Analysis of financial statement

Analysis and interpretation of financial statements

Introduction of financial statements

The financial statements are not an end in themselves; they are only vehicles of communicating the
financial health of an enterprise. Though they contain significant facts regarding the concern in the form
of figures but the figures are dumb. No meaningful conclusions can be drawn from these figures unless
they are analyzed and interpreted. Thus, the significance of these statements lies not in their preparation
but in their analysis and interpretation.

Meaning of financial statements

Financial statements are written records that convey the business activities and the financial performance
of a company. Financial statements include the balance sheet, income statement, and cash flow statement.
Financial statements are often audited by government agencies, accountants, firms, etc. to ensure
accuracy and for tax, financing, or investing purposes.

Meaning of analysis and interpretation of financial statements

Financial analysis is the process of determining the significant operating and financial characteristics of a
firm from accounting data. It involves classifying, grouping and rearranging the figures given in the
financial statements simplified desired form so that meaningful conclusions could be drawn.

According to John N. Myer, “Financial statement analysis is largely a study of relationships 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.”

Process of analysis and interpretation

1. Analysis
 Presenting the data in convenient form
 Arrangement of facts duly reclassified
2. Comparison
3. Study of trend
4. Drawing conclusion
Objectives of analysis and interpretation
1. To estimate the earning capacity of the firm.
2. To assess the financial strength and weakness of the firm.
3. To determine the long-term solvency as well as short-term liquidity of the firm.
4. To determine the debt capacity of the firm.
5. To examine the managerial efficiency and operating performance of the firm.
6. To assess the future prospects of the firm.
7. To make a comparative study of the firm with other units of the same industry, i.e., intrafirm
comparison.

Parties interested in financial analysis and Interpretation

1. To the financial executives
2. To the top management
3. To the creditors
4. To the investors and others

Types of financial analysis

Distinction between different types of financial analysis can be made either on the basis of material used
for the analysis or according to modus operandi of the analysis or object of the analysis. It is important to
distinguish between different types of analysis because the techniques of analysis and interpretation differ
according to the type of analysis.

External Analysis:

External analysis of financial statements is made by those who do not have access to the detailed
accounting records of the company, i.e., banks, creditors, investors, government agencies and general
public. These people depend almost entirely on published financial statements. Such analysis is of limited
use. The main objective of such analysis varies from party to party.

Internal Analysis:

Such analysis is made by the finance and accounting department to help the top management. These
people have direct approach to the internal and unpublished financial records so they can peep behind the
two basic financial statements and narrate the inside story. Such analysis emphasizes on the performance
appraisal and assessing the profitability of different activities and hence it serves meaningful purpose of
internal management and employees.

Horizontal Analysis:

When financial statements of a number of years are reviewed and analyzed, the analysis is called
‘horizontal analyses. Under it year-by-year changes of each item are shown and thus periodical trend of
various items is ascertained. This analysis is not based on data of any one year or an accounting period.
On the contrary, it is based on the data of many years or period. This analysis is also known as ‘Dynamic
Analysis’ or Trend Analysis. Ratio method, funds flow analysis, trend analysis, comparative financial
statements etc.

Vertical Analysis:

It is also known as ‘static analysis’ or ‘structural analysis’ as it is a study of quantitative relationship

existing among the various items at a particular date. Average analysis and common-size statements are a
good example of vertical analyses. In this type of analysis, sum of the items of the statement of a period
or a date is taken as base and this base is taken as to equal to 100 and various items shown in the
statement are expressed as percentage to the base. This relationship can be expressed by ratio analyses
technique also.

Methods, Devices or Tools of Analysis and Interpretation

Following are the important tools of financial analysis:

(1) Comparative financial statements

(2) Common size statements
(3) Trend analysis
(4) Ratio analysis

Comparative financial statements

The preparation of comparative financial statements is an important device of horizontal financial

analysis. In the general usage, statements prepared in a form that reflect the financial position for two or
more periods are known as comparative financial statements. In the words of Roy A. Foulke,
“Comparative financial statements of the financial position of a business so designed as to provide time
perspective to the consideration of various elements of the financial position embodies in such
statements.” The following facts can be disclosed in these statements:

(1) An absolute figure, i.e., rupees amounts of various items.

