Financial Statement Analysis

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Limitations of financial statements: Financial Statements suffers from various limitations which are given below: (i) Historical Records: Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future. The financial statements are not of much help as the information given in these statements is historic in nature and does not reflect the future. (ii) Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. Different assets are shown at the historical cost in financial statements. It, therefore, ignore the price level change or present value of the assets. (iii) Qualitative aspect Ignored: Financial statements considered only those items which can be expressed in terms of money. Financial Statements ignores the qualitative aspect such as quality of management, quality of labour force, Public relations. (iv) Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer. (v) Not free from Bias: Financial statements are largely affected by the personal judgement of the accountant in selecting accounting policies. Therefore, financial are not free from bias. (vi) Variation is accounting practices: Different firms follow different accounting practices. For example, depreciation can be provided either on SLM basis or WDV basis. Profits earned or loss suffered will be different when different practices are followed. Therefore, a meaningful comparison of their financial statements is not possible. Users of Financial Statements: Users of accounting information may be categorised into (1) Internal Users; and (2) External Users. (1) Internal Users: (i) Owners: Owners contribute capital in the business and they are always exposed to risk. In view of risk involved, the owners are always interested in knowing the profitability and financial strength of the company. (ii) Management: Managers has the responsibility to not only safeguard the owners investment but also to increase the value of business. Financial statements help the management to find out the overall as well as segment-wise efficiency of the business. It helps them in decision making as well as in controlling and self evaluation. (iii) Employees and Workers: Employees and workers are entitled to bonus at the year end besides the salary and wages which is directly linked with the profits of the enterprise. Therefore, the employees and workers are interested in financial statements. (2) External Users: (i) Banks and Financial Institutions: Banks and Financial Institutions provide loans to the businesses. They watch the performance of the business to ensure the safety and recovery of the loan advanced. (ii) Investors and Potential Investors: Investors uses financial statements to assess the earning capacity of the enterprise and ensure the safety of their investment.

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Financial Statement Analysis

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(iii) Creditors: Creditors supply goods and services on credit. Before granting credit, Creditors satisfy themselves about the creditworthiness of the business. The financial statement helps them in making such assessment. (iv) Government authorities: The government makes use of financial statements to compile national income accounts and other information. The information so available to it enables them to take policy decisions. (v) Consumers: Customers have an interest in information about the continuance of an enterprise, especially whey they have a long-term with the enterprise. Sometime, prices of some products are fixed by the government, so it needs accounting information to fix fair prices so that consumers and producers are not exploited.

Financial statements : Financial statements are the summarized statements of accounting data produced at the end of accounting process by an enterprise through which accounting information are communicated to the internal and external users. A set of financial statements includes: (a) Balance sheet (b) Profit and loss account (c) Schedules and notes to accounts. In the words of Myer, The financial statements provide a summary of accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a certain date and income statement showing the result of operations during a certain period. According to AICPA,Financial statements are prepared for the purpose of presenting a periodical review or report on progress made by the management and deal with the status of investments in the business and the results achieved during the period under review. Characteristics of financial Statements are: (a) Financial statements relate to past period and thus, are historic documents. (b) The statements are expressed in monetary terms. (c) Financial statements show financial position through balance sheet and profitability through profit and loss account. Nature of Financial Statements: (i) Recording facts of a business transactions; (ii) Accounting Conventions; (iii) Accounting Concepts; (iv) Personal judgments used in the application of conventions and postulates. (i) Recorded Facts: The Financial statements are statements prepared on the basis of recorded facts, they do not depict the unrecorded facts. Recorded facts means recording of transactions based on evidence in the accounting books. (ii) Accounting Conventions: Certain accounting conventions are followed while preparing financial statements such as convention of Conservatism, convention of Materiality, convention of Full disclosure, convention of Consistency. According to convention of Conservatism, provisions are made of expected losses but expected profits are ignored. This means that the real financial position of the business may be better than what has been shown by the financial statements. The use of accounting conventions makes financial statements simple, comparable, and realistic.

