the financial position of a business enterprise during a given period on
the basis of cash. In other words, it studies the changes in the cash position of a business
enterprise between two balance-sheet dates. For this purpose, a statement is prepared which
is called the funds flow statement. Its main aim is to maintain an adequate cash flow for the
business, and to provide the basis for cash flow management.

Cash flow analysis is a method of analyzing the financing, investing, and operating activities of
a company. The primary goal of cash flow analysis is to identify, in a timely manner, cash flow
problems as well as cash flow opportunities. The primary document used in cash flow analysis
is the cash flow statement.

The cash flow statement is useful to managers, lenders, and investors because it translates
the earnings reported on the income statement—which are subject to reporting regulations
and accounting decisions—into a simple summary of how much cash the company has
generated during the period in question.

A typical cash flow statement is divided into three parts: cash from operations (from daily
business activities like collecting payments from customers or making payments to suppliers
and employees); cash from investment activities (the purchase or sale of assets); and cash
from financing activities (the issuing of stock or borrowing of funds). The final total shows the
net increase or decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis for judgments concerning
the profitability, financial condition, and financial management of a company. While historical
cash flow statements facilitate the systematic evaluation of past cash flows, projected (or pro
forma) cash flow statements provide insights regarding future cash flows. Projected cash flow
statements are typically developed using historical cash flow data modified for anticipated
changes in price, volume, interest rates, and so on.
 FINANCIAL STATEMENTS
Meaning:

A financial statement can be well defined as a formal record of any business’, individual, or
entity’s financial activities. All the important information of a business enterprise is presented
in the financial statements as these are easy to understand because of their structured
presentation. These statements might, however, get complex for large corporations and might
also include a wide-ranging set of notes to financial statements explaining about the financial
policies, management discussion, and analysis.

The main objective of financial statements is to provide information about the financial
position, performance and changes in financial position of a business enterprise that is useful
to a wide range of users in making economic decisions. The financial statements of any
business entity should be relevant, understandable, reliable, and comparable. An
understandable financial statement helps business entity’s stakeholders to get reasonable
knowledge about the business and its economic activities. As far as financial statements are
easy to understand, this helps investors to make investment decisions in the company.

Importance of Financial Statements:

Financial statements show the financial performance of a company. They are used for both
internal and external purposes. When they are used internally, the management and
sometimes the employees use it for their own information. Managers use it to plan ahead and
set goals for upcoming periods. When they use the financial statements that were published,
the management can compare them with their internally used financial statements. They can
also use their own and other enterprises’ financial statements for comparison with macro
economical data and forecasts, as well as to the market and industry in which they operate in.

Externally, current and potential investors and lenders always require financial statements for
their lending or investment decisions. In important board and stockholder meetings, copies of
these are always given out to participants. Analysts, brokers, rating agencies and money
managers dig into these before making recommendations. Major customers and suppliers of
businesses ask for these in order to stay informed. Corporate raiders, competitors and
potential competitors attempt to get these before plunging into a business.

Objectives of Preparing Financial Statements:

The main objectives of preparing the financial statements are listed below:

 The financial statements are required by the owners and managers for making
imperative business decisions.
 The financial statements are used by prospective investors for assessing the feasibility
of investing in a company.

 Financial statements of a business are used by banks and other financial institutions to
make decisions about granting loan or extending debt securities, and similar more.
  Financial statements help vendors understand the financial position and
creditworthiness of a company to pay off its short term debts.

 Financial statements of a business are also helpful for government to ascertain the
accuracy of taxes and similar duties stated and paid by a company.

Different Types of Financial Statements:

The following are the various financial statements that are prepared in modern business
enterprises:

1. Income Statement/Profit and Loss Account

2. Balance Sheet/Financial Position Statement

3. Statement of Retained Earnings/Profit and Loss Appropriation Account

4. Funds Flow Statement

5. Cash Flow Statement

1. Income Statement/ Profit and Loss Account:

It is a financial statement that shows the operating results (net profit or net loss) of a
business enterprise for a given period. It has two sides viz. debit side and credit side. The left
hand side represents the debit side, whereas the right hand side represents the credit side.
The debit side of the statement records all expenses, while the credit side records all incomes.
The difference between the totals of the two sides of the income statement represents either
net profit or net loss. The format of an income statement is as follows:

XYZ Co. Ltd.

Income Statement
For the year ended ----------
Dr. Cr.
Particulars Amount ( ) Particulars Amount ( )

2. Balance Sheet/Financial Position Statement

It is a financial statement that shows the financial position of a business enterprise as on a

particular date and point of time. It has two sides viz. liabilities side and assets side. The left
hand side represents the liabilities side, whereas the right hand side represents the assets
side. The liabilities side records all outside liabilities and capital, whereas the assets side
records all assets of the business. The totals of the two sides of the balance-sheet always
become equal. The format of a balance sheet is as follows:

XYZ Co. Ltd.

