Financial Analysis

Financial Analysis is the process of critical evaluation of the financial information contained in
the financial statements in order to understand and make decisions regarding the operations of the
firm. It is basically a study of relationship among various financial facts and figures as given in a
set of financial statements, and the interpretation thereof to gain an insight into the profitability
and operational efficiency of the firm and to assess the firm’s financial health and future prospects.
The term ‘financial analysis’ includes both ‘analysis and interpretation’. The term analysis means
simplification of financial data by methodical classification given in the financial statements.
Interpretation means explaining the meaning and significance of the data. These two are
complimentary to each other. Analysis is useless without interpretation, and interpretation without
analysis is difficult or even impossible

Financial statement analysis is a judgmental process which aims to estimate current and past
financial positions and the results of the operation of an enterprise, with primary objective of
determining the best possible estimates and predictions about the future conditions. It essentially
involves regrouping and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a business enterprise,
which can be useful in decision-making involving comparison with other firms (cross sectional
analysis) and with firms’ own performance, over a time period (time series analysis).

Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or
profitable enough to be invested in. Financial analysis may be used internally to evaluate issues
such as employee performance, the efficiency of operations, and credit policies, and externally to
evaluate potential investments and the credit-worthiness of borrowers, among other things.

The analyst draws the financial data needed in financial analysis from;
- The company’s annual report and required disclosures. The annual report comprises the
income statement, the balance sheet, and the statement of cash flows, as well as footnotes
to these statements.
- Financial press and electronic media. These provide information on the market prices of
securities of publicly-traded corporations as well as stock price indices for industries and
for the market as a whole.
- Economic data, such as the Gross Domestic Product and Consumer Price Index, which may
be useful in assessing the recent performance or future prospects of a company or industry.

- Current events that may help explain the company's present condition and may have a
bearing on its future prospects. For example, did the company recently incur some
extraordinary losses? Is the company developing a new product? Or acquiring another
company? Is the company regulated?

The financial analyst must select the pertinent information, analyze it, and interpret the analysis,
enabling judgments on the current and future financial condition and operating performance of the
company.
Significance of Analysis of Financial Statements.
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm
by properly establishing relationships between the various items of the balance sheet and the
statement of profit and loss. Financial analysis can be undertaken by management of the firm, or
by parties outside the firm, viz., owners, trade creditors, lenders, investors, labour unions, analysts
and others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose of other analysts
because of the difference in the interests of the analysts. Financial analysis is useful and significant
to different users in the following ways:
(a) Finance manager:
Financial analysis focusses on the facts and relationships related to managerial performance,
corporate efficiency, financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of analysis to make rational
decisions for the firm. The tools for analysis help in studying accounting data so as to determine
the continuity of the operating policies, investment value of the business, credit ratings and testing
the efficiency of operations. The techniques are equally important in the area of financial control,
enabling the finance manager to make constant reviews of the actual financial operations of the
firm to analyse the causes of major deviations, which may help in corrective action wherever
indicated.

(b) Top management:

The importance of financial analysis is not limited to the finance manager alone. It has a broad
scope which includes top management in general and other functional managers. Management of
the firm would be interested in every aspect of the financial analysis. It is their overall
responsibility to see that the resources of the firm are used most efficiently and that the firm’s
financial condition is sound. Financial analysis helps the management in measuring the success of
the company’s operations, appraising the individual’s performance and evaluating the system of
internal control.

(c)Trade payables:
Trade payables, through an analysis of financial statements, appraises not only the ability of the
company to meet its short-term obligations, but also judges the probability of its continued ability
to meet all its financial obligations in future.
Trade payables are particularly interested in the firm’s ability to meet their claims over a very short
period of time. Their analysis will, therefore, evaluate the firm’s liquidity position.

(d) Lenders:
Suppliers of long-term debt are concerned with the firm’s long-term solvency and survival. They
analyse the firm’s profitability over a period of time, its ability to generate cash, to be able to pay
interest and repay the principal and the relationship between various sources of funds (capital
structure relationships). Long-term lenders analyse the historical financial statements to assess its
future solvency and profitability.

