SRI KRISHNA ARTS AND SCIENCE COLLEGE

Course Title: Financial Statement Analysis

Lecture1- Steps in Analysis and Interpretation

Class: II M.Com

Faculty: Dr. K.R. Sivabagyam

Department of Commerce

SKASC 1
 Topic to be discussed

• Steps in Analysis and Interpretation

SKASC 2
 Links
Source:
https://drive.google.com/file/d/10_UIAqMSPjL2P3yVyg0fxLIWVAA
UP5yY/view
Prof. Varadaraj Bapat, IIT Bombay.

Source:
https://drive.google.com/file/d/1CXVBxzXzJJt1A0AlEM0rrWtbX4H
BoAwE/view
Prof. Varadaraj Bapat, IIT Bombay.

Source:
https://www.youtube.com/watch?v=TZZFBkbC2lA
MBAbullshitdotcom SKASC 3
 FINANCIAL STATEMENT ANALYSIS
Financial statements are prepared primarily for decision making.

They play a dominant role in setting the framework of managerial decisions.

But the information provided in the financial statements is not an end in itself has no meaningful conclusion.

• However the information provided in the financial statements is of immense use in making decisions through
analysis and Interpretation of financial statements.

There are various methods or techniques used in analyzing financial statements, such as

• comparative statement,

• trend analysis,

• common size statements,

• schedule of changes in working capital, funds flow and cash flow analysis,

• cost –volume –profit analysis and

• ratio analysis.
 Meaning and concept of financial analysis
• The term financial analysis is also known as ‘analysis and interpretation of financial
statements’, refers to the process of determining financial strengths and weakness of
the firm by establishing strategic relationship between the items of the balance sheet,
profit and loss account and other operative data.

∙ It is process of evaluating relationship between component parts of financial

statements to obtain a better understanding of a firm’s position and performance.
∙ The purpose of financial analysis is to diagnose the information contained in financial
statement so as to judge the profitability and financial soundness of the firm.
 Meaning and concept of financial analysis

∙ The analysis and interpretation of financial statement is essential to bring out the
mystery behind the figures in financial statements.
∙ The term ‘analysis’ is used the mean the simplification of financial data by methodical
classification of the data given in the financial statements,

∙ and the term ‘Interpretation’ means explaining the meaning and significance of the
data so simplified.
OBJECTIVES AND IMPORTNCE OF FINANCIAL STATEMENT ANALYSIS
•The primary objective of financial statement analysis is to understand and diagnose the

information contained in financial statement with a view to judge the profitability and

financial soundness of the firm, and to make forecast about future prospects of the firm.

•The purpose of analysis depends upon the person interested in such analysis and this

object.

•However, the following purposes or objectives of financial statement analysis may

be stated to bring out the significance of such analysis:

 OBJECTIVES AND IMPORTNCE OF FINANCIAL STATEMENT ANALYSIS

i) To assess the earning capacity or profitability of the firm.

ii) To assess the operational efficiency and managerial effectiveness
iii) To assess the short term as well as long term solvency position of the firm.
iv) To identify the reason for change in profitability and financial position of the firm.
v) To make inter-firm comparison.
 OBJECTIVES AND IMPORTNCE OF FINANCIAL STATEMENT ANALYSIS

i) To make forecast about prospects of the firm.

ii) To assess the progress of the firm over a period of time.
iii) To help in decision making and control.
iv) To guide or determine the dividend action.
v) To provide important information for granting credit.
 Parties interested in financial analysis:
i. Inventors or potential investors.

ii. Management.

iii. Creditors or suppliers.

iv. Bankers and financial institutions.

v. Employees.

vi. Government.

vii. Trade associations.

iii. Stock exchanges.

ix. Economists and researchers.

x. Taxation authorities.
 Features of Financial Statement Analysis
• Financial statements are collected and analyzed according to the needs and direction
of the decision makers. Needs of the decision maker are identified first, and then
according to those needs, financial information is collected.

• The theories and models in economics, Finance and System and financial statement
analysis are interwoven here.

• Financial statement analysis is decision specific. The scope of analyzing general

purpose analysis is limited. In other words, each analysis is naturally different from
others as the models are different.
 Features of Financial Statement Analysis
• Mathematical and statistical tools of analysis are used here for model building and
FSA. Such analysis does not confine to using only ratios, since all sophisticated
analyses cannot be handled through accounting ratios. For instance, statistical tools
such as tie series, trend fitting, regression are used for collecting various information
required for analyzing the problem defined in the models.
 Features of Financial Statement Analysis
• This does not depend entirely on accounting data. Here information is collected even
from unpublished sources. For instance, information on management forecast about
current market prices of resources, firm’s future earning capacity is used for financial
analysis.

• Such analysis is not based on the statements prepared under predetermined rules and
regulations as is done in the case of accounting statements.

• Here statements are prepared according to the needs of the models incorporating
interactions among their different parts and elements.

