FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION

 Meaning of Financial Statement Analysis

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

“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating the
relationship between component parts of a financial statement to obtain abetter understanding of a firm’s
position and performance.”

 Objectives
(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 reasons for change in profitability and financial position of the firm.

(v) To make inter-firm comparison.

(vi) To make forecasts about future prospects of the firm.

(vii) To assess the progress of the firm over a period of time.

(viii) To help in decision making and control.

(ix) To guide or determine the dividend action.

(x) To provide important information for granting credit.

  Types of Financial Analysis

1. Internal Analysis
Internal analysis is made by the top management executives with the help of Management Accountant.
The finance and accounting department of the business concern have direct approach to all the relevant
financial records. Such analysis emphasis on the overall performance of the business concern and
assessing the profitability of various activities andoperations.

2. External Analysis
Shareholders as investors, banks, financial institutions, material suppliers, government department and tax
authorities and the like are doing the external analysis. They are fully depending upon the published
financial statements. The objective of analysis is varying fromone party to another.

3. Short Term Analysis

The short term analysis of financial statement is primarily concerned with the working capital analysis so
that a forecast may be made of the prospects for future earnings, ability to pay interest, debt maturities –
both current and long term and probability of a sound dividend policy.
A business concern has enough funds in hand to meet its current needs and sufficient borrowing capacity
to meet its contingencies. In this aspect, the liquidity position of the business concern is determined
through analyzing current assets and current liabilities. Hence, ratio analysis is highly useful for short
term analysis.

4. Long Term Analysis

There must be a minimum rate of return on investment. It is necessary for the growth and development of
the company and to meet the cost of capital. Financial planning is also necessary for the continued
success of a company. The fixed assets structure, leverage analysis, ownership pattern of securities and
the like are made in the long term analysis.

5. Horizontal Analysis
It is otherwise called as dynamic analysis. When financial statements for a number of years are viewed
and analyzed, the analysis is called horizontal analysis. The preparation of comparative statements is an
example of this type of analysis.

6. Vertical Analysis
It is otherwise called as static analysis. Under this type of analysis, the ratios are calculated from the
balance sheet of one year and/or from the profit and loss account of one year. It is used for short term
analysis only.

 Methods of Financial Statement

1. Comparative Statements
Comparative statements deal with the comparison of different items of the Profit and Loss Account and
Balance Sheets of two or more periods. Separate comparative statements are prepared for Profit and Loss
Account as Comparative Income Statement and for Balance Sheets.

As a rule, any financial statement can be presented in the form of comparative statement such as
comparative balance sheet, comparative profit and loss account, comparative cost ofproduction statement,
comparative statement of working capital and the like.

2. Comparative Income Statement

Three important information are obtained from the Comparative Income Statement. They are Gross
Profit, Operating Profit and Net Profit. The changes or the improvement in the profitability of the
business concern is find out over a period of time. If the changes or improvement is not satisfactory, the
management can find out the reasons for it and somecorrective action can be taken.

3. Comparative Balance Sheet

The financial condition of the business concern can be find out by preparing comparative balance sheet.
The various items of Balance sheet for two different periods are used. The assets are classified as current
assets and fixed assets for comparison. Likewise, the liabilitiesare classified as current liabilities, long term
liabilities and shareholders’ net worth. The term shareholders’ net worth includes Equity Share Capital,
Preference Share Capital, Reserves and Surplus and the like.

4. Common Size Statements

A vertical presentation of financial information is followed for preparing common-size statements.
Besides, the rupee value of financial statement contents are not taken into consideration. But, only
percentage is considered for preparing common size statement.

The total assets or total liabilities or sales is taken as 100 and the balance items are compared to the total
assets, total liabilities or sales in terms of percentage. Thus, a common size statement shows the relation
of each component to the whole. Separate common size statement is prepared for profit and loss account
as Common Size Income Statement and forbalance sheet as Common Size Balance Sheet.

5. Trend Analysis
The ratios of different items for various periods are find out and then compared under thisanalysis. The
analysis of the ratios over a period of years gives an idea of whether the business concern is trending
upward or downward. This analysis is otherwise called
as Pyramid Method.

6. Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared with industry
average. These both trends can be presented on the graph paper also in the shape of curves. This
presentation of facts in the shape of pictures makes the analysis and comparison more comprehensive and
impressive.

7. Statement of Changes in Working Capital

The extent of increase or decrease of working capital is identified by preparing the statement of changes in
working capital. The amount of net working capital is calculated by subtracting the sum of current
liabilities from the sum of current assets. It does not detail the reasons for changes in working capital.

