Introduction

The process of critical evaluation of the financial information contained in the

financial statements in order to understand and make decisions regarding the
operations of the firm is called ‘Financial Statement Analysis’. It is basically a study
of relationship among various financial facts and figures as given in a set of financial
statements, and the interpretation thereof to gain an insight into the profitability and
operational efficiency of the firm to assess its financial health and future prospects.
The term ‘financial analysis’ includes both ‘analysis and interpretation’. The term
analysis means simplification of financial data by methodical classification given in
the financial statements. Interpretation means explaining the meaning and significance
of the data. These two are complimentary to each other. Analysis is useless without
interpretation, and interpretation without analysis is difficult or even impossible.
Financial statement analysis is a judgemental process which aims to estimate current
and past financial positions and the results of the operation of an enterprise, with
primary objective of determining the best possible estimates and predictions about the
future conditions. It essentially involves regrouping and analysis of information
provided by financial statements to establish relationships and throw light on the
points of strengths and weaknesses of a business enterprise, which can be useful in
decision-making involving comparison with other firms (cross sectional analysis) and
with firms’ own performance, over a time period (time series analysis).

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Types of Financial Statement Analysis
i) Internal
ii) External

Internal financial reporting is a business practice that involves compiling financial

information on a frequent basis for use within the organization. The documents may
contain confidential information, such as business indicators, financial performance,
performance indicators, etc.. They are designed to help those individuals working
within the company to make informed decisions.

Uses of Internal Financial Reports

1. Gather employee information.

2. Track customer behavior and credit information.

External reporting involves preparing financial information to be distributed to parties

outside the organization. Unlike internal reports, external reports do not contain
confidential information about the company.

Uses of External Financial Reports

1. Provide information about a company’s financial health.

2. Compare competing entities.

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 Different Types Of Financial Analysis
Given below are some of the common types of financial analysis ratios using
financial data that companies frequently use during their day-to-day operations.

Horizontal Analysis or Dynamic Analysis

The horizontal analysis measures the financial statements line of items with the base
year. It compares the figures for a given period with the other period.

 Pros – It helps to analyze the company’s growth from year on year or quarter on
quarter with the increase in operations of the company.

 Cons – The company operates in the industrial cycle. Therefore, if the industry is
downgrading despite the company’s better performance owing to specified factors that
impact the industry, trend analysis will indicate the negative growth in the company

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 Vertical Analysis or Static Analysis

The vertical analysis measures the line items of the income statement or balance
sheet by taking any line item of the financial statement as a base and disclosing the
same in percentage form.

For example, the income statement discloses all the line items in percentage form by
taking base as net sales. Similarly, the balance sheet on the asset side reveals all the
line items in the percentage form of total assets.

 Pros – The vertical analysis helps compare the entities of different sizes as it presents
the financial statements in final form.

 Cons – It solely represents a single period’s data, so it avoids comparison across
different time phases.

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 Objective of Financial Analysis
The main objective of the financial statement analysis for any company is to provide
the necessary information required by the financial statement users for informative
decision making, assessing the current and past performance of the company,
predicting the success or failure of the business, etc.

The top 4 objectives of Financial Statement Analysis are as follows –

1. To know the current position of the company

2. Eliminating Discrepancies if any

3. Future Decision Making

4. Minimize the Chances of Fraud

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Assessing the Earning Capacity or Profitability
An earning capacity assessment is a tool for life insurance/income protection claims to
establish a person’s economic loss and provides recommendations on the person’s
functional capacity, work skills/ability, personality, transferrable skills and work
readiness.

Profitability ratios are a class of financial metrics that are used to assess a business's
ability to generate earnings relative to its revenue, operating costs, balance sheet
assets, or shareholders' equity over time, using data from a specific point in time.
They are among the most popular metrics used in financial analysis.

Profitability ratios can be a window into the financial performance and health of a

business. Ratios are best used as comparison tools rather than as metrics in isolation.

Profitability ratios can be used along with efficiency ratios, which consider how well
a company uses its assets internally to generate income (as opposed to after-cost
profits).