(e) Investors:
Investors, who have invested their money in the firm’s shares, are interested about the firm’s
earnings. As such, they concentrate on the analysis of the firm’s present and future profitability.
They are also interested in the firm’s capital structure to ascertain its influences on firm’s earning
and risk. They also evaluate the efficiency of the management and deter mine whether a change is
needed or not. However, in some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.

(f) Labour unions:

Labour unions analyse the financial statements to assess whether it can presently afford a wage
increase and whether it can absorb a wage increase through increased productivity or by raising
the prices.
(g) Others:
The economists, researchers, etc., analyse the financial statements to study the present business
and economic conditions. The government agencies need it for price regulations, taxation and other
similar purposes.

Objectives of Analysis of Financial Statements

Analysis of financial statements reveals important facts concerning managerial performance and
the efficiency of the firm. Broadly speaking, the objectives of the analysis are to apprehend the
information contained in financial statements with a view to know the weaknesses and strengths
of the firm and to make a forecast about the future prospects of the firm thereby, enabling the
analysts to take decisions regarding the operation of, and further investment in the firm. To be
more specific, the analysis is undertaken to serve the following purposes (objectives):
- to assess the current profitability and operational efficiency of the firm as a whole as well
as its different departments so as to judge the financial health of the firm.
- to ascertain the relative importance of different components of the financial position of the
firm.
- to identify the reasons for change in the profitability/financial position of the firm.
- to judge the ability of the firm to repay its debt and assessing the short-term as well as the
long-term liquidity position of the firm. Through the analysis of financial statements of
various firms, an economist can judge the extent of concentration of economic power and
pitfalls in the financial policies pursued. The analysis also provides the basis for many
governmental actions relating to licensing, controls, fixing of prices, ceiling on profits,
dividend freeze, tax subsidy and other concessions to the corporate sector
.
Tools of Analysis of Financial Statements
The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements:
These are the statements showing the profitability and financial position of a firm for different
periods of time in a comparative form to give an idea about the position of two or more periods.
It usually applies to the two important financial statements, namely, balance sheet and statement
of profit and loss prepared in a comparative form. The financial data will be comparative only
when same accounting principles are used in preparing these statements. If this is not the case,
the deviation in the use of accounting principles should be mentioned as a footnote. Comparative
figures indicate the trend and direction of financial position and operating results. This analysis
is also known as ‘horizontal analysis’.

2. Common Size Statements:

These are the statements which indicate the relationship of different items of a financial
statement with a common item by expressing each item as a percentage of that common item.
The percentage thus calculated can be easily compared with the results of corresponding
percentages of the previous year or of some other firms, as the numbers are brought to common
base. Such statements also allow an analyst to compare the operating and financing
characteristics of two companies of different sizes in the same industry. Thus, common size
statements are useful, both, in intra-firm comparisons over different years and also in making
inter-firm comparisons for the same year or for several years. This analysis is also known as
‘Vertical analysis’.

3. Trend Analysis:
It is a technique of studying the operational results and financial position over a series of years.
Using the previous years’ data of a business enterprise, trend analysis can be done to observe the
percentage changes over time in the selected data. The trend percentage is the percentage
relationship, in which each item of different years bear to the same item in the base year
Trend analysis is important because, with its long run view, it may point to basic changes in the
nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio
is falling, rising or remaining relatively constant. From this observation, a problem is detected or
the sign of good or poor management is detected.

4. Ratio Analysis:
It describes the significant relationship which exists between various items of a balance sheet and
a statement of profit and loss of a firm. As a technique of financial analysis, accounting ratios
measure the comparative significance of the individual items of the income and position
statements. It is possible to assess the profitability, solvency and efficiency of an enterprise
through the technique of ratio analysis.

