Analysis of Financial StatementsClass 12 Accountancy Part 2 Notes

Meaning of Analysis of Financial Statements

Financial statements, like the Income Statement and Balance Sheet, are like a company's report card. They summarize its performance and financial health. However, just looking at the raw numbers isn't enough. Financial Statement Analysis is the process of critically evaluating the financial information in these statements to understand a company's strengths and weaknesses and make informed decisions about its future.

Think of it as being a detective. The financial statements provide the clues, and analysis is how you piece them together to solve the case. This process involves two key parts that work together:

• Analysis: This is the first step, where you simplify the complex financial data. You do this by methodically classifying the numbers and establishing relationships between them. It's about breaking down the information into a more understandable format.
• Interpretation: This is the second step, where you explain the meaning and significance of the data you've just simplified. What does it mean if sales went up but profit went down? Interpretation helps answer these questions.

This process helps in comparing a company's performance over time (time series analysis) or against other companies in the same industry (cross-sectional analysis).

Significance of Analysis of Financial Statements

Financial analysis is a vital tool for many different groups of people, each with their own specific interests and questions about the company. The kind of analysis they do depends on what they want to find out.

Who Uses Financial Analysis and Why?

• Finance Manager: The company's own finance manager uses analysis to check on managerial performance, corporate efficiency, and the overall financial health of the firm. It helps them make rational decisions, review operating policies, and take corrective action if the company deviates from its goals.
• Top Management: The CEO and other top executives are responsible for the entire company. They use financial analysis to measure the success of operations, evaluate the performance of different departments and individuals, and ensure the company's resources are being used efficiently.
• Trade Payables (Creditors): These are the suppliers who sell goods to the company on credit. They are primarily interested in the company's short-term liquidity. Their main question is: "Will the company be able to pay its bills on time?" They analyze financial statements to assess the company's ability to meet its short-term obligations.
• Lenders: Banks and other institutions that provide long-term loans are concerned with the company's long-term solvency and survival. They want to know if the company will be able to pay interest over many years and eventually repay the principal amount. They focus on long-term profitability and the company's capital structure.
• Investors: People who buy shares in the company are investors. They are most interested in the company's current and future profitability, as this affects their earnings (dividends) and the value of their shares. They also look at the efficiency of management to decide whether to buy, sell, or hold the company's shares.
• Labour Unions: Unions analyze a company's financial health to see if it can afford to give employees a wage increase. They want to know if profits are high enough to support better pay.
• Others: Economists, researchers, and government agencies also use financial analysis. They study trends in business, regulate prices, and set tax policies based on the financial performance of companies.

Objectives of Analysis of Financial Statements

The main goal of financial analysis is to understand the information hidden in the numbers to identify a company's strengths and weaknesses. This allows for better forecasting and decision-making. Specifically, the objectives are:

• To assess the company's profitability and operational efficiency.
• To understand the relative importance of different components of the company's financial position (e.g., how much of its assets are financed by debt versus equity).
• To identify the reasons for any changes in profitability or financial position.
• To judge the company's ability to repay its debts, assessing both its short-term and long-term liquidity.

Tools of Analysis of Financial Statements

Financial analysts use several techniques, or "tools," to examine financial statements. The most common ones are:

1. Comparative Statements: These statements present financial data for two or more periods side-by-side to show the absolute and percentage changes over time. This helps in identifying trends and the direction of the business. This is also known as Horizontal Analysis.
2. Common Size Statements: In these statements, each item is expressed as a percentage of a common base. For the Balance Sheet, the base is Total Assets; for the Statement of Profit and Loss, it's Revenue from Operations. This makes it easy to compare companies of different sizes. This is also known as Vertical Analysis.
3. Trend Analysis: This technique studies a company's performance over a series of years. By selecting a base year and calculating percentage changes for all other years relative to the base, analysts can spot long-term trends in performance.
4. Ratio Analysis: This involves calculating and analyzing various financial ratios (like profitability ratios or solvency ratios) to describe the relationship between different items in the financial statements.
5. Cash Flow Analysis: This focuses on the movement of cash into (inflow) and out of (outflow) the company. The Cash Flow Statement summarizes how cash was generated and used during a period.

Comparative Statements

A Comparative Statement is a tool of horizontal analysis that shows the financial figures of a company for two or more consecutive years. It places the figures in adjacent columns, making it easy to see changes. The statement includes two additional columns:

• Absolute Change: The increase or decrease in the amount of each item from the previous year to the current year.
• Percentage Change: The absolute change expressed as a percentage of the previous year's figure.

This format clearly highlights the direction and magnitude of changes, helping to identify significant trends in a company's performance and financial position.

How to Prepare a Comparative Statement

1. List the absolute figures for two periods (e.g., Year 1 and Year 2).
2. Calculate the Absolute Change by subtracting the Year 1 figure from the Year 2 figure.
3. Calculate the Percentage Change using the formula: (Absolute Change / First Year's Figure) * 100

Common Size Statement

A Common Size Statement, also known as a component percentage statement, is a tool of vertical analysis. It converts all figures on a financial statement into percentages of a common base. This standardizes the statements, allowing for easy comparison between different periods or even different companies, regardless of their size.

• For the Statement of Profit and Loss: Each item (like expenses, profit, etc.) is shown as a percentage of Revenue from Operations, which is taken as 100%.
• For the Balance Sheet: Each asset is shown as a percentage of Total Assets, which is taken as 100%. Each item of equity and liability is shown as a percentage of Total Equity and Liabilities, which is also 100%.

How to Prepare a Common Size Statement

1. List the absolute figures for the periods you are analyzing.
2. Choose a common base and set it to 100%.
3. Calculate the percentage for every other item on the statement by dividing its absolute amount by the base amount and multiplying by 100.

Limitations of Financial Analysis

While financial analysis is incredibly useful, it has certain limitations that analysts must keep in mind. These limitations arise because the analysis is based on financial statements, which have their own constraints.

• Ignores Price Level Changes: Financial statements are prepared using historical costs and do not account for inflation. This can distort the real financial position of a firm.
• Affected by Changes in Accounting Procedures: If a company changes its accounting methods (e.g., its method of depreciation), it can make comparisons over time misleading unless these changes are known and understood.
• Based on Historical Data: Financial analysis is a study of past performance. While it helps in forecasting, it is not a perfect predictor of the future, which can be affected by many unforeseen factors.
• Considers Only Monetary Information: Analysis focuses only on what can be measured in money. It ignores important non-monetary aspects like the quality of management, employee morale, or brand reputation, which are crucial for a company's success.
• Does Not Reflect Current Position: Since statements are based on accounting concepts and historical data, they may not show the true current market value or financial health of the business.