FINANCIAL STATEMENT ANALYSIS

MEANING OF FINANCE:Finance means provision of money at the time when it is required. In simple words, finance means any value in terms of money and all financial resources covered under it. Finance is so indispensable today that it said to be the lifeblood of an enterprise. Without finance, no enterprise can possibly accomplish its objectives. It concerns with the application of skills in manipulations, use and control of money. Finance function may be defined as procurement of funds and their effective utilization. According to Guthmann and Dougall, finance can be broadly defined as the activity concerned with the planning, raising, controlling and administering and disbursing funds by privately owned business units operating in non-financial fields used in business. According to Wheeler, that business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprise.

MEANING OF FINANCIAL STATEMENTS

Financial statement refers to the process of financial strength and weakness of affirm by establishing relationship between the items of the balance sheet and P/L a/c and other operated data. Its purpose is to convey an understanding of some financial aspects of a business firm. Financial statements are the outcome of summarising process of accounting. Financial statements are used for the purpose of decision-making. A financial statement is a collection of data organized according to logical and consistent accounting procedure. Financial statements are prepared for the purpose of presenting a periodical review or report on the progress by the management and deals with: (a) Status of investments in the business and (b) The results achieved during a period under review. The preparation of financial statements is the responsibility of top management. Financial statements are also called financial reports. The profit and loss account and balance sheet are indicators of two significant factors profitability and financial soundness.

DEFINATION OF FINANCIAL STATEMENTS

According to John n Myer, The financial statements provide a summary of the business enterprise the balance sheet reflecting the assets, liabilities and capital as on certain date and the income statement showing the results of operation during a certain period.

PURPOSE OF FINANCIAL STATEMENTS

The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. These should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organisations financial position. Reported income and expenses are directly related to an organisations financial performance. Financial statements are intended to be understandable by readers who have a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently.

FINANCIAL ANALYSIS
Financial analysis refers to an assessment of the viability, stability and profitability of a business. Financial statements analysis is an attempt to determine the significance and meaning of the financial statement data, so that forecasting may be made of future earnings, ability to pay interest and ability to repay debt amount. Analysis of statements means such a treatment of the information contained in the two statements as to afford a full diagnosis of the profitability and financial soundness of the firm concerned. Financial analysis is the process of identifying the financial strength and weakness of the firm by profit and loss account properly establishing relationship between the items of balance sheet and profit and loss account. According to Metcalf and Titard, is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firms position and performance. Management should be particularly interested in knowing the financial strengths of the firm to make their best use and to be able to spot-out financial weakness of the firm to take suitable actions.

Understanding the past is pre-requisits for anticipating the future. The analysis and interpretations of the financial statements is the essence to bring out the mystery behind the figures in the financial statements. Interpretation analysis has no value. Analysis and interpretation acts as a bridge between the art of recording financial information and act of using this information. It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their basis in making business decisions. Based on these reports management may:(a) Continue or discontinue its main operation or parts of its business. (b) Make or purchase certain materials in the manufacturer of its product. (c) Acquire or rent/ lease certain machineries and equipments in the production of its goods. (d) Issue stocks or negotiate for a bank loan to increase its working capital.

GOALS
Financial analysts often assess the firms: 1. Profitability- its ability to earn income and sustain growth in both short-term and long-term. A companys degree of profitability is usually based on the income statement, which reports on the companys results of operations. 2. Solvency- its ability to pay its obligation to debtors and other third parties in the long-term. 3. Liquidity- its ability to maintain positive cash flow, while satisfy immediate obligations. 4. Stability- the firms ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a companys stability requires the use of both the income statement and balance sheet as well as other financial and non-financial indicators.

IMPORTANCE OF FINANCIAL STATEMENTS ANALYSIS

Financial statements analysis is to understand and diagnose the information contained in financial statement with a view to judge the profitability and financial soundness of the firm, and to make forecast about future prospects of the firm. The purpose of analysis depends upon the person interested in such analysis and his object. The

following purpose of financial statements analysis may be stated to bring out the significance of analysis:i) To access the earning capacity or profitability of the firm. ii) To access the operational efficiency and managerial effectiveness. iii) To identify the reasons for change in profitability and financial position of the firm. iv)To access the short term as well as long term solvency position of the firm. v) To make inter-firm comparison. vi) To help in decision making and control. vii) To access the progress of the firm over a period of time. viii) To make forecasts about future prospects of the firm. ix) To guide or determine the dividend action. x) To provide important information for granting credit.

