ANALYSIS OF FINANCIAL STATEMENTS

The annual statement of accounts prepared by a business unit consists of

balance sheet and profit & loss account. In case the business unit is a company, the
accounts will generally be audited and certified by a Chartered Accountant.

Balance Sheet:

It is a statement of what a business entity 'owns' and what it 'owes' as on a

particular date. In other words, it is a statement of 'assets' and 'liabilities' of a
business.

PROFIT & LOSS ACCOUNT:

It reveals net result of the business operations for a particular period. It lists
items of income on the one hand and items of expenses/cost on the other hand, the
difference between them represents profit or loss for the period. It is also known as
income and expenditure statement.

LIMITATIONS OF FINANCIAL STATEMENTS:

i) The Financial statements contain information which is historical in nature.

Although this information has its own utility, the users may be concerned more
about the present and the future.

ii) These statements are based on certain accounting concepts and

conventions. A user of these statements should be aware of them.

iii) The statements contain only that information which can be expressed in
monetary terms e.g. loss incurred by a firm due to fire will be included since it can
be expressed in monetary terms. But the loss to a firm due to resignation of a
qualified and experienced senior executive will not be reflected, since it can not be
expressed in monetary terms.

iv) At times managements may resort to manipulation of data, which is also

called as 'window dressing'. This may be done by changing accounting practices or
methods followed for charging depreciation etc.

WINDOW DRESSING

Before taking up the analysis of financial statements a user should find out
whether any manipulations have been done. If so, the effect of such manipulation
should be removed first. A dishonest management may manipulate accounts by
resorting to some of the following methods:

a) Changes in accounting policies in respect of

i) method of charging depreciation on fixed assets

ii) valuation of inventory, investments and fixed assets
iii) treatment of liability towards gratuity payable to the
employees on their retirement
 iv) treatment of contingent liabilities.

b) Revaluation of the fixed assets of the firm. (Please note that all the cases of
revaluation may not be fraudulent). However, a firm with weak financial position
due to continuous losses incurred, may revalue its fixed assets upwards with an
intention of showing better financial position.

c) Capitaliation of interest on term loans and deferred payment liabilities.

Please note that capitaliation of interest on term liabilties during the construction
period of a project is an accepted accounting practice.

d) Non or under provision of depreciation e.g. not providing for extra shift
depreciation allowance, write back of extra shift depreciation allowance claimed in
the earlier years etc.

e) Under-statement, or over-statement of items of revenue and expenditure.

f) Change in accounting year with a view to delaying finalisation of audited

statement of accounts

An user should closely scrutinize the financial statements of a firm in order

to see whether any of the manipulations mentioned above have taken place.
Reading the auditor's report and notes to the balance sheet may give vital clues in
this regard. Analysis of financial statements may be undertaken only after the areas
of manipulation have been identified and effect of such manipulation has been
removed.

AN EXAMPLE

Depreciation provided by the company for the year ended March 31, 1998 is
Rs. 40 lakhs. There has been a change in the method of depreciation from straight
line to written down value in the year. Had the straight line method of depreciation
been consistently followed, the depreciation would have been Rs. 60 lakhs.
Therefore, the profit for the year is overstated by Rs. 20 lakhs.

IN ORDER TO REMOVE THE IMPACT OF THE MANIPULATION

By changing the method of depreciation from straight line to written down

value method depreciation has been provided less by Rs. 20 lakhs and consequently
profit overstated by the same amount. As depreciation has been charged less, in
order to restore the correct position, a sum of Rs. 20 lakhs will be deducted from
Net Fixed Assets. As profit accrues to net worth, the overstatement of profit by Rs.
20 lakhs has increased the net worth. Therefore, the amount of Rs. 20 lakhs has to
be reduced from net worth in order to reveal the correct position.

ANALYSIS OF FINANCIAL STATEMENTS

The analysis of financial statements consists of a study of relationships and

trends to determine whether the financial position and results of operations as well
as the financial progress of a firm are satisfactory. The type of analysis of the
financial statements depends on the objective of the person who is engaged in the
exercise. For example, a share holder is interested in the yield and safety of his
capital. He is more interested in the profitability and the management's policy of
declaring dividend. A term lender such as a financial institution is interested in
knowing the firm's ability to service its long term debt. A banker providing working
capital finance, which is of short term nature, is more interested in the liquidity
position of the company. The government may also be interested in the financial
statements of companies because it can formulate its policies which serve the best
interests of all the concerned parties. The management is also interested in the
analysis. It is not only interesetd in the profitability, liquidy or solvency of the
company but also optimal allocation of available funds in fixed/current assets in
order to maximise the return in the short run as well as long run.

COMPARATIVE FINANCIAL STATEMENTS

Balance sheet figures of a company at the end of a year may be compared

with correspondending figures at the beginning of the year in order to find out the
increase or decrease in various items of assets, liabilities and net worth. Similarly a
comparative income statement may be prepared to show the operating results for a
given number of years. Besides comparing the absolute figures, percentages may
also be calculated e.g. cost of raw materials as a percentage of sales, salaries and
wages as a percentage of sales, gross profit as a percentage of sales etc.

TREND ANALYSIS

Comparative financial statements may be used to study the trends.

Percentages may be used to calculate increase or decrease as compared to the base
year e.g. one may find that a firm's net sales have increased at the rate of 20% per
annum over a period of past 5 years. One may find a trend that while sales are
continuously declining the inventories are increasing. This may be considered as an
unfavourable trend. Similarly, one may find that while the sales are increasing
every year, the gross profit figure is declining or remaining stagnant indicating
reducing profitability of operations.

COMMON SIZE STATEMENTS

Common size balance sheet may be prepared consisting of percentages,

showing the relation of each asset item to the total assets and each liability item to
the total liabilities. Similarly a common size income statement may show each item
of expense as a percentage of net sales. By preparing common size statements
comparison can be made between two business firms belonging to the same
industry but of different size.

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