Balance Sheet
As on ------

Liabilities Amount ( ) Assets Amount ( )

3. Statement of Retained Earnings/Profit & Loss Appropriation Account

It is a financial statement that shows the various appropriations made out of the profits
earned during the year like transfer to general reserve, transfer to any other reserve or fund,
interim dividend, proposed dividend, provision for taxation etc. It has two sides viz. debit side
and credit side. The left hand side represents the debit side, whereas the right hand side
represents the credit side. The debit side of the statement records all appropriations made out
of the profits, while its credit side records the previous year’s profits, if any and current year’s
profits. The difference between the totals of the two sides of the income statement represents
the profit surplus left which is called retained earnings. These retained earnings mean the
profit that is retained in the business for reinvestment purposes and are carried to the balance
sheet under the heading ‘Reserves & Surplus’. The format of a statement of retained earnings
is as follows:

XYZ Co. Ltd.

Statement of Retained Earnings
For the year ended -------
Dr. Cr.
Particulars Amount ( ) Particulars Amount ( )
To Transfer to general reserve - By Balance b/d -
To Transfer to any other By Net profit for the year -
reserve or fund -
To Interim dividend -
To Proposed dividend -
To Provision for taxation -
To Retained earnings -
(Balancing Figure)
- -

4. Funds Flow statement

Funds flow statement is a statement which depicts the sources from which funds were
obtained and the uses to which they have been put. It speaks about the changes in financial
items of balance sheets prepared at two different dates. It studies the movement of funds
(inflows and outflows of funds) during a given period, generally a year. Thus, funds flow
statement provides information relating to the changes in working capital of a firm between
the two points of time.

In other words, a funds flow statement is a statement which is prepared to show the various
causes of changes in the working capital position of an enterprise during a given period. It
studies the causes of changes in the financial position of a business enterprise between two
balance sheet dates on the basis of working capital. The format of a funds flow statement is as
follows:

XYZ Co. Ltd.

Funds Flow Statement
For the year ----

Sources of Funds Amount ( ) Applications of Funds Amount ( )

5. Cash Flow statement

A cash flow statement is a statement which is prepared to show the various causes of changes
in the cash position of an enterprise during a given period. It studies the causes of changes in
the financial position of a business enterprise between two balance sheet dates on the basis of
cash.

In other words, a cash flow statement is a statement which shows the various inflows and
outflows of cash made in a business enterprise during a period. The format of a cash flow
statement is as follows:

XYZ Co. Ltd.

Cash Flow Statement
For the year ------

Cash inflows Amount ( ) Cash outflows Amount ( )

Limitations of Financial Statements:

1. Historic Nature: Financial statements provide financial statistics of past events; but they
are not forward looking i.e. financial statements represent the past performance of a company
and it carries no guarantee of future results.
2. Ignores Non-financial Information: They don’t provide key non-financial information
like quality of revenues, types of customers and risk factors.

3. Ignores Qualitative Aspects: Certain qualitative elements are not considered in the
financial statements terms like the quality and reputation of the management team and
employees because they cannot be measured in monetary terms. Financial statements ignore
the productivity and the skills of the employee in an organization. That means looking at
through the financial statement, there is no reflection of how well or bad our staffs or
employees perform the work and it is unable to evaluate the skills which a company has
through financial statement.

4. Not Attributable to Future: The figures provided in financial statements can’t be

attributed to future since future earnings depend on many more factors like local and global
market conditions, inflation etc.

5. Do not Directly Show the Changes in the Structure of the Company: It's absolutely
crucial to know about structural elements of a company that change over a time period. For
instance, a company could have added a new plant, launched a new product, be preparing for
an acquisition etc. But financial statements don't directly show the changes in the structure of
the company.

Limitations of Financial Statements:

Financial statements are based on historical costs and as such the impact of price level
changes is completely ignored. They are interim reports. The basic nature of financial
statements is historic. These statements are neither complete nor exact. They reflect only
monetary transactions of a business. The following limitations may be noted as below:

1. The financial position of a business concern is affected by several factors-economic, social

and financial, but financial factors are being recorded in these financial statements. Economic
and social factors are left out. Thus the financial position disclosed by these statements is not
correct and accurate.

2. The profit revealed by the Profit and Loss Account and the financial position disclosed by the
Balance Sheet cannot be exact. They are essentially interim reports.