TYPES OF FINANCIAL ANALYSIS

We can classify various types of financial analysis into different categories depending upon:1. On the basis of material. (a) External analysis (b) Internal analysis 2. on the basis of modus operandi. (a) Horizontal analysis (b) Vertical analysis

1. ON THE BASIS OF MATERIAL

(a) External analysis- This analysis is done by the outsiders who does not have access to the detail internal accounting records of firm. This analysis serves only a limited purpose. The recent changes in the government regulations requiring business firms to make available more detailed information to the public through audited published accounts have considerably improve the position of external analysis. (b) Internal analysis- This analysis conducted by person who has access the internal accounting records of business firm is known as internal analysis. Such an analysis can be performed by executives and employees of the organisation as well as government agencies which have statutory powers vested in them.

2. ON THE BASIS OF MODUS OPERANDI

(a) Horizontal analysis- It refers to the comparison of financial data of a company for several years. The figures of this type of analysis are presented horizontally over a number of columns. The figures of various years are compared with standard or base year. This type of analysis is also called dynamic analysis, as it based on the data from year to year rather than on data of any one year. (b) Vertical analysis- It refers to the study of relationship of the various items in the financial statement of one accounting period. In this type of financial analysis the figures of the years are compared with base selected from the same years statement. It is also know as Static analysis.

TOOLS &TECHNIQUES OF FINANCIAL ANALYSIS

A financial analyst can adopt following tools for the analysis of financial statement. There are a number of tools for studying the relationship between different statements. Comparative statement analysis Common- size statement analysis Trend analysis

COMPARATIVE STATEMENT ANALYSIS

Comparative statement analysis is the statement of the financial position at different periods of time. The elements of financial position are shown in a comparative form so as to give an idea of financial position at two or more periods. While preparing financial statement for the purpose of financial analysis, it must always kept in mind that the techniques , procedures and principles followed in the collection, recording and presentation of accounting should not materially differ over the period for which the business history is studied. Any material change in the techniques, procedures and principles will render these statements to be useful and insignificant tool of financial analysis. The financial statement of two or more firms can be done if these are of some age, uniform size and having the same accounting principles. Financial analysis of two or more firms is known as inter-firm comparison. The comparative statements may show: i) Absolute figures ii) Change in absolute figures i.e increase or decrease in absolute figures.

iii) Absolute data in form of percentages. iv) Increase or decrease in term of percentages.

TYPES OF COMPAPATIVE STATEMENTS

The comparative statements comprises of:1. Comparative balance sheet 2. Comparative income statement or profit and loss account

1. COMPARATIVE BAANCE SHEET

The effects of all business transactions are visible in the form of increase and decrease in the value of various assets, liabilities and capital fund. These changes can be studied by comparing the opening and closing balance sheets of the same enterprise. The changes in periodic balance sheet items reflect the conduct of a business. The comparative balance sheet has two columns for the data of original balance sheets. A third column is used to show increase in figures. The fourth column may be added for giving percentages of increases or decreases. While interpreting the statement, the interpreter is expected to study the following aspects: Current financial position Long term financial position Profitability of the concern

According to Prof. Foul Key, the comparative balance sheet analysis is the study of the same items and computed items in two or more balance sheets of same enterprise on the different dates.

2. COMPARATIVE INCOME STATEMENT

The income statement summaries the results of the operations of business concern transacted during a define period of time and conveys the amount of profit/loss earned by the concern. It shows an idea of the progress of business over a period of time. A comparative study of P/L a/c for more than one year may enable us to have a definite knowledge about the progress of business. The changes in absolute data in money values and percentages can be determined to analyse the profitability of the firm. The analysis and interpretation of income statement will involve the following steps: The increase or decrease in sales should be compared with the increase or decrease in cost of goods sold. An increase in sales will not always mean an

increase in profit. The profitability will increase will improve if increase in sales is more than the increase in cost of goods sold. The second step of analysis should be the study of operational profits. The operating expenses such as office and administrative expenses, selling and distribution expenses should be deducted from gross profit to find out operating profits. The increase or decrease in net profit will give an idea about the overall profitability of concern. Non- operating expenses such as interest paid, losses from sales of assets, writing off of deferred expenses, payment of tax etc. decrease the figure of operating profit.