8. Fund Flow Analysis

Fund flow analysis deals with detailed sources and application of funds of the business concern for a
specific period. It indicates where funds come from and how they are used
during the period under review. It highlights the changes in the financial structure of the company.

9. Cash Flow Analysis

Cash flow analysis is based on the movement of cash and bank balances. In other words, themovement of
cash instead of movement of working capital would be considered in the cash flow analysis. There are two
types of cash flows. They are actual cash flows and notional cashflows.

10. Ratio Analysis

Ratio analysis is an attempt of developing meaningful relationship between individual items (or group of
items) in the balance sheet or profit and loss account. Ratio analysis is not onlyuseful to internal parties of
business concern but also useful to external parties. Ratio analysis highlights the liquidity, solvency,
profitability and capital gearing.

11. Cost Volume Profit Analysis

This analysis discloses the prevailing relationship among sales, cost and profit. The cost is divided into
two. They are fixed cost and variable cost. There is a constant relationship between sales and variable
cost. Cost analysis enables the management for better profit planning.

 Advantages of financial statement analysis

(1) It helps in measuring the profitability : Financial statement analysis helps to know
whether the business is making profits or losses. It also helps to know whether the
profits/losses of the firm are increasing or decreasing. It also helps to know the business
organisation's ability to pay interest on loans taken and its ability to pay dividend to its
shareholders.

(2) It helps to measure the overall financial strength : Financial statement analysis helps to
understand the overall financial strength of the business. It also helps to take decisions
regarding funds available for purchase of assets, payment of liabilities, etc. It alsohelps to know
whether company's internal sources of funds (retained earnings of past years) are sufficient or a
loan would be required.

(3) It helps to know the efficiency of management : Financial statement analysis help toknow
the efficiency of management in running the business. It helps to know whether financial
policies followed by management are proper or not.

(4) It helps to know the trend of business : Financial statement analysis help to know the
business trends by comparing various types of data such as net profit, sales, purchases, etc. for
two or more years. This helps to know how much the progress business is doing.

 Limitations of Financial Statement

(i) It is only a study of interim reports

(ii) Financial analysis is based upon only monetary information and non-monetary factors are
ignored.

(iii) It does not consider changes in price levels.

(iv) As the financial statements are prepared on the basis of a going concern, it does not give
exact position. Thus accounting concepts and conventions cause a serious limitation to financial
analysis.

(v) Changes in accounting procedure by afirm may often make financial analysis
misleading.

(vi) Analysis is only a means and not an end in itself. The analyst has to make interpretationand
draw his own.

 COMPARATIVE STATEMENTS
The comparative financial statements are statements of the financial position at different periods; of time.

The elements of financial position are shown in a comparative form so as to give an idea of financial

position at two or more periods. Any statement prepared in a comparative form will be covered in

comparative statements.

From practical point of view, generally, two financial statements (balance sheet and incomestatement)

are prepared in comparative form for financial analysis purposes. Not only the comparison of the figures

of two periods but also be relationship between balance sheet and income statement enables an in depth

study of financial position and operative results.

The comparative statement may show:

(i) Absolute figures (rupee amounts).

(ii) Changes in absolute figures i.e., increase or decrease in absolute figures.

(iii) Absolute data in terms of percentages.

(iv) Increase or decrease in terms of percentages.

I. Comparative Income Statement:
A comparative income statement shows the absolute figures for two or more periods and the absolute
change from one period to another. Since the figures are shown side by side, the user can quickly
understand the operational performance of the firm in different periods and draw conclusions.

II. Comparative Balance Sheet:

Balance sheets as on two or more different dates are used for comparing the assets, liabilities andthe
net worth of the company. Comparative balance sheet is useful for studying the trends of an
undertaking.

 Advantages Of Comparative Statement

The comparative financial statements are useful for analysis of the following:
1] Comparative statements indicate trends in sales, cost of production, profits etc. and help the
analyst to evaluate the performance of the company.

2] Comparative statements can also be used to compare the performance of the firm with the average
performance of the industry or inter-firm comparison. This helps in identification of theweaknesses of
the firm and remedial measures can be taken accordingly.

 Disadvantages Of Comparative Statement

The comparative financial statements suffers from the following weaknesses:

1] Inter-firm comparison can be misleading if the firms are not identical in size and age and whenthey
follow different accounting procedures with regard to depreciation, inventory valuation etc.
2] Inter-period comparison may also be misleading, if the period has witnessed changes in
accounting policies, inflation, recession etc.