3. Facts which have not been recorded in the financial books are not depicted in the financial
statement. Only quantitative factors are taken into account. But qualitative factors such as
reputation and prestige of the business with the public, the efficiency and loyalty of its
employees, integrity of management etc. do not appear in the financial statement.

4. The rupee of 1995, as for example, does not mean the same as the rupee of 2010. The
existing historical accounting is based on the assumption that the value of monetary unit, say
rupee, remains constant and accordingly assets are recorded by the business at the price at
which they are required and the liabilities are recorded at the amounts at which they are
contracted for. But monetary unit is never stable under inflationary condition. This instability
has resulted in a number of distortions in the financial statements and is the most serious
limitation of historical accounting.

5. Many items are left to the personal judgment of the accountant. For example; provision of
depreciation, stock valuation, bad debts provision etc. depend on the personal judgment of
accountant.
6. On account of convention of conservation the income statement may not disclose true
income of the business since probable losses are considered while probable incomes are
ignored.

7. The fixed assets are shown at cost less depreciation on the basis of "going concern concept"
(one of the accounting concept). But the value placed on the fixed assets may not be the
same which may be realized on their sale.

8. The data contained in the financial statements are dumb; they do not speak themselves.

The human judgment is always involved in the interpretation of statement. It is the analyst or
user who provides tongue to those data and makes them to speak.

Funds Flow Analysis

Meaning:

Flow of funds refers to change in fund. Increase of funds of any transaction is a source and
decrease of funds in any transaction is application or uses of funds. Fund being working
capital, funds flow refers to the flow of working capital between two points of time. It involves
information relating to the various transformations undergone by working capital (i.e. the
changes that have taken place in working capital) during the period involved between the two
points of time.

Every change in working capital is associated with (or is on account of) a flow either an inflow
or an outflow. Thus, funds flow involves information relating to the inflows and outflows that
resulted in a change in working capital between the two points of time.

Funds flow statement is a statement which depicts the sources from which funds were
obtained and the uses to which they have been put. It speaks about the changes in financial
items of balance sheets prepared at two different dates. Therefore, the funds flow analysis
studies the movement of funds (inflows and outflows of funds) during a given period,
generally a year. Thus it exhibits the movements of funds in both the directions – inside and
outside the business. In other words, the term ‘flow’ in the context of funds flow analysis
indicates the transfer of cash or cash equivalent from asset to equity or from one equity to
equity or from one asset to another asset.

Significance of funds flow:

  Helps shareholders, creditors and others to evaluate the uses of funds by the
enterprise.
 Assists in analysis of past t rends and thus aid future expansion decisions.
 Helps finance managers in identification of problems, enabling detailed analysis and
immediate action.

Uses of Funds Flow Statement:

 Guides the management in deciding about the dividend and retention policies.
 Enables planning for long-term purposes.
 Facilitates proper allocation of resources and funds.
 Indicates the sources from which the company has obtained its funds.
 Helps in ascertaining the factors resulting in change in working capital.

Advantages of Funds Flow Statement:

Funds flow statement is prepared to show changes in the assets, liabilities and equity between
two balance sheet dates, it is also called statement of sources and uses of funds. The
advantages of preparing funds flow statement are:

 Funds flow statement reveals the net result of operations done by the company during
the year.
 In addition to the balance sheet, it serves as an additional reference for many
interested parties like creditors, suppliers, government etc. to look into financial
position of the company.

 It shows how the funds were raised from various sources and also how those funds
were put to use in the business, therefore it is a great tool for management when it
wants to know about where and from funds were raised and also how those funds got
utilized into the business.

 It reveals the causes for the changes in liabilities and assets between the two balance
sheet dates therefore providing a detailed analysis of the balance sheet of the
company.

 Funds flow statement helps the management in deciding its future course of plans and
also it acts as a control tool for the management.

Funds flow statement should not be looked alone rather it should be used along with balance
sheet in order judge the financial position of the company in a better way.

Limitations of Funds Flow Statement:

Though funds flow statement has many advantages, it has also some disadvantages or
limitations. The major limitations of funds flow statement are:

 Funds flow statement has to be used along with balance sheet and profit and loss
account, it cannot be used alone.
 It does not reveal the cash position of the company, and that is why company has to
prepare cash flow statement in addition to funds flow statement.

 Funds flow statement merely rearranges the data which is there in the books of
account and therefore it lacks originality. In simple words it presents the data in the
financial statements in systematic way and therefore many companies tend to avoid
preparing funds flow statements.
  Funds flow statement is basically historic in nature, that is it indicates what happened
in the past and it does not communicate anything about the future, only estimates can
be made based on the past data and therefore it cannot be used the management for
taking decision related to future.