 Profitability ratios assess a company's ability to earn profits from its sales or
operations, balance sheet assets, or shareholders' equity.
 They indicate how efficiently a company generates profit and value for
shareholders.
 Profitability ratios include margin ratios and return ratios.
 Higher ratios are often more favorable than lower ratios, indicating success at
converting revenue to profit.

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  These ratios are used to assess a company's current performance compared to
its past performance, the performance of other companies in its industry, or the
industry average.

Assessing Managerial Efficiency

The conditions at the universities in developing countries call both for the assessment

and subsequent improvement of managerial processes, and for a study process

that will ensure self-determination in these matters — the argument being that

any movement forward must spring from self-knowledge and discovery and not

from the instructions, suggestions and prescriptions of others, particularly external

funding agencies, if the remedies are to be accepted and enacted. It was this

recognition that prompted the leaders of 'Our University' to begin in Fall, 1990 to

discuss the ways in which it could conduct a self-assessment of its management

processes in order to establish an agenda for change. A completely new top team

of leaders had been selected for the university, all of them experienced academics.

They were assisted by an able 'grants and links' officer with management

training who were anxious to see improvements. They wanted to identify those

things that could be enacted without additional funds or with little funding, as

well as improvements that would require the infusion of large amounts of

expertise and funding, probably from donor agencies over a number of years. But

the focus at the 'OU' as decidedly on establishing their own agenda before any

interaction with outside agencies. This visitor arrived at the University in early

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January, 1991 and assumed the role of consultant in the design of the study

process and member of its steering committee, which role was held for three

months..

Assessing the Short Term and Long Term Solvency of

an Enterprise
Solvency and liquidity are two ways to measure the financial health of a company, but
the two concepts are distinct from each other.

Liquidity refers to the ability of a company to pay off its short-term debts; that is,
whether the current liabilities can be paid with the current assets on hand. Liquidity
also measures how fast a company is able to covert its current assets into cash.

Solvency, on the other hand, is the ability of the firm to meet long-term obligations
and continue to run its current operations long into the future. A company can be
highly solvent but have low liquidity, or vice versa. However, in order to stay
competitive in the business environment, it is important for a company to be both
adequately liquid and solvent.

Assessing the Solvency of a Business

The solvency of a business is assessed by looking at its balance sheet and cash flow

statement.

The balance sheet of the company provides a summary of all the assets and liabilities
held. A company is considered solvent if the realizable value of its assets is greater
than its liabilities. It is insolvent if the realizable value is lower than the total amount
of liabilities.

The cash flow statement also provides a good indication of solvency, as it focuses on

the business’ ability to meet its short-term obligations and demands. It analyzes the

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company’s ability to pay its debts when they fall due, having cash readily available to
cover the obligations.

The cash flow also offers insight into the company’s history of paying debt. It shows
if there is a lot of debt outstanding or if payments are made regularly to reduce debt
liability. The cash flow statement measures not only the ability of a company to pay
its debt payable on the relevant date but also its ability to meet debts that fall in the
near future.

A solvency analysis can help raise any red flags that indicate insolvency. It can
uncover a history of financial losses, the inability to raise proper funding, bad
company management, or non-payment of fees and taxes.

Other Ratios

Several different ratios can help assess the solvency of a business, including the
following:

1. Current debts to inventory ratio

The ability of a company to rely on current inventory to meet debt obligations.

2. Current debt to net worth ratio

The total amount of money owed to shareholders in a year’s time, expressed as a

percentage of the shareholder’s investment.

3. Total liabilities to net worth ratio

The relationship between the total debts and the owner’s equity in a company. The
higher the ratio, the lower the protection for the business’ creditors.

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Inter – Firm Comparison
The inter-firm comparison refers to the process of comparing and evaluating different
companies in relation to one another. This can include comparing their products or
services, financial performance, market position, or any other relevant factors. Inter-
firm comparisons can help businesses understand the competitive landscape and make
informed decisions about strategy, partnerships, and other business endeavours.