5. Cash Flow Analysis:

It refers to the analysis of actual movement of cash into and out of an organisation. The flow of
cash into the business is called as cash inflow or positive cash flow and the flow of cash out of
the firm is called as cash outflow or a negative cash flow. The difference between the inflow and
outflow of cash is the net cash flow. Cash flow statement is prepared to project the manner in
which the cash has been received and has been utilised during an accounting year as it shows the
sources of cash receipts and also the purposes for which payments are made. Thus, it summarises
the causes for the changes in cash position of a business enterprise between dates of two balance
sheets.

Limitations of Financial Analysis

Though financial analysis is quite helpful in determining financial strengths and weaknesses of a
firm, it is based on the information available in financial statements. As such, the financial
analysis also suffers from various limitations of financial statements. Hence, the analyst must be
conscious of the impact of price level changes, window dressing of financial statements, changes
in accounting policies of a firm, accounting concepts and conventions, personal judgement, etc.
Some other limitations of financial analysis are:
1. Financial analysis does not consider price level changes.
2. Financial analysis may be misleading without the knowledge of the changes in accounting
procedure followed by a firm.
3. Financial analysis is just a study of reports of the company.
4. Monetary information alone is considered in financial analysis while non-monetary aspects are
ignored.

5 The financial statements are prepared on the basis of accounting concept, as such, it does not
reflect the current position.
Comparative Statements

As stated earlier, these statements refer to the statement of profit and loss and the balance sheet
prepared by providing columns for the figures for both the current year as well as for the previous
year and for the changes during the year, both in absolute and relative terms. As a result, it is
possible to find out not only the balances of accounts as on different dates and summaries of
different operational activities of different periods, but also the extent of their increase or decrease
between these dates. The figures in the comparative statements can be used for identifying the
direction of changes and also the trends in different indicators of performance of an organisation.
The following steps may be followed to prepare the comparative statements:
Step 1 : List out absolute figures in shillings relating to two points of time (as shown in columns
2 and 3 of Exhibit 4.1).
Step 2 : Find out change in absolute figures by subtracting the first year (Col.2) from the second
year (Col.3) and indicate the change as increase (+) or decrease (–) and put it in column 4.
Step 3 : Preferably, also calculate the percentage change as follows and put it in column 5.

Absolute Increase or Decrease (Col.4)

____________________________________________________________ × 100

First year absolute figure (Col.2)

Format of comparative statement/horizontal analysis/

Particular item Year 1 Year 2 Absolute difference % Difference

Example. Colgate co. ltd had the following comprehensive income statements.
(sh. MILLION)
2006 2005
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,238 11,397
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . ….. 5,536 5,192
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . .. 6,702 6,205
Selling, general, and administrative expenses . …. 4,355 3,921
Other expense, net . . . . . . . . . . . . . . . . . . . . . . …... 186 69
Operating profit . . . . . . . . . . . . . . . . . . . . . . . …….2,161 2,215
Interest expense, net . . . . . . . . . . . . . . . . . . . . . . … .159 136
Income before income taxes . . . . . . . . . . . . . . . … 2,002 2,079
Provision for income taxes . . . . . . . . . . . . . . . . ….. 648 728
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...1,354 1,351

Colgate’s comparative income statements analysis.

(sh. MILLION)
2006 2005 Change % Change
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,238 11,397 841 7.38%
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . ….. 5,536 5,192 344 6.63
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . .. 6,702 6,205 497 8.01
Selling, general, and administrative expenses . …. 4,355 3,921 434 11.07
Other expense, net . . . . . . . . . . . . . . . . . . . . . . …... 186 69 117 169.57
Operating profit . . . . . . . . . . . . . . . . . . . . . . . …….2,161 2,215 (54) –2.44
Interest expense, net . . . . . . . . . . . . . . . . . . . . . . … .159 136 23 16.91
Income before income taxes . . . . . . . . . . . . . . . … 2,002 2,079 (77) –3.70
Provision for income taxes . . . . . . . . . . . . . . . . ….. 648 728 (80) –10.99
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...1,354 1,351 3 0.22