COMMON SIZE STATEMENT ANALYSIS

In the common size statement analysis of financial statements, an items is used as a base value and all other accounts on the financial statement are compared to this base value. The figures are shown as percentages os total assets, total liabilities and total sales. On the balance sheet, total assets equal 100% and each asset is stated as a percentage of total assets. Similarly, total liabilities and stockholders equity are assigned 100% with a given liability or equity account stated as a percentage of total liabilities and stockholders equity. On the income statement, 100% is assigned to net sales, with all revenue and expense accounts then related to it.

TYPES OF COMMON SIZE STATEMENTS

The common size statement comprises:1. Common size balance sheet 2. Common size income statement or profit & loss account

1. COMMON SIZE BALANCE SHEET

A statement in which the balance sheet items are expressed the ratio of each liability to total liability is called common size balance sheet. The common size balance can be prepared by putting in the following steps:i) The total of assets and total of all liabilities are taken as 100. ii) The individual assets are expressed as a percentage to total assets that is 100 and different liabilities are calculated in relation to total liabilities.

The common size balance sheet can be used to compare companies of different size. The comparison of figures in different periods is not useful because total figures may be affected by a number of factors.

2. COMMON SIZE INCOME STATEMENT

The items in the income statement are shown as a percentage of sales to show the relation of each item to the sales a significant relationship can be established between the items of income statement and the volume of sales. The increase in sales will certainly increase selling expenses and not administrative or financial expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise. The common size income statement can be prepared by putting in the following steps:i) At first, total sales are taken to be 100. ii) The individual items of the income statement for e.g. cost of sales, operating expenses, non- operating expenses, miscellaneous income etc. are shown as a percentage of the total sales 100. If the sales are increasing it will lead to increase it will lead to increase in selling distribution expenses. In simple words we can say that relationship between sales and each item of income statement is helpful in evaluating the operational activities.

TREND ANALYSIS
The financial statement may be analysed by computing trends of series of information. This method determines the direction upwards or downwards and involves the computation of the percentage relationship that each bears to the same item in base year. The figures of a base year are taken as 100 and trend ratios for other year are calculated on the basis of base year. The analyst is able to see the trend of figures, whether upward or downward. However, trend analysis is not calculated for all of the items in the financial statements. They are usually calculated only for major items since the purpose is to highlight important changes.

LIMITATIONS OF FINANCIAL ANALYSIS

Financial analysis is a powerful mechanism of determining financial strength and weakness of the firm. But, the analysis is based on the information available in the financial statements. The financial analyst has also to be careful about the impact of price level changes, window-dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, and personal judgement etc. Thus the financial analysis suffers from serious which are as follows:1. It is only a study of interim reports. (Reports between two balance sheet dates) 2. Financial analysis is based upon only monetary information and non- monetary factors are ignored. 3. It does not consider changes in the price levels. 4. As the financial statements are prepared on the basis of a going concern, it does not give exact position. Thus, accounting concepts and conventions cause a serious limitation to financial analysis. 5. Changes in the accounting procedure by a firm may often make financial analysis misleading. 6. Analysis is only a means and not an end in itself. The analyst has to make interpretation and draw his own conclusions. Different people may interpret the same analysis in the different ways.

ADVANTAGES OF FINANCIAL STATEMENT ANALYSIS

The various advantages of financial statements analysis are as follows:1. The major benefit is that the investors get enough idea about the investments of their funds in the specific company. 2. The regulatory authorities like International Accounting Standard Board can ensure whether the company is following accounting standards or not. 3. Financial statements analysis can help the government agencies to analyze the taxation due to the company. 4. Company can analyze its own performance over the period of time through financial statements analysis.