Types of Inter-Firm Comparisons

Compare and contrast the various inter-firm comparisons to better understand the
performance and competitive position of your business:

1. Cross-Sectional Analysis

It includes a comparison of the financial statements of two or more companies at a

specific point in time. It helps identify which company is performing better in terms of
financial performance and financial position.

2. Industry Analysis 

It includes a comparison of financial statements for companies in the same industry.

The analysis helps to identify trends in financial performance and the position of the
industry as a whole.

3. Ratio Analysis 

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Ratio Analysis includes a comparison of the financial ratios between two or more
companies in the same sector. It identifies the strengths and weaknesses that help in
making informed decisions about investment, lending and other business decisions.

Forecasting and
Preparing Budget
 Budgets and forecasts are similar financial tools companies use
to establish plans for their future.
 A budget shows the financial direction of where management
wants to take a company within the span of a year, whereas a
forecast uses past historical data to predict a company's future
financial outcomes.
 A budget forecast combines budgeting and forecasting. It usually
uses data from the budget for the upcoming fiscal period to
predict the outcome of a budget.

Budget : A budget is a financial document that outlines estimates of revenue,

expenditure, debt reduction and cash flow for a fixed period based on historical data.
Budgets are often static or unchanging, and businesses update their budgets once a
quarter or year. Budgeting looks at how much a company earns and spends and how it
can increase sales and reduce expenses to improve profits. Financial professionals also
review the budget at the end of each period and compare budgeted and actual
performance to help determine the budget for the next period. Some refer to
this comparison as variance analysis.

Forecast : A forecast is a prediction of potential future business performance or

outcomes. Forecasts are dynamic, and they update as revenue and expenses change. A
company affects short-term forecasts for frequent operational needs and uses long-

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term forecasts to help with strategic planning and long-term business development.
Forecasting makes predictions based on a detailed review of actual revenue and
expenses and doesn't perform variance analysis.

Using forecasting and budgeting together helps businesses align goals across an
organization and plan for future business development. It provides a basis for strategic
business and financial decisions that are realistic. A forecast budget is the
responsibility of managerial staff who work with teams to monitor existing revenue
and expenses and forecast the performance of budgeted values.

Explainable and Understandable

Understandable ability is the concept that financial information should be presented so that a
reader can easily comprehend it. This concept assumes a reasonable knowledge of business by
the reader, but does not require advanced business knowledge to gain a high level of
comprehension. Adherence to a reasonable level of understandability would prevent an
organization from deliberately obfuscating financial information in order to mislead users of its
financial statements .

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Explainable AI (XAI) and its counterpart Interpretable Machine Learning (IML). These
two are algorithm families that aim to present explanations behind predictions made by
AI/ML models. XAI has become the solution to make models less opaque to ensure
accountability.

XAI operates on two granularities:

 Global explanations: Interpretations achieved at this granularity seek to explain

the model behavior in the purview of the features.
 Local explanations: Interpretations at local granularity focus on data instances to
explain the influence of features

Limitation of Financial Statement Analysis

i. Historical Analysis : Historical analysis is a method of the examination of
evidence in coming to an understanding of the past. It is particularly applied to
evidence contained in documents, although it can be applied to all artefacts. The
historian is, first, seeking to gain some certainty as to the facts of the past.
ii. Ignore Price Level Change : A change in price level makes analysis of of
different accounting year meaningless because accounting records ignore changes
in value of money.
iii. Qualitative aspects ignore : The financial statements incorporate the information
which can be expressed in monetary terms. Thus, they fail to assimilate the
transactions which cannot be converted into monetary terms. For example, a
conflict between the marketing manager and sales manager cannot be recorded in
the books of accounts due to its non-monetary nature, but it will certainly affect the
functioning of the activities adversely and consequently, the profits may suffer.
iv. Not free from BIAS : Due to an involvement of personal judgement while making
decisions regarding methods of depreciation, the method of inventory valuation etc.
This makes the financial statement not always free from personal bias.
v. Suffer from the limitation of financial analysis : Those factors that a user should
be aware of before relying on them to an excessive extent. Knowledge of these

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 factors could result in a reduction of invested funds in a business, or actions taken
to investigate further.
vi.Variation in accounting practice : Variance analysis is the study of deviations of
actual behaviour versus forecasted or planned behaviour in budgeting or
management accounting. This is essentially concerned with how the difference of
actual and planned behaviours indicates how business performance is being
impacted.
vii. Window Dressing : The term 'window dressing' means manipulation of accounts
so as to present the financial statements in a way to show better position than the
actual. e.g., assets may be overstated and liabilities may be understated.

