Chapter overview

➢ Meaning of financial statement analysis.

➢ Tools and techniques of financial statement analysis
➢ Types of Financial statement analysis
➢ Process of financial statement analysis
➢ Objectives and significance of financial statement analysis
➢ Uses of financial statement analysis
➢ Parties involved in financial statement analysis
➢ Limitations of financial statement analysis
MEANING OF
FINANCIAL
STATEMENT
ANALYSIS
 MEANING
It is a systematic process of reviewing and
analyzing a company’s financial statements to
make better economic decision to earn income in
future. It includes income statement, balance sheet,
statement of cash flow, notes to accounts and a
statement of changes in equity
 TOOLS AND
TECHNIQES OF
FINANCIAL
STATEMENT
ANALYSIS
Comparative Common size Ratio
statement statement analysis

Fund flow Cash flow

statement statement
 Comparative STATEMENT
➢ Comparative statement or comparative financial
statement means a comparative study of
individual item all component of financial
statement i.e. Balance sheet and statement of
profit and loss of two or more years of the
enterprise itself.
➢ It is also called “Horizontal analysis”
➢ It shows the financial positions of a company at
different time periods.
 COMMON SIZE STATEMENT
➢The figures of financial statements are
converted to percentages. The balance sheet
items are expressed as the ratio of each asset
to total assets and the ratio of each liability
to total liabilities.
➢Items are expressed as a percentage of base
year. It is time series analysis
 Ratio analysis
➢The most popular way to analyze the
financial statements is computing ratios.
➢It is an important and widely used tool of
analysis of financial statements.
➢It is study of ratio between various items or
groups in financial statement.
➢It helps in assessing the profitability,
solvency, liquidity and efficiency of an
enterprise
 Cash flow STATEMENT
In financial accounting, a cash flow
statement, also known as “Statement of cash
flows”, is a financial statement that shows
how changes in balance sheet accounts and
income affect.
A cash and cash equivalents, and breaks the
analysis down to operating, investing and
financing activities
 fund flow STATEMENT
It is a statement which discloses the analytical
information about the different sources of a
fund and the application of the same in an
accounting cycle. It deals with the
transactions which change either the amount
of current assets and current liabilities or
fixed assets, long-term loans including
ownership fund
 External Analysis
External Analysis is conducted by those who
do not have access to the detailed records of
an enterprise and, therefore, have to depend
on published accounts, i.e., Statement of
Profit and Loss, Balance Sheet, Directors'
and Auditor's Reports. Such type of
analysis is made by investors, lenders,
creditors, government agencies and research
scholars
 Internal Analysis
➢ Internal Analysis is conducted by the
management to know the financial position
and operational efficiency of the organization.
The important feature of such analysis is that
the management has access to all information
of the enterprise and, therefore, the analysis is
more detailed, extensive and accurate.
➢ External Analysis is carried out by outsiders
such as creditors, lenders, bankers, debenture
holders and government agencies. Internal
Analysis is meant for management
 Horizontal of dynamic