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Financial Statement Analysis

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(iii) Accounting Concepts: While preparing financial statements the accountants make a number of assumptions known as accounting concepts such as going concern concept, money measurement concept, realisation concept, etc. According to the going concern concept, it is assumed that the business of the concern shall be continued indefinitely. The assets are shown in the balance sheet at their book value rather than their market value. (iv) Personal Judgement: Personal judgement also has an important bearing on financial statements. For example, selection of one method out of various methods of charging depreciation, inventory valuation etc., depends on the personal judgement of the accountant. Essential of Financial Statements: The essential of financial statements are: (i) Accurate Information: Financial statements should disclose the accurate information about the financial strength or weakness of the company. It should not disclose the position better or worse than the actual. (ii) Understandability: Financial statements should be prepared following the accepted accounting principles for better understanding of the users. (iii) Comparable: Financial statements should disclose the information in such a manner that they are conformable for inter-firm and intra-firm comparison. (iv) Verifiable: Information disclosed by the financial statements should be verifiable from the records of the company. (v) Relevant: Information disclosed by the financial statements should be in accordance with the legal requirements. Only information relevant to the users should be disclosed in the financial statements. (vi) Timeliness: Financial statements should be prepared and presented within a reasonable period after the accounting period is over.

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Financial Statement Analysis

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Q.N.1. Define financial Statement analysis. What are its objectives? Explain various types of financial statement analysis. Ans: - Financial Statement Analysis: It is the process of identifying the financial strength and weakness of a firm from the available accounting and financial statements. The analysis is done by properly establishing the relationship between the items of balance sheet and profit and loss account. In the words of Myer Financial Statement analysis is largely a study of relationship among the various financial factors in a business, as disclosed by a single set of statements, and a study of trends of these factors, as shown in a series of statements. In simple words, analysis of financial statement is a process of division, establishing relationship between various items of financial statements and interpreting the result thereof to understand the working and financial position of a business.

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Financial Statement Analysis

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Objectives (Purposes) and significance of Financial Statement analysis: Financial analysis serves the following purposes and that brings out the significance of such analysis: (i) To judge the financial health of the company: The main objective of the financial analysis is to determine the financial health of the company. It is done by properly establishing the relationship between the items of balance sheet and profit and loss account. (ii) To judge the earnings performance of the company: Potential investors are primarily interested in earning efficiency of the company and its dividend paying capacity. The analysis and interpretation is done with a view to ascertain the companys position in this regard. (iii) To judge the Managerial efficiency: The financial analysis helps to pinpoint the areas wherein the managers have shown better efficiency and the areas of inefficiency. Any favourable and unfavourable variations can be identified and reasons thereof can be ascertained to pinpoint weak areas. (iv) To judge the Short-term and Long-term solvency of the undertaking: On the basis of financial analysis, Long-term as well as short-term solvency of the concern can be judged. Trade creditors or suppliers are mainly interested in assessing the liquidity position for which they look into the following: (a) Whether the current assets are sufficient to pay off the current liabilities. (b) The proportion of liquid assets to current assets. (v) Inter-firm Comparison: Inter-firm comparison becomes easy with the help of financial analysis. It helps in assessing own performance as well as that of others. (vi) Understandable: Financial analysis helps the users of the financial statement to understand the complicated matter in simplified manner. Types of financial Statement analysis: The main objective of financial analysis to determine the financial health of a business enterprise. The analysis may be of the following types: (i) External analysis: This analysis is performed by outside parties such as trade creditors, investors, suppliers of long term debt etc. (ii) Internal analysis: This analysis is performed by the corporate finance and accounting department and is more detailed than external analysis. (iii) Horizontal analysis: This analysis compares the financial statements viz., profit and loss accounts and balance sheet of previous year along with the current year. (iv) Vertical analysis: This analysis converts each element of the information into a percentage of the total amount of statement so as to establish relationship with other components of the same statement. (v) Trend analysis: This analysis compares ratios of different components of the financial statements related to different period to those of a base year. (vi) Ratio analysis: This analysis establishes the numerical relationship between two items of financial statement so that the strength and weakness of a firm can be determined. (vii) Funds flow statement: This statement provides a comprehensive idea about the movement of finance in a business unit during a particular period of time. (viii) Break-even analysis: This type of analysis refers to the interpretation of financial data that represent operating activities. Q.N.2. What are the limitations of financial analysis?