Comparative Statement
Comparative statements or comparative financial statements are statements of
financial position of a business at different periods. These statements help in
determining the profitability of the business by comparing financial data from two or
more accounting periods.

The data from two or more periods are updated side by side, which is why it is also
known as Horizontal Analysis. The advantage of such an analysis is that it helps
investors to identify the trends of business, check a company’s progress and also
compare it with that of its competitors.

The financial data will be considered to be comparative only when the same set
of accounting principles are being used for preparing the statements.

Types of Comparative Statements

There are two types of comparative statements which are as follows
1. Comparative income statement
2. Comparative balance sheet

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Purpose of Comparative Statement
i) Data Presentation become simple and comparable

The main aim behind the preparation of Comparative Financial Statements is to

put the data for a number of years in a simple and comparable form. When the
data for a number of years are put side by side, the comparison between their
figures becomes easier. Besides, one can also easily draw conclusions regarding
the operating results and financial health of the company/companies.
ii) Indicates Trend

The Comparative Financial Statements of a company indicate its trend of change

by putting the figures of revenue from operations, production, expenses, profits,
etc., for a number of years, side-by-side. For example, If the Cost of Production
is increasing over the years along with an increase in its expenses, it indicates
that the business is not in good condition and needs to perform some corrective
measures. 
iii) Indicates Strength and Weakness

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 By making a comparison between the financial statements for a number of years,
one can also indicate the strong and weak points of the firm. With these strong
and weak points, the management of the firm can then investigate and find out
the reasons for its weak points and can take corrective measures.

iv) Comparison with other firm and Industry performance

With the help of Comparative Financial Statements, a business unit can compare
its performance with the average performance of the industry.

v) Forecasting and Planning

By performing a comparative study of the changes in the key figures of a

company over a period can help its management in forecasting the profitability
and financial soundness of the business. 

Limitation of Comparative Statement

Limitation of financial statement are the limitation of Comparative statement or
comparative financial statement. These are

i) Historical Record : it is an analysis of historical records , i.e. analysis of past

financial statements. It , at the most, indicates the trend of the happenings in the
past. It is not reflective of future, which is more relevant.

ii) Qualitative Elements are Ignored : Financial Statement when prepared do not
consider qualitative elements of the business such as man power quality. It
considers only those items which can be measured in terms of money. Since a
comparative statement is based on financial statements, it also ignores qualitative
elements of the business which gave a significant impact on it.

iii) Price level changes are ignored : Comparative Financial Statments do not show
price level changes because all the items in the financial statement are recorded at
cost and value of money in the latest year is not same as it was in the previous
year.

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iv) Variation in Accounting Policies : It two firms follow different accounting
polices then a meaningful comparison of their financial statements is not possible.

v) Affected by Personal Judgement: Financial statements are prepared on the basis

of accounting concepts and conventions along with estimates, examples being
depreciation, provision for doubtful debts etc. If the estimates are incorrect the
projections based on comparative statements will not be reliable.

Comparative Balance Sheet

A technique of comparing financial statements through which the balance sheet of a
company is analysed by comparing its Asset, and Equity and Liabilities for two or
more two accounting periods is known as Comparative Balance Sheet. It is a
horizontal analysis of Balance Sheet, and with this tool, every item of Assets, and
Equity and Liabilities is analysed for two or more accounting periods. This analysis
can help in forming an opinion regarding the progress of the enterprise.

Comparative Balance Sheet analysis is the study of the trend of the same items,
group of items, and computed items in two or more Balance Sheets of the same
business enterprise on different dates.