This analysis is made to review and analyze

financial statements for a number of years.
It is a Time Series Analysis. It shows
comparison of financial data for several
years against a chosen base year. It is useful
for trend analysis and long-term planning.
Comparative Statements or Comparative
Financial Statements are examples of
horizontal analysis.
 Vertical or static
➢ This analysis is made to review and analyze the
financial statements of one year only. It is a Cr oss-
sectional Analysis. Ratio analysis of the financial
statement relating to a particular accounting year
is an example of this type of analysis. Such an
analysis is useful in comparing the performance of
several companies of the same type or divisions or
departments in one enterprise.
➢ Horizontal or Dynamic Analysis is a time series
analysis. Vertical or Static Analysis is carried out
at one particular point of time, generally when the
accounts are closed.
Intra-firm Comparison
➢ A comparison of financial variables of an enterprise
over a period of time is known as Intra-firm
Comparison.
➢ It is also called Time Series Analysis or Trend
Analysis.
➢ The main objective of time series analysis is to
observe the behaviour of the same ratio over a given
period of time. It evaluates the financial performance
and position of the firm during given period.
Inter-firm Comparison
➢ A comparison of two or more enterprises or firms
is known as Inter-firm Comparison. It compares
financial variables of two or more enterprises or
firms to determine their competitive position.
When single set of statements of two firms is
compared, it is known as Cross-sectional
Analysis.
➢ The main objective of Cross-sectional Analysis
is to ascertain the relative position of the
business in the industry by highlighting weak
areas (if any) and taking the corrective actions
 Rearrangement of
Financial Statements
For analysis, it is necessary to reclassify the
complex data contained in the financial
statements into purposive classes so that
maximum desired information from every
data for analysis can be extracted or
obtained. Reclassification and
rearrangement of different data depends
upon the purpose of analysis.
 Comparison
After the classification of data of financial
statements into different categories, it is
necessary to obtain comparative data of the
same enterprise of the past periods if it is a
time series analysis. In case of cross-
sectional analysis, it is necessary to obtain
comparative data of the same accounting
period of similar or comparable enterprises.
For this, a comparative study is necessary.
 Analysis
Comparative financial data are then analyzed
with reference to financial characteristics like
profitability, solvency and liquidity.
Interpretation The concluding part of financial
statement analysis is interpretation of
financial information generated in the process
of financial statement analysis. The
interpretation should be precise and directed
towards indicating the movement of various
financial characteristics.
 Assessing the Earning
Capacity or Profitability
On the basis of financial analysis, the
earning capacity or profitability of an
enterprise can be assessed. In addition, the
earning capacity of the enterprise, in coming
years, may also be forecast. All the external
users of financial statements, especially
investors and potential investors, are
interested in earning capacity and forecast.
 Assessing the Managerial
Efficiency
The financial statement analysis helps to
identify the areas where the managers have been
efficient and the areas where they have been
inefficient. For example, by using accounting
ratios, it is possible to analyze relative
proportion of production, administrative and
marketing expenses. Any favorable or
unfavorable variation can be identified and
reasons thereof can be ascertained to pinpoint
managerial efficiency or inefficiency.
Assessing the Short-term and
Long-term Solvency of the
Enterprise
Long-term and short-term solvency of an
enterprise can be assessed on the basis of
financial statement analysis. Creditors or
suppliers are interested to know the short-
term solvency or liquidity of the enterprise,
i.e., its ability to meet short-term liabilities.
Debenture holders and lenders are interested
to know the long-term and short-term
solvency of the enterprise to assess the ability
of the company to repay the principal
amount and interest thereon.
Inter-firm Comparison
Inter-firm comparison becomes easy with the
help of financial analysis. It helps an
enterprise in assessing its own performance
as well as that of others, if mergers and
acquisitions are to be considered
 Forecasting and
Preparing Budgets
Past financial statement analysis helps in
assessing developments in future, especially
in the next year. For example, given a certain
investment, it may be possible to forecast the
next year's profit on the basis of earning
capacity shown in the past. An analysis
thus helps in forecasting and preparing the
budgets.
 Explainable and
Understandable
Financial analysis helps the users of the
financial statements to understand the
complicated matter in a simplified manner.
Financial data can be made more
comprehensive by charts graphs and
diagrams, which can be easily explained and
understood.
 Securities Analysis
It is a process by which the investor comes to
know whether the firm is fulfilling his
expectations with regard to payment of
dividend, capital appreciation and security
of money. Such analysis is done by a
securities analyst who is interested in cash-
generating ability, dividend payout policy
and the behavior of share prices.
 Credit Analysis
Such analysis is useful when a firm offers
credit to a new customer or a dealer. The
manager of the firm would like to know
whether to allow or extend credit to them or
not. Such analysis is also useful for a bank
before granting loan.
 Debt Analysis

Such analysis is done by the firm to know its

borrowing capacity.
 Dividend Decision
Financial analysis helps the firm in deciding
about the rate of dividend. The management
would have to decide about how much portion
of the earnings to distribute and how much
to retain. Such decisions indicate the
profitability of the firm and hence, to some
extent affect the behavior of share prices.
 General Business
Analysis
Financial analysis can be used to identify the
key profit drivers and business risks in
order to assess the profit potential of the firm.
It helps in future growth scenarios for the
firm
 Management
Financial analysis helps the management to
ascertain overall as well as segment-wise
efficiency of the business. Besides, it helps
them in decision-making, controlling and
self-evaluation.
 Employees and Trade
Unions
Employees are interested in better emoluments,
bonus, better working conditions and security
of their jobs. So, they are always interested in
profitability, operating sustainability and
financial strength of the business. Trade
Unions are also interested in financial analysis
because the degree of profitability helps them in
negotiating and entering into revised wage
agreements with the employers.
•
Shareholders or Owners
or Investors
Owners invest their savings in the enterprise.
Therefore, they are interested in profitability
and safety of their investments. They would
like to know whether the business is profitable,
has growth potential and its progress is on
expected lines. Growth potential of business
helps in appreciation of their investment.
•
Potential Investors
They are interested to know the present
profitability (i.e., earning) and financial
position as well as future prospects to
determine whether they should invest in a
particular company or not.
 Suppliers or
Creditors
They are interested to know the short-term
solvency position of a firm, i.e., the ability to
meet its short-term liabilities. Short-term
solvency of a firm can be determined with
the help of financial statement analysis. On
the basis of analysis, they decide whether
they should allow or extend credit to the
enterprise or not.
Bankers and Lenders
Bankers and Lenders are interested in
servicing of the loans granted to an
enterprise, i.e., regular payment of interest
and repayment of principal amount on due
dates. In other words, they are interested in
long-term and short-term solvency of a firm,
i.e., ability to pay interest on loans and debts
and its repayment.
 Tax Authorities
Tax authorities are interested in ensuring
proper assessment of tax liabilities of the
enterprise as per the laws in force from time
to time.
•
 Customers
Customers have an interest in information
about the continuance of an enterprise,
especially when they have a long-term
involvement with, or are dependent on the
enterprise.
Historical Analysis

Financial statement analysis is a historical

analysis. It analyses what has happened till
date. It does not reflect the future. Persons
like shareholders, investors, etc., are more
interested in knowing the likely position in
future. .
.
.
Ignores Price Level
Changes Price level changes and purchasing
power of money are inversely related. A
change in the price level makes analysis of
financial statements of different accounting
years invalid because accounting records
ignore change in value of money.
Qualitative Aspect
Ignored Since the financial statements are
confined to monetary matters alone, the
qualitative aspects like quality of
management, quality of staff, public
relations are ignored while carrying out the
analysis of financial statements
 Suffers from the
Limitations of Financial
Statements
Analysis of financial statements is based on
the information given in the financial
statements. Hence, this analysis suffers
from all such limitations from which the
financial statements suffer. Therefore,
unless the basic data given in the financial
statements is reliable, the conclusions
derived on the basis of the analysis of this
data cannot be reliable.
Not Free from Bias
In many situations, the accountant has to
make a choice out of alternatives available,
e.g., choice in the method of inventory
valuation, choice in the method of
depreciation (straight line or written down
value), etc. Since the subjectivity is inherent
in personal judgment, the financial
statements are, therefore, not free from bias.
 Variation in
Accounting Practices
For inter-firm comparison, it is necessary that
accounting practices followed by the firms do
not vary significantly. As there may be
variations in accounting practices followed
by different firms, a meaningful
comparison of their financial statements is
not possible.
 Window Dressing
Window dressing refers to the presentation of a
better financial position than what it
actually is by manipulating the books of
account. On account of such a situation,
financial analysis may give false
information to the users
Identifies Symptoms

Financial analysis identifies symptoms of the

problems but does not offer its diagnosis. The
management has to look for the remedies to
rectify the problems