Cash Flow Analysis

Meaning:

Cash flow is essentially the movement of cash into and out of a business firm. It is the cycle of
cash inflows and cash outflows that determine the firm’s solvency. Cash flow analysis is the
study of the changes in the financial position of a business enterprise during a given period on
the basis of cash. In other words, it studies the changes in the cash position of a business
enterprise between two balance-sheet dates. For this purpose, a statement is prepared which
is called the funds flow statement. Its main aim is to maintain an adequate cash flow for the
business, and to provide the basis for cash flow management.

Cash flow analysis is a method of analyzing the financing, investing, and operating activities of
a company. The primary goal of cash flow analysis is to identify, in a timely manner, cash flow
problems as well as cash flow opportunities. The primary document used in cash flow analysis
is the cash flow statement.

The cash flow statement is useful to managers, lenders, and investors because it translates
the earnings reported on the income statement—which are subject to reporting regulations
and accounting decisions—into a simple summary of how much cash the company has
generated during the period in question.
A typical cash flow statement is divided into three parts: cash from operations (from daily
business activities like collecting payments from customers or making payments to suppliers
and employees); cash from investment activities (the purchase or sale of assets); and cash
from financing activities (the issuing of stock or borrowing of funds). The final total shows the
net increase or decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis for judgments concerning
the profitability, financial condition, and financial management of a company. While historical
cash flow statements facilitate the systematic evaluation of past cash flows, projected (or pro
forma) cash flow statements provide insights regarding future cash flows. Projected cash flow
statements are typically developed using historical cash flow data modified for anticipated
changes in price, volume, interest rates, and so on.

Purpose/Objectives of Cash Flow Statement:

The balance sheet is a snapshot of a firm's financial resources and obligations at a single point
in time, and the income statement summarizes a firm's financial transactions over an interval
of time. These two financial statements reflect the accrual basis accounting used by firms to
match revenues with the expenses associated with generating those revenues. The cash flow
statement includes only inflows and outflows of cash and cash equivalents; it excludes
transactions that do not directly affect cash receipts and payments. These non-cash
transactions include depreciation or write-offs on bad debts or credit losses to name a few.
The cash flow statement is a cash basis report on three types of financial activities: operating
activities, investing activities, and financing activities. Non-cash activities are usually reported
in footnotes.

The different objectives of cash flow statement are:

1. to provide information on a firm's liquidity and solvency and its ability to change cash
flows in future circumstances
2. to provide additional information for evaluating changes in assets, liabilities and equity
3. to improve the comparability of different firms' operating performance by eliminating
the effects of different accounting methods
4. to indicate the amount, timing and probability of future cash flows

The cash flow statement has been adopted as a standard financial statement because it
eliminates allocations, which might be derived from different accounting methods, such as
various timeframes for depreciating fixed assets.

Cash flow activities:

The cash flow statement is partitioned into three segments. They are:

1. Cash flow resulting from operating activities

2. Cash flow resulting from investing activities

3. Cash flow resulting from financing activities.

The money coming into the business is called cash inflow, and money going out from the
business is called cash outflow.

i. Operating activities
Operating activities include the production, sales and delivery of the company's product as
well as collecting payment from its customers. This could include purchasing raw materials,
building inventory, advertising, and shipping the product.

Measuring the cash inflows and outflows caused by core business operations, the operations
component of cash flow reflects how much cash is generated from a company's products or
services. Generally, changes made in cash, accounts receivable, depreciation, inventory and
accounts payable are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by adding or subtracting
differences in revenue, expenses and credit transactions (appearing on the balance sheet and
income statement) resulting from transactions that occur from one period to the next. These
adjustments are made because non-cash items are calculated into net income (income
statement) and total assets and liabilities (balance sheet). So, because not all transactions
involve actual cash items, many items have to be re-evaluated when calculating cash flow
from operations.

For example, depreciation is not really a cash expense; it is an amount that is deducted from
the total value of an asset that has previously been accounted for. That is why it is added back
into net sales for calculating cash flow. The only time income from an asset is accounted for in
CFS calculations is when the asset is sold.

Changes in accounts receivable on the balance sheet from one accounting period to the next
must also be reflected in cash flow. If accounts receivable decreases, this implies that more
cash has entered the company from customers paying off their credit accounts - the amount
by which AR has decreased is then added to net sales. If accounts receivable increase from
one accounting period to the next, the amount of the increase must be deducted from net
sales because, although the amounts represented in AR are revenue, they are not cash.