(2) Increase or decrease in absolute figures. Increase or decrease of data may be shown in:
(a) Money values
(b) Percentages.
(3) Comparisons expressed in ratios.
(4) Showing figure of each item as a percentage of total amount. These are called comparative
common size statements.

Significance of comparative financial statements

Comparative statements are very helpful in measuring the effects of the conduct of a business enterprise
over the period under consideration. They indicate the trend and direction of financial position and
operating results over a period of time. Inter-period and/or inter-firm comparisons are also facilitated by
such comparative statements. With the help of such comparisons, weaknesses in the operating cycle,
financial health, etc. can be easily identified and necessary remedial steps may be taken.
Miscellaneous comparative statements

Any statement can be prepared in comparative form but the statements in practice as follows:

(1) Comparative balance sheet

(2) Comparative profit and loss account/Income statement

(1) Comparative Balance Sheet

The effects of all operations of a business firm are visible in its balance sheet in the form of increase or
decrease in the value of different assets, liabilities and owner’s equity. These changes can be studied by
comparing the opening and closing balance sheets of the same business enterprise. For this comparison,
the technique of comparative balance sheet can be used.

In a comparative balance sheet, items of balance sheets prepared at two different dates are presented in
such a way that the changes in each related item between two dates could be found easily. In the words of
Roy A. Foulke, “Comparative Balance sheet analysis is the study of the trend of the same items and
computed items in two or more balance sheets of the same business enterprise on different dates.”
However, such comparison can also be undertaken between balance sheets of the same date of two or
more business enterprises.

Preparation of Comparative Balance Sheet

For showing comparative position of different items of Balance sheet of two periods, a summary of
balance sheet changes is prepared. It will have two columns for the data of original balance sheet and a
third column for showing increases and decreases in various items. A fourth column, showing percentages
of increases or decreased may also be added. For showing these changes in the form of ratios, one
additional column may also be added. The use of ratios avoids the use of Plus or minus signs because
when ratio is less than the one, it implies that the amount of current year is less than the amount of base
year and vice versa.
Q1. The comparative Balance sheets of Mohan metal works are given below:

BALANCE SHEETS as at 31st Dec. 2000 and 2001

(Amount in lakh)

Liabilities 2000 2001 Assets 2000 2001

𝑅𝑠. 𝑅𝑠. 𝑅𝑠. 𝑅𝑠.
Equity Share Capital 800 1200 Current Assets:
Capital Reserve 120 220 Debtors 418 20
General Reserve 444 418 cash 236 380
Sinking Fund 80 100 stock 320 260
Fixed Liabilities: others 64 26
Debentures 400 650 Investments 540 340
Current Liabilities: Fixed Assets:
Sundry Creditors 510 234 Furniture Less 18 36
Depre.
Others 14 20 Building less depre. 620 1572
Land 40 60
Total 2368 2842 Other Assets 112 148

Calculate absolute change and percentage change & also write interpretation on the basis of
results achieved in balance sheet.

(2) Comparative Income statement

This statement is prepared to analyze the progress of a business concern. It contains operating results of
many accounting periods. Like comparative balance sheet, additional columns are drawn in this statement
showing increase or decrease in various items together with absolute values. The change of different
items can be shown both in absolute amounts and percentages. Changes can also be shown in the form of
ratios, if desired.
Q2. From the following income statements of XYZ Co. Ltd. Prepare a Comparative Income statement and
interpret the results:

(Amounts in lakh rupees)

For the year ending 31st Dec.

2000 2001

Net sales 685 721

Cost of Goods sold 419 463

Gross Profit 266 258

Operating Expenses:

Selling Expenses 94 91

General and administrative Exp. 47 141 46 137

Operating Profit 125 121

Add Other Income- Dividend 22 25

147 146

Less Other Deductions- Interest paid 22 22

Net profit before tax 125 124

Less income tax 62 62

Net profit after tax 63 62