Unit 2- Financial Analysis

Meaning of Financial Statements

Financial statements are reports prepared by a
company’s management to present the financial
performance and position at a point in time. A
general-purpose set of financial statements usually
includes a balance sheet, income statements,
statement of owner’s equity, and statement of cash
flows. These statements are prepared to give users
outside of the company, like investors and
creditors, more information about the company’s
financial positions. Publicly traded companies are
also required to present these statements along with
others to regulator agencies in a timely manner.
 LIMITATIONS OF FINANCIAL STATEMENTS

 Dependence on historical costs: Transactions are initially recorded at their cost. This is a concern when reviewing
the balance sheet, where the values of assets and liabilities may change over time. Some items, such as marketable
securities, are altered to match changes in their market values, but other items, such as fixed assets, do not change.
 Inflationary effects: If the inflation rate is relatively high, the amounts associated with assets and liabilities in the
balance sheet will appear inordinately low, since they are not being adjusted for inflation. This mostly applies
to long-term assets.
 Intangible assets not recorded: Many intangible assets are not recorded as assets. Instead, any expenditures made
to create an intangible asset are immediately charged to expense. This policy can drastically underestimate the value
of a business, especially one that has spent a large amount to build up a brand image or to develop new products
 Based on specific time period: A user of financial statements can gain an incorrect view of the financial results
or cash flows of a business by only looking at one reporting period
 Not always comparable across companies.: If a user wants to compare the results of different companies, their
financial statements are not always comparable, because the entities use different accounting practices.
 Subject to fraud: The management team of a company may deliberately skew the results presented. This situation
can arise when there is undue pressure to report excellent results, such as when a bonus plan calls for payouts only
if the reported sales level increases.
 No discussion of non-financial issues.:The financial statements do not address non-financial issues, such as the
environmental attentiveness of a company's operations, or how well it works with the local community.
 Not verified: If the financial statements have not been audited , this means that no one has examined the accounting
policies, practices, and controls of the issuer to ensure that it has created accurate financial statements. An audit
opinion that accompanies the financial statements is evidence of such a review.
 No predictive value: The information in a set of financial statements provides information about either historical
results or the financial status of a business as of a specific date. The statements do not necessarily provide any value
in predicting what will happen in the future
Meaning of Financial Analysis
 The process of reviewing and analyzing a
company’s financial statements to make better economic
decisions is called analysis of financial statements. In other
words, the process of determining financial strengths and
weaknesses of the entity by establishing
the strategic relationship between the items of the balance
sheet, profit and loss account and other financial statements.
 The term ‘analysis’ means the simplification of financial
data by methodical classification of the data given in the
financial statements, ‘interpretation’ means, ‘explaining the
meaning and significance of the data so simplified.’
However, both’ analysis and interpretation’ are interlinked
and complementary to each other.
 Objectives of Financial Analysis
 Reviewing the performance of a company over the past periods: To predict
the future prospects of the company, past performance is analyzed. Past
performance is analyzed by reviewing the trend of past sales, profitability, cash
flows, return on investment, debt-equity structure and operating expenses, etc. 
 Assessing the current position & operational efficiency: Examining the
current profitability & operational efficiency of the enterprise so that the
financial health of the company can be determined. For long-term decision
making, assets & liabilities of the company are reviewed. Analysis helps in
finding out the earning capacity & operating performance of the company.
 Predicting growth & profitability prospects: The top management is
concerned with future prospects of the company. Financial analysis helps them
in reviewing the investment alternatives for judging the earning potential of the
enterprise. With the help of financial statement analysis, assessment and
prediction of the bankruptcy and probability of business failure can be done.
 Loan Decision by Financial Institutions and Banks: Financial analysis helps
the financial institutions, loan agencies & banks to decide whether a loan can be
given to the company or not. It helps them in determining the credit risk,
deciding the terms and conditions of a loan if sanctioned, interest rate, maturity
date etc.
 Tools of Financial Analysis
 Comparative Financial Statements
 Also known as ‘horizontal analysis, are financial statements showing financial position
& profitability at different periods of time. These statements give an idea of
the enterprise financial position of two or more periods. Comparison of financial
statements is possible only when same accounting principles are used in preparing these
statements.
 Comparative Balance Sheet
 The progress of the company can be seen by observing the different asset and
liabilities of the firm on different dates to make the comparison of balances from one
date to another. To understand the comparative balance sheet, it must have two columns
for the data of original balance sheets. A third column is used to show increases/decrease
in figures. The fourth column gives percentages of increases or decreases.
 By comparing the balance sheets of different dates, one can observe the following
aspects
 Current financial position and Liquidity position
 Long-term financial position
 Profitability of the concern
 
 Comparative Income Statement

Traditionally known as trading and profit and loss A/c. Net

sales, cost of goods sold, selling expenses, office expenses
etc are important components of an income statement. To
compare the profitability, particulars of profit & loss are
compared with the corresponding figures of previous years
individually. To analyze the profitability of the business,
the changes in money value and percentage is determined.
 By comparing the profits of different dates, one can
observe the following aspects:
 The increase/decrease in gross profit.
 The study of operational profits.
 The increase or decrease in net profit
 Study of the overall profitability of the business.
 Common Size Statements
Common size statements are also known as ‘Vertical analysis’. Financial
statements, when read with absolute figures, can be misleading. Therefore, a
vertical analysis of financial information is done by considering the percentage
form. The balance sheet items are compared:
to the total assets in terms of percentage by taking the total assets as 100.
to the total liabilities in terms of percentage by taking the total liabilities as
100.
Therefore the whole Balance Sheet is converted into percentage form. And
such converted Balance Sheet is known as Common-Size Balance Sheet.
Similarly profit & loss items are compared:
to the total incomes in terms of percentage by taking the total incomes as 100.
to the total expenses in terms of percentage by taking the total expenses as
100.
Therefore the whole Profit & loss account is converted into percentage form.
And such converted profit & loss account is known as Common-Size Profit &
Loss account. As the numbers are brought to a common base, the percentage
can be easily compared with the results of corresponding percentages of the
previous year or of some other firms.
 Trend Analysis

 Also known as the Pyramid Method. Studying the

operational results and financial position over a series of
years is trend analysis. Calculations of ratios of different
items for various periods is done & then compared
under this analysis. Whether the enterprise is trending
upward or backward, the analysis of the ratios over a
period of years is done. By observing this analysis, the
sign of good or poor management is detected.