Financial statements comprising the balance sheet and the profit and loss account donot provide all the information in relation to the financial operation of a business enterprise, The balance sheet depicts the financial position on a particular date and the profit and loss account reveals the results of financial activities during a certain period of time.
Analysis and interpretation of financial statements help to diagnosis the profitability and financial soundness of the business. Analysis and interpretation are two different terms.
S.N. Maheshwari states” the term analysis means methodical classification of data given in the financial statements. The figures given in the financial statements will not help one unless they are put in a simplified form. For example, all items relating to current assets are put at one place while all items relating to currant liabilities’ are put another place. The term ‘Interpretation’ means explaining the meaning and significance of the data so simplified.
According to Metcalf and Titard “ The analysis of financial statements as a process of evaluating the relationship between component parts of financial statements to obtain a better understanding of the firm’s position and performance.” The financial analyst selects the information related to the decision under consideration from total information available in financial statements. Thereafter he arranges the information in a way to establish significant relationships. The last step is to interpret and to draw inferences and conclusions. According to Spicer and pegelar” Interpretation of accounts may be defined as the art and science of translating the figures in such a way as to reveal the financial strength and weakness of a business and the causeswhich have contributed therein.”
Users of Financial Statement Analysis
There are a number of users of financial statement analysis. They are:
- Creditors: Anyone who has lent funds to a company is interested in its ability to pay back the debt, and so will focus on various cash flow measures.
- Investors: Both current and prospective investors examine financial statements to learn about a company’s ability to continue issuing dividends, or to generate cash flow, or to continue growing at its historical rate.
- Management: The company controller prepares an ongoing analysis of the company’s financial results, particularly in relation to a number of operational metrics that are not seen by outside entities (such as the cost per delivery, cost per distribution channel, profit by product, and so forth).
- Regulatory authorities: If a company is publicly held, its financial statements are examined by the Securities and Exchange board to see if its statements conform to the various accounting standards.
- Bankers and financial institutions
- Trade associations
- Economists and researchers
- Taxation authorities
Objective of Financial Statement Analysis
The objectives of financial statements analysis and interpretation may differ from the point of view of different stakeholders. Shareholders are generally interested in earning per share while debentureholders have focus on capital structure and projected earnings.
According to Anthony, Robert N. “The overall objective of a business is to earn a satisfactory return on the funds invested in it,consistent with maintaining a sound financial position. Hence the purpose of analysis of financial statement is a detailed cause and effect study of profitability and financial position.
Although analysis of financial statement is not an automatic and authentic process but it helps in answering the questions of financial analyst.
The main objectives of analysis and interpretation of financial statements are being explained hereunder:
- To measure profitability and to find out responsible factors in case of declining and improving profitability ratios.
- To measure financial soundness with the help of various ratios for corrective actions in case of adverse position.
- To measure operating efficiency through comparison of current year’s production, sales, expenses with last year’s figures of these items.
- To assessshortterm as well as long term solvency for creditors, debenture holders etc.
- To show trend of various items of financial statements e.g. sales, purchases, profits, expenses and to make strategies for future. This information will also help in budgeting and planning.
- To conduct inter-firm and intra-firm comparison for self evaluation and for operating efficiency to take corrective actions.
Types of Financial Statement Analysis
Financial statement analysis can be undertaken in different ways. The purpose of which the financial statement analysis to be undertaken and the person doing financial statement analysis are two main deciding factors of types of financial statement analysis.
Financial statement analysis may be categorised on the two main basis which are being presented here:
According to Material Used
Financial analysis according to this type can be of two type:
- Internal Analysis: Executives and employees of the enterprise conduct internal analysis because they have access to the books of accounts and all other information related to business. Therefore, such analysis becomes more reliable and useful to management.
- External Analysis: An external analysis is done by those who are outsiders for the business and do not have access to the detailed records of the company. Shareholders, prospective investors, creditors, bankers, governmental agencies, researchers are outsiders who conduct such analysis on the basis of published financial statements. Increased governmental control over companies and governmental regulations have directed companies to disclose more detailed informations in order to improve analysis.
