Analysis and Interpretation of

Financial Statements

Meaning of Financial Statements:

Financial Statements refers to formal

and original statements prepared by a s
business concern to disclose it financial
information.
Financial Statements are the
summarized periodical reports which
disclose the financial aspects of the
business such as the operating results
and the financial position of the
business as on a particular date.

The financial statements include two

main statements namely:

a) Profit and Loss a/c or a Income

statement which shows the profit
 or loss made by a concern for a
particular period.

b) The statement of financial

position or balance sheet which
shows the total assets and
liabilities of a concern as on a
particular date.

These financial statements no doubt

gives accurate values (since these are
based on historical translations), but the
use of these statements is very limited.

These statements do not reveal the

exact financial strength of a company.
Hence Management Accounting is
being introduced which reveals the
exact position of the company by x-
raying the financial statements.
Analysis and interpretation of
financial statements:

The Analysis and Interpretation of

Financial Statements basically involves
3 concepts or steps and they are:

a) Analysis: It means methodical

classification of the data given in the
financial statements into homogenous
and comparable parts. (i.e, interrelated
parts).

In other words, analysis of financial

statements refers to grouping up of
various components of financial
statements on the basis of the nature or
characteristics of such components.

For ex. Share capital, all kinds of

accumulated reserves and surplus are
grouped under one group namely,
proprietors’ Funds, because by nature
these components belong to
shareholders.

b) Comparison: It refers to comparing

the various components of financial
statements from one year to another or
from one group to another in the same
year and measuring their relationship.
Fro ex., the total current assets may be
compared from one year to other or to
total current liabilities or total assets for
the same year.

c) Interpretation: Interpretat6ion of
the results implies formation of rational
judgement and drawing out proper
conclusions about the progress,
financial position and future prospects
of the business based on the results of
the above two steps. For the top
managers, the interpretation will best
serve in faster decision making.
Types of Financial Analysis:
Financial analysis may be classified
into following three types:

I) On the basis of materials used for

financial analysis: On this basis
analysis may be of two types:

a) External Analysis: It is done by

external parties of the business, such as
the investors or suppliers, banks and
other financial institutions, who have
no access to the books of accounts and
the internal records of the concern. This
type of analysis is dependent on the
published financial statements of the
firm.

b) Internal Analysis: It is done by

internal parties who have access to the
books of accounts and the internal
records of the concern. Internal parties
include the executives, employees and
government agencies who have power
to go through the internal records of the
concern.

II) on the basis of method of

operation followed in the analysis):
On this basis analysis can be of two
types:

a) Vertical analysis or Static Analysis:

It is a type of analysis made to study
the quantitative relationship among the
items in a single set of financial
statements (i.e, the financial statement
of one year only).

b) Horizontal analysis or dynamic

analysis: When the financial
statements of a number of years are
studied and analysed the analysis is
called horizontal analysis.
For a comprehensive and wise analysis,
both horizontal and vertical analysis
must be done simultaneously.

III) On the basis of the objective:

On this basis analysis can be of two
types:

a) Long-term Analysis: It is a type of

analysis made in order to study the
long-term financial stability, solvency
and liquidity as well as profitability of
a business concern. It helps in long-
term financial planning, which is
essential for the successful continued
existence of a business.

b) Short-term Analysis: Short-term

analysis is made to determine the short-
term solvency, stability and liquidity as
well as earning capacity of the business.
It facilitates in evaluating whether in
the short run a business concern will
have adequate funds readily available
to meet its short-term requirements. It
helps in short-term financial planning
or working capital analysis.

Tools or Methods for Analysis and

Interpretation of Financial
Statements:

The Management Accountant can make

use of the following managerial tools in
order to analyze and interpret the
financial statements:
a) Comparative Financial Statement
b) Common Size Financial Statement
c) Trend Analysis
d) Ratio Analysis
e) Funds Flow Statement
f) Cash Flow Statement. Etc.

COMPARATIVE FINANCIAL
STATEMENTS:
The comparative financial statements
are statements of the financial position
at different period’s .The elements of
financial position are shown in a
comparative form so as to give an idea
of financial position of two or more
periods.

COMMON SIZE FINANCIAL

STATEMENTS:
The common size statements, balance
sheet and income statement are shown
in analytical percentages. The figures
are shown as percentages of total
assets, total liabilities and total sales,
the total assets are taken as 100 and
different assets are expressed as
percentage of total.

TREND ANALYSIS: The financial

statements may be analysed by
computing trends of series of
information. Here one year is taken as
base year. Generally, the first or the
last is taken as base year and figures of
the base year are taken as 100.
Formulae = current year/ base year x
100