An increase in inventory, on the other hand, signals that a company has spent more money to
purchase more raw materials. If the inventory was paid with cash, the increase in the value of
inventory is deducted from net sales. A decrease in inventory would be added to net sales. If
inventory was purchased on credit, an increase in accounts payable would occur on the
balance sheet, and the amount of the increase from one year to the other would be added
to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance. If
something has been paid off, then the difference in the value owed from one year to the next
has to be subtracted from net income. If there is an amount that is still owed, then any
differences will have to be added to net earnings.

Operating cash flows include:

 Receipts from the sale of goods or services

 Receipts for the sale of loans, debt or equity instruments in a trading portfolio
 Interest received on loans
 Dividends received on equity securities
 Payments to suppliers for goods and services
 Payments to employees or on behalf of employees
 Interest payments (alternatively, this can be reported under financing activities)
 buying Merchandise

Items which are added back to [or subtracted from, as appropriate] the net income figure
(which is found on the Income Statement) to arrive at cash flows from operations generally
include:

 Depreciation (loss of tangible asset value over time)

 Deferred tax
  Amortization (loss of intangible asset value over time)
 Any gains or losses associated with the sale of a non-current asset, because
associated cash flows do not belong in the operating section.(unrealized
gains/losses are also added back from the income statement)

ii. Investing activities

Changes in equipment, assets or investments relate to cash from investing. Usually cash
changes from investing are a "cash out" item, because cash is used to buy new equipment,
buildings or short-term assets such as marketable securities. However, when a company
divests of an asset, the transaction is considered "cash in" for calculating cash from investing.
Investing activities include:
 Purchase or Sale of an asset (assets can be land, building, equipment, marketable
securities, etc.)
 Loans made to suppliers or received from customers
 Payments related to mergers and acquisitions

iii. Financing activities

Financing activities include the inflow of cash from investors such as banks and shareholders,
as well as the outflow of cash to shareholders as dividends as the company generates income.
Other activities which impact the long-term liabilities and equity of the company are also listed
in the financing activities section of the cash flow statement.

Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash
from financing are "cash in" when capital is raised, and they're "cash out" when dividends are
paid. Thus, if a company issues a bond to the public, the company receives cash financing;
however, when interest is paid to bondholders, the company is reducing its cash.

Financing activities include:

 Proceeds from issuing short-term or long-term debt
 Payments of dividends
 Payments for repurchase of company shares
 Repayment of debt principal, including capital leases
 For non-profit organizations, receipts of donor-restricted cash that is limited to
long-term purposes

Items under the financing activities section include:

 Dividends paid
 Sale or repurchase of the company's stock
 Net borrowings
 Payment of dividend tax

Uses/Significance/Advantages of Cash Flow Statement:

 It is especially useful in preparing cash budgets.

 It helps the newly formed companies to know their inflow and outflow of cash.

 It helps the investors to judge whether the company is financially sound or not.

 It helps the company to know whether it will be able to cover the payroll and other
expenses.

 It helps the lenders to know the company’s ability to repay.

  A cash flow statement is provided on monthly basis or quarterly basis or six monthly
basis or yearly basis.

 These statements help to have an accurate analysis of the firm’s ability to meet its
current liabilities.

 A cash flow statement is helpful for planning and managing future financial
commitments.

 A cash flow statement summarizes the company’s cash receipts and cash payments
over a period of time.

 It is useful for determining the short term ability of the concern to meet its liabilities
i.e. helps the management in taking short-term financial decisions.

 A cash flow statement gives vital information not only about the company’s
performance but also about its major activities during the year.

 Cash Flow statement is also a control device for the management.

 Since it gives a clear picture of cash inflow from operations (and not income flow of
operation), it is, therefore, very useful to internal financial management such as in
considering the possibility of retiring long-term debts, in planning replacement of plant
facilities or in formulating dividend policies.

 It enables the management to account for situation when business has earned huge
profits yet run without money or when it has suffered a loss and still has plenty of
money at the bank.

Disadvantages/Limitations of Cash Flow Statement:

 By itself, it cannot provide a complete analysis of the financial position of the firm.
 It can be interpreted only when it is in confirmation with other financial statements
and other analytical tools like ratio analysis.

 It may not give accurate details about the money coming into and going out of the
business. Costs may change and this could cause the business to loose money.

 Since it shows only cash position, it is not possible to arrive at actual profit and loss of
the company by just looking at this statement alone.

 In isolation this is of no use and it requires other financial statements like balance
sheet, profit and loss etc…, and therefore limiting its use

 It is difficult to precisely define the term ‘cash’.

 Working capital is a wider concept of funds. Therefore a funds flow statement gives a
clearer picture than a cash flow statement.