According to Modus Operandi
This type of analysis can be classified in two categories
- Horizontal Analysis: when financial statements for a number of years are reviewed and analysed, it is termed as ‘Horizontal Analysis’.Under this method, figures of two or more years regarding each items are shown with changes from the base year. Generally, the first year is assumed as base or standard year. Increase or decrease in each item as compared to base year is shown in percentage form.
For example, creditors shown in the balance sheet have increased or decreased as compared to the year 2011, and 2012. Horizontal analysis is used in comparative balance sheet and profit and loss account and in trend analysis. Area of strength and weakness from considerable insight are given to the management by this analysis. It is also known as ‘Dynamic Analysis.
- Vertical Analysis:- It is a study of quantitative relationship of the various items in the financial statements on a particular date. It is related to one date or one accounting period.
Therefore, it is termed as ‘Static Analysis’. Common size balance sheet and profit and loss account are examples of vertical analysis. Totals of financial statements of a particular accounting period are taken as 100 and then all items related to that statement are converted into percentage. For example, each item of Balance sheet is stated as a percentage of the total of the Balance sheet.
Procedure of Financial Statement Analysis
The analysis process of financial statements involves the compilation and study of financial and operating data. Analytical representation and promptness are attributes of ideal financial analysis.
The following procedure has to be adopted for financial statement analysis:
- Re-arrangement of Financial statements: First of all a financial statement analyst must know the object of financial statements analysis. Profit and loss account reveals trend of progress and Balance sheet depicts financial position. Director’s report and chairman speech are useful to know future plans. Financial data should be presented in a condensed form according to the object.
- Study of Financial Statements: Detailed study of Balance sheet and Profit and loss account of current year and past years should be made to create a comprehensive vision and to guess about future.
- Approximation of Figures And Classification of Items: The figures should be approximated to the nearest thousand or lakh of rupees to remove complexity of process. The items related to particular heading should be put at one place. Such classification of items will help in analysis.
- Comparison by Establishing Relationship Between Items: Absolute figure is useless until it is compared with another figure. Various items are taken and a relationship with other item is established according to the object. An item of current year may be compared with its past year figures or may be compared with an other item.
For example sales of current year may be compared with lastyear’s sales or may be compared with gross profit, net profit or with different assets. Figures of a particular company may be compared with the figures of other company. All these depend on the object of analysis.
Importance of Financial Statement Analysis
Financial statement analysis is useful for stakeholders because it helps in decision making form their point of view. The importance of financial statement analysis may be understood from the points given below:
- Disclosure of Facts: Financial statements presents only figure of related various items. They do not provide information regarding solvency, requirement of working capital, liquidity position, debtor’s collection policy etc. Analysis of financial statements helps to answer of such questions and provides explanation about all required informations.
- Comparative Study of Efficiency:- various items are compared with past data of the firm and also with other firms engaged in the same business. It measures efficiency of business itself and in comparison to others.
- Help in Planning and Decision Making:-After analysis of financial statements, a firm may know increasing or decreasing trend of various items. It will provide a base for future planning and remedial measures can be planned for solution of future problems.There is no room for personal biasness in decision making because data are scientifically analysed.
- Effective Control: – Control can be exercised effectively in case of variations. Analysis of financial statement provides information regarding day to day activity of business. If there is any negative sign, corrective actions may be taken.
- Importance to Various Stakeholders. Investor, debenture holders, employees, management, government and researchers are various stakeholders who want to know different informations related to them. Analysis of financial statement provides informations to various stakeholders.
Techniques of Financial Statement Analysis
Different persons undertake analysis of financial statement for different purposes. The methodology for analysis may vary from one situation to other.
Horizontal or vertical analysis of items given in financial statements shows profitability and financial position of firm. The techniques which help to study the relationship of horizontal and vertical analysis are termed as Techniques of Financial Statement Analysis. The main techniques are being explained here
- Comparative Financial Statements
- Common-size Financial Statements
- Trend Percentages
- Ratio Analysis
- Fund Flow Analysis
- Cash Flow Analysis
- Break-Even Analysis
A technique useful for one analyst may be useless for another to their different objects. It is not necessary to use all above techniques. The analyst should adopt only these techniques which are helpful in their object of investigation.