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Advantages of Comparative Balance Sheet

1. More Realistic Approach: A Balance Sheet only shows the balances of Assets,
and Equity and Liabilities of a company after closing the books of accounts at a
certain date. However, a Comparative Balance Sheet not only shows the
balances of Assets, and Equity and Liabilities at a certain date, but also the
extent to which those figures have increased or decreased between these dates.
 
2. Emphasis on Changes: A Balance Sheet emphasises on the status of the
company; however, a Comparative Balance Sheet emphasises on the change.

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3. Reflects Trend: A Comparative Balance Sheet allows the user to study the
nature, size, and trend of change in various items of a Balance Sheet. Therefore,
it is more useful than a Balance Sheet of a single year.

4. Link between Balance Sheet and Statement of Profit & Loss: A Comparative
Balance Sheet acts as a link between the Balance Sheet and Statement of Profit
& Loss of a company as it shows the effects of business operations on its Assets,
and Equity and Liabilities.

5. Facilitates Planning: A Comparative Balance Sheet helps an organisation in

determining the trends of its growth or decrease in the value of its Assets, and
Equity and Liabilities. The trends ultimately help in planning the future course
of action of the firm. 

Comparative Income Statement

A comparative income statement summarises the operational outcomes over many
fiscal quarters. It allows the reader to compare the results over time for a better
understanding and comprehensive study of the variance of line-by-line items in the
income statement.
The comparative income statement format includes numerous income statements as
columns in a single statement, allowing the viewer to study patterns and compare
performance across reporting periods. It may also be used to compare the operating
data of two distinct firms. Such analysis aids in comparing performance with other
businesses by analysing how companies respond to market variables impacting
companies in the same industry. 

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Thus, the comparative income statement is an essential tool for analysing the results of
a business's operations over multiple accounting periods to understand the various
factors contributing to the change over time for better interpretation and analysis. It
enables various business stakeholders and the analyst community to study the impact
of business actions on the company's top line and bottom line. It also enables the
discovery of numerous trends over time, which would otherwise be difficult and time-
consuming. 

Objectives of Comparative Income Statement

Different objectives of a Comparative Income Statement are as follows:

1. The basic objective of a Comparative Income Statement or Statement of Profit &

Loss is to analyse every item of Revenue and Expenses for two or more years. 

2. It is also prepared to analyse the increase or decrease in every item of Revenue

and Expenses in terms of rupees and percentages. With this increase or decrease, the
trend of each item is determined. 

3. A Comparative Statement of Profit & Loss or Income Statement also compares

data of more than one year, showing the overall trend of profit.

Common Size Balance Sheet

It is a vertical analysis of Balance Sheet in which Total Assets is taken as 100 and
each item of Assets is expressed as percentage of the Total Assets. Similarly, each
item of Equity and Liabilities is expressed as percentage of total amount of Equity and
Liabilities.

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Objectives of common size balance sheet
Different objectives of a Common-size Balance Sheet are as follows:

1. The basic objective of a Common-size Balance Sheet is to analyse the changes in

the individual items of a Balance Sheet.

2. It is also prepared to see the trends of different items of assets, equity and
liabilities of a Balance Sheet. 

3. Lastly, it is prepared for the assessment of the financial soundness of the

organisation and to understand its financial strategy.

Conclusion
In conclusion, financial statements include the cash flow statement, balance sheet, and

income statement. Separately, each statement is providing a glimpse at the company’s

financial situation. With the financial statements combined, determines the company’s

financial condition by displaying if the company can manage their own incoming and

outgoing funds, an estimate of their value, and the expenses and sales revenue

incurred by them.

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Analysis of financial statements is extremely important for every business to grow and

increase their revenue. It should not be compromised since it increases the efficiency

of business operations. Better processes and expert analysts can help in the detailed

analysis process.

Bibliography
 https://www.google.com/

 https://www.cashstock.in/comparative-financial-statement-definition/

 https://byjus.com/

 https://www.geeksforgeeks.org/comparative-income-statement-

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 www.wikipedia.com

 https://www.accountingtools.com/articles/limitations-of-financial-

statements.html

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