Interpretation;
This analysis reveals several items of note. First, net sales increased by 7.38% but cost of goods
sold increased by only 6.63%, therefore increasing Colgate’s gross profit by 8.01%, which is
higher than its revenue increase. Overall, this suggests that Colgate has been able to control its
production costs and therefore increase its profit margin on sale. Selling, general, and
administrative expenses increased by 11.07%. Pretax income decreased by 3.70%, but tax expense
decreased by 10.99%, thereby increasing net income by 0.22%. Colgate reports that the increased
tax expense is primarily the result of a tax incentive provided. In sum, Colgate is performing well
in a tough competitive environment.
(a) Comparative Balance Sheet:
Comparative balance sheet analysis concentrates only the balance sheet of the concern at different
period of time. Under this analysis the balance sheets are compared with previous year’s figures
or one-year balance sheet figures are compared with other years. Comparative balance sheet
analysis may be horizontal or vertical basis. This type of analysis helps to understand the real
financial position of the concern as well as how the assets, liabilities and capitals are placed during
a particular period.

Exercise 1
The following are the balance sheets of Tamil Nadu Mercantile Bank Ltd., for the years 2003 and
2004 as on 31st March. Prepare a comparative balance sheet and discuss the operational
performance of the business concern.
Balance Sheet of Tamil Nadu Mercantile Bank Limited
As on 31st March
Equity & other 2003 2004 2003 2004
Liabilities.
Share Cap. 2,845 2,845 Cash/ 2,706,808 2,237,601
Reserve and 3,966,009 4,765,406 Bank Bal. 1,136,781 1,607,975
surplus
10% Debentures. 40,845,783 44,042,730 Investments 21,421,060 23,537,098
Accruals 727,671 284,690 Pre-Payments 19,599,764 21,139,869
Trade Creditors 1,674,165 1,799,197 Fixed Assets 493,996 536,442
Others. 1,858,064 1,835,883
Total 47,216,473 50,894,868 47,216,473 50,894,868

Solution
Comparative Balance Sheet Analysis.
Particulars Year ending 31st March Increased/Decreased Increased/Decreased
Amount % (percentage)
2003 (sh.) 2004 (sh.) Sh.
 Assets

Cash/ 2,706,808 2,237,601 (-) 469,207 (-) 17.33

Bank Bal. 1,136,781 1,607,975 (+) 471,194 (+) 41.45
Total current Assets 3,843,589 3,845,576 1,987 0.052
Fixed Assets;

Investments 21,421,060 23,537,098 (+) 2,116,038 (+) 9.88

Pre-Payments 19,599,764 21,139,869 (+) 1,540,105 (+) 7.86
Fixed Assets 493,996 536,442 (+) 42,446 (+) 8.59
Others 1,858,064 1,835,883 (-) 22,181 (-) 1.19
Total fixed assets 43,372,884 47,049,292 (-) 3,676,408 (-) 8.48
Total Assets 47,216,473 50,894,868 3,678,395 7.79
Current Liabilities;
Trade creditors 727,671 284,690 (-) 442,981 (-) 60.88
Accruals 1,674,165 1,799,197 (+) 125,032 (+) 7.47
Total C. liabilities 2,401,836 2,083,887 (-) 317,949 (-) 13.24
Equity
Share capital 2,845 2,845 - -
Reserve and surplus 3,966,009 4,765,406 (+) 799,397 20.16
10% Debentures 40,845,783 44,042,730 (+) 3,196,947 7.83
Total L. Liabilities. 44,814,637 48,810,981 (+) 3,996,344 8.92

Total Liabilities 47,216,473 50,894,868 3,678,395 7.79

INTERPRETATION;

Current Ratio increased from 1.6: 1 in 2003 to 1.85: 1 in 2004. The ratio in both years is below
the standard of 2:1 although it quite close in 2004.

Current assets increased while current liabilities decreased implying that money was obtained
from either sale of fixed assets or from long-term source.