• Some of the elements are future oriented, some are, however, based on past events.
 Key points
• earning capacity
• operational efficiency
• Profitability
• Managerial effectiveness
• Solvency position
 Steps to analyzing financial statements
• Ultimately the aim of an analysis is to form an opinion or judgement based
on facts and figures and related economic environment. Again, rational
judgement can be made after the following steps of operations.
 Step I - Defining specific objective of analysis
• The objective of evaluating issues i.e., forming an opinion on specific issues should
be stated in a well-defined way.

• Extraneous objectives should be eliminated and unnecessary analysis should be

avoided.

• For example, in the case of lending decision, the anlaysis should be concentrated on
asessing the ability or intention of the borrower. Focus should not be given on
extraneous issues like long-term industry conditions affecting borrowers’ long-term
performances.
 Step II - Formulations of specific questions
• For realizing the objectives stated in step I specific questions necessary for forming the
opinion should be formulated.
• Answers to the questions may depend on various sources of information, and some but not
all the questions might be answered from the analysis of financial statements.
• Hence, sources other than financial statements may be required for answering these
questions.
• For example, if the purpose is to analyze the growth of revenue, questions on rate of
changes in sales, cost of sales, operating expenses should be formulated. Such information
can be derived from financial statements.
• But the rate of change in sales might be affected by extraneous factors like business
recession. For such information, sources other than financial statements are to be used.
Steps III identification of the most effective tool for getting the answers to the formulated questions

• Tools to answer the questions set must be relevant for the concerned decision. Most
of the tools are accounting ratios, or percentage changes.
• But they are not all. Many of the tool relate to estimates and projections of future
conditions.
• This future orientation helps in linking all the tools for analysis.
• For example, if the question is about the long-term solvency position of the firm over
the years, the debt-equity ratio ad other related ratios are to be selected.
• But these ratio analyses alone cannot fully the causes of the trend in the capital
structure.
• In such cases the change in the interest rate structure over the years should also be
required.
 Step IV Computing various parameters through the application of the tools

• various ratios,

• changes in rates,

• statistical results are to be calculated through applying the selected tools on the related
information derived from the financial statements.

• In this age of computer, these jobs become easier, since various packages have been
developed for the purpose.
 Step V Interpretation of the evidences derived from the
application of the tools
• It is the most difficult stge. Here evidences derived from financial statements should
be treated as the starting point for the discovery of economic facts about a enterprise.
Business reality behind these numbers in the statements should be pictured. There s
no mechanical substitute for this stge.
 Steps to analyzing financial statements
• Accounting data are the abstractions of reality.

• But analysis attains further level of abstraction.

• Analysis should go beyond the picture through these descriptions.

• They are to make these derived numbers speak the economic reality of the business.
 Steps to Interpretation
• segregate the data into components and compare them. Study the relations among
the various components of the evidences.
• Identify the economic conditions that the business has been facing.
• Identify the strategies that the firm selected to compete in the business environment.
• Go beyond the financial statements.
• Visit companies. You may use their products, buy their services, visit stores and
talk to customers.
• That means, you are to immerse yourself in the business activities of the company.
• Relate your purpose of enquiry with these above findings and draw your conclusion
for making your decision.
 Techniques of Financial Statement Analysis

I. Analyzing through comparison

• Intra-firm comparison
• Inter-firm comparison
• Inter-period comparison or trend analysis
 Intra firm comparison

• When comparisons are made among various components, divisions, and segments of

a firm for a particular period, such an analysis is called intra-firm comparison.

 Inter-firm comparison
• When analysis is made by comparing financial performances or
positions of similar firms, with an ideal standard, or with industry
averages, such as an analysis is called inter-firm comparison.
 Inter-period comparison or trend analysis
• when comparisons are made about various components of a
single firm over a number of years, such an analysis is called
inter-period comparison or trend analysis.
 INSTRUMENTS OF ANALYSIS
Comparisons may be made through descriptions , numbers or a combinations of the two.
However analysis through numbers help in getting objective interpretation.
The financial reality of a firm is quantified in monetary terms.

But business activities comprise multifarious functions.

By means of accounting numbers, these functions are reported to the public.
These numbers are to be analyzed.
It should be noted that it is very difficult to manage absolute figures as the nature and size of
the businesses differ.
That apart, interrelations among factors cannot always clearly expressed through absolute
figures.
 PERCENTAGES
Suitability:

This technique is most suitable for structural analysis, particularly when a large number
of components of a whole are to be considered a time.

For instance, when composition of total assets, aggregate of liabilities and net worth are
to be enquired or how total revenue is shared by various cost items and margins.

This system of analysis is most suitable.

 Ratios
1. suitability: it helps reveal the relation between two items or two groups of item .This
technique is used in most financial analysis.

2. Advantage; this technique helps in identifying the relation between two factors. It is
easy to calculate and comprehend.

3. Shortcoming: This technique does not help in finding out structural relations when
more than two items are involved for forming the aggregate.
 TOOLS AND TECHNIQUES OF ANALYSIS
Traditionally financial statements are analyzed mostly by means of
(a) comparative statements

(b) common-size statements and

(c) trend analysis.