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Financial Statement Analysis

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Ans: Limitations of financial analysis: Financial analysis suffers from various limitations which are given below: (i) Historical Analysis: Financial analysis analysed what has happened till date but it does not reflect the future. Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future. (ii) Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. A change in the price level makes the financial analysis of different accounting years invalid because accounting records ignores change in value of money. (iii) Qualitative aspect Ignored: Since the financial statements are based on quantitative aspects only, the quality aspect such as quality of management, quality of labour force etc., are ignored while carrying out the analysis of financial statements. (iv) Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer. (v) Not free from Bias: Financial statements are largely affected by the personal judgement of the accountant in selecting accounting policies. Therefore, financial are not free from bias. (vi) Variation is accounting practices: Different firms follow different accounting practices. Therefore, a meaningful comparison of their financial statements is not possible. Q.N.3. Explain various tools of financial statement analysis with their merits and demerits. Ans: - Tools of financial Statement analysis: The main objective of financial analysis to determine the financial health of a business enterprise. The analysis may be done with the help of following tools: (a) Comparative balance sheets and income statements, (b) Common size statements, (c) Trend analysis, (d) Ratio analysis, (e) Funds flow analysis, (f) Cash flow analysis. I. Comparative Financial Statements: Comparative Financial Statements is primarily an analytical study of the different items shown in the Income Statement and Balance Sheet over a period of time. It may refer to: (i) Financial statements of an enterprise for two or more accounting years (Inter-period Comparison) (ii) Financial statements of different enterprises for the same accounting year (Inter-firm Comparison). The Financial Statements reveals the trading results and financial statement of a concern. But the Comparative Statement presents a review of two or more years. It shows the absolute change from one period to another. Comparative statements are of two types Comparative balance sheets and Comparative income statements. Merits of Comparative Financial Statements: (a) Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise.

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Financial Statement Analysis

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(b) These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise. (c) These statements help the management in making forecasts for the future. Demerits of Comparative Financial Statements: (a) Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies. (b) Inter-period comparison will also be misleading if there is frequent changes in accounting policies. II. Common Size Statements: Common size statement is the statement in which amounts of individual item of balance sheet and profit and loss account for two or more years are written. These amounts are further converted into percentage to some common base. It can be net sales in the case of profit and loss account and total of balance sheet for the balance sheet. Merits of Common Size Statements: (d) Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise. (e) These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise. (f) These statements help the management in making forecasts for the future. Demerits of Common Size Statements: (b) Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies. (b) Inter-period comparison will also be misleading if there is frequent changes in accounting policies. III. Trend Analysis: Trend analysis is an important tool of horizontal financial analysis. This is helpful in making a comparative study of the financial statements for several years. Under this method trend percentages are calculated for each item of the financial statements taking the figure of base year as 100. The starting year is taken as the base year. The trend percentages show the relationship of each item with its preceding years percentages. Merits of Trend analysis: (a) Trend percentages can be presented in the form of Index Numbers showing relative change in the financial statements during a certain period. (b) Trend analysis will exhibit the direction to which the concern is proceeding. (c) The trend ratio may be compared with the industry, in order to know the strong or weak points of a concern. Demerits of Common Size Statements: (a) These are calculated only for major items instead of calculating for all items in the financial statements. (b) Trend values will also be misleading if there is frequent changes in accounting policies. (FOR RATIO, FUNDS FLOW AND CASH FLOW ANALYSIS REFER TO NEXT CHAPTER)

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