The gearing ratio remained constant at 86.5% in both years. This is above the recommended
ceiling of 67%. It means that the company has over –borrowed and may face solvency problems.
A comparative balance sheet shows the balance of accounts of assets and liabilities on different
dates and also the extent of their increases or decreases between these dates throwing light on the
trends and direction of changes in the position over the periods. This helps in predicting about the
position of the business in future. A specimen of the comparative balance sheet is given below:
Ram & Sons.
Comparative Balance Sheet
(as on 31st March, 2012 and 2013)
Particulars 31.3.2012 1.3.2013 Absolute change % change
Current Assets
Cash in hand and at bank 118,000 10,000 108,000 92
Receivables 209,000 190,000 19,000 9
Inventory(Stock) 160,000 130,000 30,000 19
Prepaid expenses 3,000 3,000 0 0
Other current assets 29,000 10,000 19,000 66
Total Current Assets 519,000 343,000 176,000 34
Fixed Assets
Land and buildings 270,000 170,000 100,000 37
Plant and machinery 310,000 786,000 476,000 150
Furniture and fixtures 9,000 18,000 9,000 100
Other fixed assets 20,000 30,000 10,000 50
Total Fixed Assets 609,000 1,004,000 395,000 65
Investments 46,000 59,000 13,000 28
Total Assets 1,174,000 1,406,000 232,000 20
Liabilities and Capital
Current Liabilities
Accounts payables 255,000 117,000 138,000 54
Other short-term liabilities 7,000 10,000 3,000 43
Total Current Liabilities 262,000 127,000 135,000 52
Debentures 50,000 100,000 50,000 100
Long-term loans 150,000 225,000 75,000 50
Total Liabilities 462,000 452,000 10,000 2
Capital
Equity share capital 400,000 600,000 200,000 50
Reserve and surplus 312,000 354,000 42,000 13
Total capital EMP. 1,174,000 1,406,000 232,000 20

An analysis and interpretation of the above balance sheet reveals:

1. Current assets have decreased by 176,000 between 2012 and 2013, while current liabilities have
decreased only by 135,000. But this has no adverse effect on current ratio because the percentage
decrease in current assets (34%) is much less than the percentage decrease in current liabilities
(52%).
2. Non-current assets have increased by 395,000, major increase being a plant and machinery of
476,000, which amounts to the increase in production and profit earning capacities. Increase in
fixed assets appears to have been partly financed by an increase in equity capital 200,000, partly
by release of working capital, and partly by increase in debentures and long-term borrowings
125,000.
3. The increase in reserves and surpluses 42,000 may be the result of profits retained, and has gone
to account for increase in long-term loans and fixed assets.
4. There has been a drastic fall in cash balance 108,000. This reflects an adverse cash position.
Common Size Statement
Common Size Statement, also known as component percentage statement, is a financial tool for
studying the key changes and trends in the financial position and operational result of a company.
Here, each item in the statement is stated as a percentage of the aggregate, of which that item is a
part. For example, a common size balance sheet shows the percentage of each asset to the total
assets, and that of each liability to the total liabilities. Similarly, in the common size statement of
profit and loss, the items of expenditure are shown as a percentage of the net revenue from
operations. If such a statement is prepared for successive periods, it shows the changes of the
respective percentages over a period of time.
Common size analysis is of immense use for comparing enterprises which differ substantially in
size as it provides an insight into the structure of financial statements. Inter-firm comparison or
comparison of the company’s position with the related industry as a whole is possible with the
help of common size statement analysis.
The following procedure may be adopted for preparing the common size statements.
1. List out absolute figures in shillings at two points of time, say year 1, and year 2 (Column 2 &
4 of Exhibit 4.2).
2. Choose a common base (as 100). For example, revenue from operations may be taken as base
(100) in case of statement of profit and loss and total assets or total liabilities (100) in case of
balance sheet.
3. For all items of Col. 2 and 3 work out the percentage of that total. Column 4 and 5 shows these
percentages in Exhibit 4.2.

