"Sound Financial Management is a key to the progress for corporations”.

Explain.

Introduction to Analysis and Interpretation of Financial Statements:

Analysis and interpretation of financial statements are an attempt to determine the significance and
meaning of the financial statement data so that a forecast may be made of the prospects for future
earnings, ability to pay interest, debt maturities, both current as well as long term, and profitability of
sound dividend policy.

The main function of financial analysis is the pinpointing of the strength and weaknesses of a business
undertaking by regrouping and analysis of figures contained in financial statements, by making
comparisons of various components and by examining their content. The analysis and interpretation of
financial statements represent the last of the four major steps of accounting.

The first three steps involving the work of the accountant in the accumulation and summarisation of
financial and operating data as well as in the construction of financial statements are:

(i) Analysis of each transaction to determine the accounts to be debited and credited and the
measurement and variation of each transaction to determine the amounts involved.
(ii) Recording of the information in the journals, summarisation in ledgers and preparation of a
worksheet.

(iii) Preparation of financial statements.

 
The fourth step of accounting, the analysis and interpretation of financial statements, results in the
presentation of information that aids the business managers, investors and creditors.

Interpretation of financial statements involves many processes like arrangement, analysis, establishing
relationship between available facts and drawing conclusions on that basis.

Types of Financial Analysis:

The process of analysis may partake the varying types. Normally, it is classified into different categories
on the basis of information used and on the basis of modus operandi.

(a) On the basis of Information Used:

(i) External analysis.

(ii) Internal analysis.

External analysis is an analysis based on information easily available to outsiders (externals) for the
business. Outsiders include creditors, suppliers, investors, and government agencies regulating the
business in a normal way.
These parties do not have access to the internal records (information) of the concern and generally
obtain data for analysis from the published financial statements. Thus an analysis done by outsiders is
known as external analysis.
Internal analysis is an analysis done on the basis of information obtained from the internal and
unpublished records and books. While conducting this analysis, the analyst is a part of the enterprise
he is analysing. Analysis for managerial purposes is the internal type of analysis and is conducted by
executives and employees of the enterprise as well as governmental and court agencies which may
have major regulatory and other jurisdiction over the business.

(b) On the basis of Modus Operandi:

(i) Horizontal analysis.

(ii) Vertical analysis.

Horizontal analysis is also known as ‘dynamic analysis’ or ‘trend analysis’. This analysis is done by
analysing the statements over a period of time. Under this analysis, we try to examine as to what has
been the periodical trend of various items shown in the statement. The horizontal analysis consists of a
study of the behaviour of each of the entities in the statement.

Vertical analysis is also known as ‘static analysis’ or ‘structural analysis’. It is made by analysing a single
set of financial statement prepared at a particular date. Under such a type of analysis, quantitative
relationship is established between the different items shown in a particular statement. Common size
statements are the form of vertical analysis. Thus vertical analysis is the study of quantitative
relationship existing among the items of a particular data.

"Excessive working capital is harmful for the business”. Explain the

statement.

Disadvantages of Redundant or Excessive Working Capital:

1. Excessive Working Capital means idle funds which earn no profits for the business and
hence the business cannot earn a proper rate of return on its investments.

2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.

3. Excessive working capital implies excessive debtors and defective credit policy which may
cause higher incidence of bad debts.

4. It may result into overall inefficiency in the organisation.

5. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.

6. Due to low rate of return on investments, the value of shares may also fall.

7. The redundant working capital gives rise to speculative transactions.