Problem 1:
From the following particulars pertaining to ABC Ltd. you are required to prepare acomparative
Income Statement and interpret the changes:

Solution:

Interpretation:
(1) There is a modest increase in sales. While gross sales have increased, returns have come downby
40%, which is a healthy sign. It points towards increased acceptability of the company’s products and
customer satisfaction.
(2) The rate of growth of sales is considerably higher than the rate of growth of cost of goods
sold.This has resulted in a handsome rise in gross profit of the company.

(3) There is a marginal fall is administration expenses and a marginal rise in selling expenses,
which do not affect the overall financial position of the company significantly.

(4) There is an abnormally high rise in non-operating income. However, it can be attributed to the low
base of the previous year. The increase in operating profit without considering the non- operating
income has been impressive.

(5) The net profit before and after tax have increased at the same rate, since the tax rate applicable to
both the years is the same. Both the figures have doubled in 2016.

(6) The overall profitability of the company is more than satisfactory.

 Common-Size Financial Statements

The figures shown in financial statements viz. profit and loss account and balance sheet are converted
to percentages so as to establish each element to the total figure of the statement and these statements
are called ‘common-size statements’. These statements are useful in analysis of the performance of the
company by analyzing each individual element to the total figure of the statement.

These statements will also assist in analyzing the performance over years and also with the figuresof the
competitive firm in the industry for making analysis of relative efficiency. The following statements
show the method of presentation of the data.

I. Common-Size Income Statement:

In common size income statement, the sales figure is taken as 100 and all other figures of costs and
expenses are expressed as percentage to sales. When other costs and expenses are reduced from sales
figure of ‘100’, the balance figure is taken as net profit. This reveals the efficiency of the firm in
generating revenue which leads to profitability and we can make analysis of different components of cost
as proportion to sales. Interfirm comparison of common size income statements reveal the relative
efficiency of costs incurred.

II. Common-Size Balance Sheet:

In common size balance sheet, the total of assets side or liabilities side is taken as ‘100’ and all figures of
assets and liabilities, capital and reserves are expressed as a proportion to the total i.e.
100. The common size balance sheet reveals the proportion of fixed assets to current assets,
composition of fixed assets and current assets, proportion of long-term funds to current liabilities and
provisions, composition of current liabilities etc. It also helps in making interfirm comparison and
highlights the financial health and long-term solvency, ability to meet short-term obligations and
liquidity position of the enterprise.

Problem 3:
The following is the income statement of a XYZ Ltd. for the years 2015 and 2016. Convert them into
Common-size Income Statement and comment on the profitability.

Solution:

Interpretation:
(1) The cost of goods in the year 2015 was 85%. It was reduced to 76.88% in 2016 and as a result
the gross profit increased from 15% in 2015 to 23.12% in 2016.

(2) The operating expenses were decreased from 5.1% in 2015 to 4.56% in 2016. So, the operatingprofit
shows an increase.

(3) The net profit in 2015 was 9.82% to 19.32% in 2016. The net profit actually doubled during
period. The profitability of the concern is satisfactory.
  Trend Ratios
The trend ratios of different items are calculated for various periods for comparison purpose. The trend
ratios are the index numbers of the movements of reported financial items in the financial statements
which are calculated for more than one financial year. The calculation of trend ratios are based on
statistical technique called ‘ index numbers’. The trend ratios help in making horizontal analysis of
comparative statements. It reflects the behaviour of items over a period of time.

The methodology used in computation of trend ratios is as follows:

I. The accounting principles and policies should be consistently followed throughout the period
forwhich the trend ratios are calculated.

II. The trend ratios should be calculated only for the items which have logical relationship with one
another.

III. The trend analysis should be made at least for four consecutive years.

IV. The financial statements of one financial year should be selected as a base statement
and financial items of it should be assigned with value as 100.

V. Then trend ratios of subsequent years’ financial statements are calculated by applying the
following formula:

VI. Tabulate the trend ratios for analysis of trend over a period.

The trend percentages are calculated for select major financial items in the financial statements toarrive
at the conclusions for important changes. The trend may sometimes be affected by external factors like
government policies, economic conditions, changes in income distribution, technology development,
population growth, changes in tastes and habits etc. The trend analysis is a simple technique and does
not involve tedious calculations.

 Limitations of Trend Analysis

The analysis through trend ratios is subject to the following limitations:
I. The trend ratios are incomparable, if there is inconsistency in accounting policies and practices.

II. The price level changes are represented in trend ratios.

III. The trend ratios must be studied along with absolute data for correct analysis.

IV. While analyzing the trend ratios, non-financial data should also be considered, otherwiseconclusions would
be misleading.

Problem 4:
From the following data, calculate trend a percentage taking 2014 as base:

Solution: