Financial statements are the end products of financial acounting. They are

the summarised statements and reports prepared by business concerns to disclose

their accounting information and communicate them to the interested parties.

Financial statements include mainly two statements which the accountant prepares

at the end of a given period. These are Income Statement (Profit and Loss

Account) and Position Statement (Balance Sheet). These statements are

supplemented by Cash Flow Statement, Fund Flow Statement, Statement of

Retained Earnings, Schedules etc.

1. Income Statement: It is prepared to determine the operational position of

the concern. It is a statement of revenues earned and the expenses incurred

for earning that revenue. The difference is either profit or loss. The income

statement is prepared for a particular period.

2. Position Statement: It is one of the important financial statements depicting

the financial strength of the concern. It shows on the one hand the properties

that it utilises and on the other hand the sources of these properties. The

balance sheet shows all the assets owned by the concern and the liabilities

and claims it owes to owners and outsiders. It is prepared as on a particular

date.

3. Cash Flow Statement: It summarises the causes of changes in cash position

of a business enterprise between two Balance Sheet dates. It focuses

attention on cash changes only. It describes the sources of cash and its uses.

4. Fund Flow Statement: It is designed to analyse the changes in the financial

condition of a enterprise between two periods. This statement will show the

sources from which the funds are received and the uses to which these have

been put.

5. Statement of Retained Earnings: Also known as Profit and Loss

Appropraition Account. It shows the appropriaion of earnings like dividend

paid, transfer to reserve, etc. The balance in this account will show the

amount of profits retained and carried forward.

6. Schedules: A number of schedules are prepared to supplement the

information supplied in the Balance Sheet. The schedules of investments,

fixed assets, debtors, etc. are prepared to give details about these

transactions. All these schedules are used as part of financial statements.

ANALYSIS AND INTERPRETATION OF FINANCIAL

STATEMENTS

The financial statements become meaningless unless they are analysed and

interpreted. On proper analysis and interpretation of the results, they become of

valuable and useful. Managerial decisions often depend on the results of financial

statements and their interpretations.

Analysis of finacial statement is the process of determining the significant

operating and financial characteristics of a firm from the accounting data. It is the

treatment of the information contained in the fiancial statements to afford a full

diagnosis of the profitability and financial position of the firm. It helps the

executives to evaluate past performance, present financial position, liquidating

situation, profitability of the firm, and to make forecast for the future earnings.

Interpretation of financial statement refers to drawing inferences or

conclusions on the basis of analysis conducted on the financial statements. Proper

interpretation leads to proper conclusion and judgement and taking effective

measures for improvements.

Objectives of Financial Analysis

1. Efficiency of operation: The earning capacity of a firm varies between

periods due to different factors such as pricing, competition, etc. The

analysis of financial statements helps to estimate the effieciency of

operations of the firm. The ratios such gross profit ratio, net profit ratio, etc.

are calculated and interpreted for the purpose of measuring the efficiency of

operations of the business.

2. Measure the financial position and financial performance of the firm: The

analysis of financial statement help to gauge the financial position as on any

particular date and the financial performance of the firm within the period

under review.

3. Long term liquidity of funds: Analysis of finacial statements help to

determine the long term liquidity of funds. It helps to make arrangement for

funds for the future when required.

4. Solvency of the firm: Analysis of Balance Sheet figures helps to measure the

solvency of the firm. The solvencies measures by studying the value of

assets over liabilities. It shows the debt paying capacity of the firm.

5. Future prospects of the firm: The future prospects of the firm can be

ascertained by studying the trend of activities for the last few years and the

expected changes that may take place in the near future. Trend ratios help to

measure the future prospects of the business.

6. Progress of the firm: By comparing the profit and loss account and balance

sheet figures of the current year with those of the previous year or of the

previous years helps to measure the progress of the firm. Comparative

statements are prepared for the purpose of measuring the progress of the

firm.

Features of Financial Analysis

To present a complex data contained in the financial statement in simple and

understandable form.

To classify the items contained in the financial statement in convenient and

rational groups.

To make comparison between various groups to draw various conclusions.

Goals

Financial analysts often assess the firm’s:

1. Profitability - The firm’s ability to earn income and sustain growth in both

short-term and long-term. A company’s degree of profitability is usually

based on the income statement, which reports on the company’s results of

operations.

2. Solvency - The firm’s ability to pay its obligation to creditors and other third

parties in the long-term.

3. Liquidity - The firm’s ability to maintain positive cash flow, while satisfying

immediate obligations.

4. Stability – The firm’s ability to remain in business in the long run, without

having to sustain significant losses in the conduct of its business. Assessing

a company’s stability requires the use of the income statement and the

balance sheet, as well as other financial and non-financial indicators.

Purpose of Analysis of Financial Statements

To know the earning capacity or profitability.

To know the solvency.

To know the financial strengths.

To know the capability of payment of interest and dividends.

To make comparative study with other firms.

To know the trend of business.

To know the efficiency of management.

To provide useful information to management.

Procedure of Financial Statement Analysis

The following procedure is adopted for the analysis and interpretation of

financial statements:

1. The analyst should acquaint himself with principles of accounting. He

should know the plans and policies of the management so that he may be

able to find out whether these plans are properly executed or not.

2. The extent of analysis should be determined so that the sphere of work may

be decided. If the aim is to find out the earning capacity of the enterprise,

then, analysis of income statement will be undertaken. On the other hand, if

financial position is to be studied, then, balance sheet will be necessary.

3. The financial data given in the statement should be recognized and

rearranged. It involves grouping of similar data under same heads, breaking

down of individual components of statement according to its nature and

reducing the data to a standard form.

4. A relationship is established among financial statements with the help of

tools and techniques of financial analysis such as ratios, trends, common

size statements, fund flow statements, etc.

5. The information is interpreted in a simple and understandable way. The

significance and utility of financial data is explained for help in decision

making.

6. The conclusions drawn from interpretation are presented to the management

in the form of reports.

Functions of Finance Department

The functions of finance department include the following areas:

1) Effective management of financial resources of the company.

2) Coordinates & Monitors the functions of accounts activities in the

units/marketing offers.

3) Establish and maintain systems of financial control, internal check and

render advice on financial & accounting matters including examination of

feasibility report and detailed project reports.

4) Establish and maintain proper system of budgetary control, cost control and

management reporting.

5) Maintain financial accounts and compile annual periodical accounts in

accordance with the companies Act, 1956, ensuring the audit of accounts as

per law/Govt. directions.

6) Looks after overall funds management and arranges funds required for the

capital schemes and working capital form govt., banks and financial

institutions etc.

7) Timely payment of all taxes, levies & duties under the Law, Maintenance of

records and filing returns statements connected with such taxes, levies and

duties with the appropriate authorities, as per law.

All the power involving financial implications are to be exercised in prior

consultation with head of concerned finance department. In the event of any

difference of opinion between the General Manger and the Head of Finance Dept.,

the matter shall be referred to Managing Director who after consulting Director

(Finance) shall issue appropriate instruction after following the prescribed

procedures.

Types of Financial Analysis

Distinction between the different types of finacial analysis can be made

either on the basis of material used for the same or according to the modus

operandi of the analysis or the object of the analysis. The following chart will give

a snap-shot view of it.

1. External Analysis: It is made by those who do not have access to the

deatailed accounting records of the company, i.e., banks, creditors and

general public. These people depend almost entirely on published financial

statements. The main objective of such analysis varies from party to party.

2. Internal Analysis: Such analysis is made by the finance and accounting

department to help the top management. These people have direct approach

to the relevant financial records. So they can peep behind the two basic

Types of financial analysis

According to materials used

External Analysis

Internal Analysis

According to modus operandi

Horizontal Analysis

Vertical Analysis

According to objectives of analysis

Long term Analysis

Short term Analysis

financial statements and narrate the inside story. Such analysis emphasises

on the performance appraisal and assessing the profitability of different

activities.

3. Horizontal Analysis: When the financial statements for a number of years

are reviewed and analysed, the analysis is called ‘horizontal analysis’. The

preparation of comparative statements is an example of horizontal analysis.

As it is based on data from year to year, rather than on one date or period or

time as a whole, this is also known as ‘Dynamic Analysis’.

4. Vertical Analysis: It is also known as ‘Static Analysis’. When ratios are

calculated from the Balance Sheet of one year, it is called vertical analysis. It

is not very useful for long term planning as it does not include the trend

study for future.

5. Long term Analysis: In the long run, the company must earn a minimum

amount sufficient to maintain a suitable rate of returm on the investment to

provide for the necessary growth and development of the company and to

meet the cost of capital. Thus, in the long run analysis the stress is on the

stability and earning potentiality of the concern. In long term analysis, the

fixed assets, long term debt structure and the ownership interst is analysed.

6. Short term Analysis: It is mainly concerned with the working capital

analysis. In the short run, a company must have ample funds readily

available to meet its current needs and sufficient borrowing capacity to meet

the contingencies. Hence, in short term analysis, the current assets and

current liabilities are analysed and cash position of the concern is

determined. For short term analysis the ratio analysis is very useful.

Tools and Techniques of Financial Analysis (Methods)

The analysis of financial statements consists of a study of relationships and

trends to determine whether or not the financial position of the concern and its

operating efficiency have been satisfactory. In the process of this analysis, various

tools or methods are used by the financial analyst. The analytical tools generally

available to an analyst for this purpose are as follows:

1. Comparative financial and operating statements

2. Common-size statements

3. Trend ratios(trend percentages)

4. Average analysis

5. Statement of changes in working capital

6. Funds flow and cash flow analysis

7. Ratio analysis

1. Comparative Financial and Operating Statements

The preparation of comparative financial and operating statements is

an important device of horizontal financial analysis. Financial data becomes

more meaningful when compared with similar data for a previous period or a

number of prior periods. Statements prepared in a form that reflects financial

data of two or more periods are known as comparative statements. Such

statements are very helpful in measuring the effects of the conduct of a

business during the period under consideration. Comparative satatement

may show :

i. Absolute figures

ii. Change in the absolute figures (increase or decrease)

iii. Absolute data in terms of percentages

iv. Increase or decrease in terms of percentages

Comparative statements can be of 2 types:

i. Comparative Balance Sheet: The comparative balance sheet

analysis is the study of the trend of the same items or group of

items of two or more balance sheets of the same business

enterprise on different dates. The changes in periodic balance

sheet items reflect the conduct of the business. It has 2 columns

for the data for original balance sheet. A third column is used to

show increase in figures, the fourth column may be added for

giving percentage of increase or decreases.

ii. Comparative Income Statement: The comparative income

statement is a statement prepared to get an idea of the progress

of a business over a period of time. The changes in absolute

data in money values and percentages help to analyse the

profitability of a business. It has 4 columns. First two columns

give figures of various items for two years. Third and fourth

columns are used to show increase or decrease in figures, in

absolute amounts and percentages respectively.

2. Common Size Statements

These are the statements prepared to show the relationship of different

individual items with some common items. These are the comparative

statements that give only the vertical percentage ratio for financial data

without giving rupee values. They are also known as 100% statements. It

shows the relation of each component to the whole. It is useful in vertical

financial analysis and comparison of two business enterprises at a certain

date. Common size statements include:

i. Common Size Balance Sheet: A statement in which balance

sheet items are expressed as percentage of each asset to total of

assets and percentage of each liability to total of liabilities is

called Common Size Balance Sheet. This statement establishes

the relationship between each asset to total value of assets and

each liability to total of liabilities.

ii. Common Size Income Statement: A common size income

statement is a statement in which each item of expense is shown

as a percentage of net sales. A significant relationship can be

established between items of income statement and volume of

sales. Increase in sales will certainly increase the selling

expense and not the administration and financial expenses

which are mostly fixed in nature. In case the volume of sales

increases to a considerable extent, administration and financial

expenses may also go up.

3. Trend Ratios (Trend Percentages)

Trend signifies tendency. Therefore, review and appraisal of tendency

in accounting variables is simply called as trend analysis. Trend ratios are

also an important tool of horizontal financial analysis. Under this technique

of financial analysis, the ratios of different items for various periods are

calculated and then a comparison is made. An analysis of the ratios over the

past few years may well suggest the trend or direction in which the concern

is going upward or downward.

Uses or advantages of trend analysis:

i. It helps in easily knowing the direction of movement of the

activity of the business, i.e., whether upward or downward.

ii. Trend analysis is helpful in forecasting and budgeting.

iii. It helps in comparing one period with another period.

iv. It makes data brief and easily understandable.

Procedure for calculation of trends:

i. One year is taken as the base year. Usually, the first year is

taken as the base year.

ii. The figures of base year are taken as 100.

iii. Trend percentages are calculated in relation to the base year.

If a figure in a year is less than the base year figure, the rend

percentage will be less than 100 and if the figure is more than

the base year figure the trend percentage will be more than 100.

Trend percentage = Current year amount * 100

Base year amoun

4. Average Analysis

It is an improvement over trend analysis method. When trend ratios

have been determined for the concern, these figures are compared with

average trend of the industry. Both these 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.

5. Statement of Changes in Working Capital

To discuss the increase or decrease in working capital over a period of

time, the preparation of a statement of changes in working capital is also

very useful. The main objective of this statement preparation is to derive a

fairly accurate summary of the events that affected the amount of working

capital. The amount of net working capital is determined by deducting the

total of current liabilities from the total of current assets. Hence, it is a rough

statement which may be prepared by using balance sheet date only. But it

does not explain the detailed reasons for the changes in working capital and

methods of financing additional requirements of working capital. Hence, the

preparation of funds flow statement becomes necessary.

6. Ratio Analysis

It is an important and widely used tool of analysis of financial

statements. It is essentially an attempt to develop meaningful relationship

between individual items or group of items in the balance sheet or profit and

loss account. The object and utility of ratio analysis as a technique of

financial analysis is confined not only to the internal parties but to the trade

creditors, banks and lending institutions also. It functions as a sort of health

test. In the nut-shell, ratio analysis gives the answer to the problems such as:

i. Whether the enterprise’s financial position is basically sound,

ii. Whether the capital structure is in proper order,

iii. Whether the profitability is satisfactory,

iv. Whether the credit policy in relation to sales and purchase is

sound,

v. Whether the company is credit worthy.

Thus, ratio analysis highlights the liquidity, solvency,

profitability, capital gearing etc.

Limitations of Financial Statement Analysis

The analysis of financial statement has certain limitations

also. Hence, any person using this technique must keep in mind those

limitations. Main limitations are as follows:

i. The analysis of financial statements is only a means to reach

conclusions and not conclusion in itself. So, it cannot work as

a substitute for sound judgement. The judgement, ultimately,

will depend upon the intelligence and skill of the analyst.

ii. The figures drawn from statement of just one year have

limited use and value. So, it will be dangerous to depend on

them only.

iii. The basic nature of financial statement is historic. Past can

never be hundred per cent representative of the future. Hence,

future course of business events should be forecasted and

interpreted in the context.

iv. The results of the analysis of financial statements should not

be taken as an indication of good or bad management. The

ratios or other figures explain only probable state of events.

v. Any change in the method o r procedure of accounting marks

the utility of such analysis. The figures of different financial

statements lose the characteristic of comparability.

vi. An analyst should also be cautious from window dressing in

the accounts.

vii. The rapid changes in the value of money also reduce the

validity of such analysis and no useful conclusions can be

drawn from a comparative study of the financial statements

of different years.

viii. It does not disclose reasons for changes.

i.

RATIO ANALYSIS

Ratio analysis is one of the most powerful tools of analysis of

financial statements. It aims at making use of quantitative information

for decision making. These are widely used as they are simple to

calculate and easy to understand.

A ratio is an expression of relationship between two figures or two

amounts. It is a yardstick which measures relationship between two

variables. Ratios are simply a means of highlighting in arithmetical

terms the relationship between the figures drawn from various financial

statements. Robert Anthony defines a ratio as “simply one number

expressed in terms of another.” A large number of ratios can be

compared from the basic financial statements – Balance Sheet and Profit

& Loss Account.

Meaning and Definition

Ratio analysis is the analysis of financial statements with the help of ratios.

It includes comparison and interpretation of these ratios and their use for future

projection. Ratio analysis does not provide and end in itself, but only a means to

understand the financial position and performance of business concerned.

Ratio analysis may be defined as “the process pf computing, determining

and presenting the relationship of items and groups of items of financial statements

with the help of ratios and interpreting the results there from”.

A ratio may be expressed in any of the following terms:

a. Quotient or Pure Ratio (which is arrived at by the simple division of one

number by another: Eg, current asset to current liability ratio is 3 : 1).

b. Percentage (which is a special type of ratio expressing the relationship in

hundred. It is arrived at by multiplying the quotient by 100. Eg, gross profit

is 40% of sales).

c. Rates (which is the ratio between the two numerical facts over a period of

time. Eg, stock turnover is five times a year).

Objectives of Ratio Analysis

It is an important tool for checking the efficiency of a firm. It helps the

financial management in evaluating the financial position and performance of the

firm. It functions as a sort of health test of the firm. The main objective of ratio

analysis is to help the management of a firm, especially in areas of sales and costs.

But at present they are used in many ways as follows:

a. Aid in comparison: The techniques of inter-firm comparison and intra firm

comparison can be carried out successfully with the help of ratio analysis.

b. Financial forecasting: With the help of ratios of various preceding years,

projections can be made for the future.

c. Cost controlling: Different expenses ratios help to reduce and control cost

elements.

d. Trend analysis: The trend of the movement of items can be studied with the

help of ratios.

e. To test profitability: The profitability of the concern can be measured with

the help of ratios such as gross profit ratio, operating profit ratio, net profit

ratio, etc.

f. To test solvency position: the solvency of a concern can be measured with

the help different ratio computed from Balance Sheet items

g. As an instrument of management: Ratio can be used as instrument of control

regarding sales, cost and profit.

h. Taking investment decisions: Ratios are helpful in computing return on

investment. It helps management in exercising effective decisions regarding

profitable avenues of investment.

i. Measuring efficiency: Ratios help to know operational efficiency by

comparison of present ratios with those of the past working and also with

those of other firms in the industry.

Importance and uses(Advantages) of Ratio Analysis

Ratio analysis is an important and useful technique to check the efficiency

with which working capital is being used in the enterprise. Some ratios indicate the

trend or progress or downfall of the firm. It helps the financial management in

evaluating the financial position and performance of the firm. The trade creditor,

bank, lending institutions and experienced investor all use ratio analysis as their

initial tool in evaluating the firm as a desirable borrower or as potential investment

outlet. It functions as a sort of health test. The following are the important

advantages of ratio analysis:

a. It makes it easy to grasp the relationship between various items and helps in

understanding the financial statements.

b. Ratios indicate trends in important items and thus helps in forecasting.

c. Inter-firm comparison can be made with the help of ratios, which may help

management in evolving future ‘market strategies’.

d. Standard ratios can be computed. Comparison of actual ratios with standard

will help in control.

e. Ratios can effectively communicate what has happened between two

accounting dates.

f. It helps in a simple assessment of liquidity, profitability, solvency and

efficiency of the firm.

g. Ratios may be used as measures of efficiency.

h. Ratios are very useful for measuring the performance and very useful in

cost control.

i. The ratio analysis proves to be a significant value to the management in the

process of the discharge of its elementary functions such as planning, co-

ordination, communication and control.

j. It throws light on the degree of efficiency of the management and utilization

of the assets and that is why it is called surveyor of efficiency. They help

management in decision making.

ii.

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viii.