(a) Common-size Income Statement:

In a common size income statement the sales figure is assumed to be equal to 100 and all other
figures of costs or expenses are expressed as percentages of sales. A comparative income statement
for different periods helps to reveal the efficiency or otherwise of incurring any cost or expense.
If it is being prepared for two firms, it shows the relative efficiency of each cost item for the two
firms.

. A comparative common-size income statement and balance sheet for two firms in an industry is
illustrated below:
Old Guards and Young Ones Companies
Common-size Income Statement
Period ending 31st March, 2013
Old Guards Co. Young Ones Co.
 Amount % Amount %
Net sales 2,538,000 100.0 970,000 100.0
Cost of goods sold 1,422,000 56.0 475,000 49.0
Gross Profit on Sales 1,116,000 44.0 495,000 51.0
Selling expenses 720,000 28.4 272,000 28.0
General & admin. Exp. 184,000 7.2 97,000 10.0
Total Operating Exp. 904,000 35.6 369,000 38.0
Operating profit 212,000 8.4 126,000 13.0
Other income 26,000 1.0 10,000 1.0
238,000 9.4 1 36,000 14.0
Other expenses 40,000 1.6 29,000 3.0
Income before tax 198,000 7.8 107,000 11.0
Income-tax 68,000 2.7 28,000 2.9
Net Income after tax 130,000 5.1 79,000 8.1

Common-size Balance Sheet:

In a common size balance sheet, total of assets or liabilities is taken as 100 and all the figures are
expressed as percentage of the total. Comparative common size balance sheets for different periods
help to highlight the trends in different items. If it is prepared for different firms in an industry, it
facilitates to judge the relative soundness and helps in understanding their financial strategy

Common-size Balance Sheets

As on 31st March, 2013
Old Guards Co. Young Ones Co.
Amount % Amount %
Assets
Current Assets:
Cash 54,000 2.7 72,000 7.0
Sundry debtors 440,000 22.0 226,000 22.0
Trading stock 200,000 10.0 174,000 17.0
Prepaid expenses 22,000 1.0 21,000 2.0
Other current assets 20,000 1.0 21,000 2.0
Total Current Assets 736,000 36.7 514,000 50.0
Fixed Assets (Net) 1,270,000 63.3 513,000 50.0
Total 2,006,000 100.0 1,027,000 100.0

Liabilities and Capital:

Current Liabilities:
Sundry creditors 84,000 4.2 134,000 13.0
Other current liabilities 156,000 7.8 62,000 6.0
Total Current Liabilities 240,000 12.0 196,000 19.0
Mortgage debentures 450,000 22.4 318,000 31.0
Total Liabilities 690,000 34.4 514,000 50.0
Capital and reserves 1,316,000 65.6 513,000 50.0
Total Liabilities and Capital 2,006,000 100.0 1,027,000 100.0
The following conclusions can be drawn from a careful analysis of the above financial
statements:
(1) Old Guards company has a better and efficient credit and collection system because its debtors
and trading stock amounts to 32% of total assets as compared to 39% in case of Young Ones
Company.
(2) The cash position of Young Ones Company (7% of total assets) compares favourably with that
of Old Guards (2.7%).
(3) The turnover of Old Guards is larger 2,538,000 than Young Ones Company 970,000, but the
cost of goods absorbs a larger i.e. 56% of net sales compared to 49% in case of Young Ones
Company. This reflects a better pricing mark-up by Young Ones.
(4) The selling, and administrative and general expenses are 35.6% of net sales in case of Old
Guards while 38% in case of Young Ones. Administration costs in Young Ones is higher as
compared to Old Guards, reflecting a highly paid or over staffed administrative function.
(5) Old Guards appear to be more traditionally financed with share-holders equity of 65.6% of
total liabilities as against 50% in case of Young Ones. This reflects the financial value ability of
Young Ones.
(6) The fixed assets of Old Guards company is larger (1,270,000) than of Young Ones Company
513,000. But, if this is compared with turnover that of the two companies, we find that Old Guards
has a lower asset turnover (50%) than that of Young Ones Company (53%). This reflects a better
asset utilisation by Young Ones Company.